Introductory Macroeconomics 2020 2021

Introductory
Macroeconomics
T.R. Jain Dr. V.K. Ohri
Former Principal Associate Professor(Retd.)
S.A. Jain College Shyam Lal College
Ambala City (Delhi University), Delhi
Class XII
Printing History: Edition: 2020-21
Syllabus Covered: Central Board of Secondary Education, Delhi
Medium: ENGLISH (Hindi medium is also available)
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Price: Three Hundred Sixty Rupees (� 360/-)
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ISBN: 978-93-89452-93-8
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Contents
Introductory Macroeconomics
1. Introduction..........................................3
2. Some Basic Concepts of Macroeconomics ...............15
3. National Income and Related Aggregates ................51
4. Methods of Calculating National Income ................ 81
5. Money.............................................133
6. Banking............................................ 151
7. Aggregate Demand, Aggregate Supply and

Related Concepts....................................177
8. Short Run Equilibrium Output ........................ 213
9. Problem of Deficient Demand

and Excess Demand .................................255
10. Government Budget and The Economy ................291
11. Foreign Exchange Rate...............................333
12. Balance of Payments ................................365
• Solved Numericals
• Unsloved Numericals
• Project Work
• CBSE Sample Question Paper, 2020 (Solved)

Syllabus
Central Board of Secondary Education, Delhi
Economics
Class-XII
Paper One 3 Hours Theory: 80 Marks
Project: 20 Marks
Units Periods Marks
Part-A: Introductory Macroeconomics
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1. National Income and Related Aggregates 28 10
2. Money and Banking 15 06
3. Determination of Income and Employment 27 12
4. Government Budget and the Economy 15 06
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5. Balance of Payments
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100 40
Part-B: Indian Economic Development
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6. Development Experience (1947-90)
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and Economic Reforms since 1991 28 12
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7. Current Challenges facing Indian Economy 22
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8. Development Experience of India
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A Comparison with Neighbours 12

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Part-C: Project Work 20 20

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PART-A: INTRODUCTORY MACROECONOMICS

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Unit-1: National Income and Related Aggregates (28 Periods)
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What is Macroeconomics?
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Basic concepts in macroeconomics: consumption goods, capital goods, final
goods, intermediate goods; stocks and flows; gross investment and
depreciation.
Circular flow of income (two sector model); Methods of calculating National
Income-Value Added or Product method, Expenditure method, Income
method.
Aggregates related to National Income:
Gross National Product (GNP), Net National Product (NNP), Gross and Net
Domestic Product (GDP and NDP)-at market price, at factor cost; Real and
Nominal GDP.
GDP and Welfare.
Unit-2: Money and Banking (15 Periods)

Money-meaning and supply of money-Currency held by the public and net
demand deposits held by commercial banks.
Money creation by the commercial banking system.
Central bank and its functions (example of the Reserve Bank oflndia): Bank of
issue, Government Bank, Banker's Bank, Control of Credit through Bank Rate,
CRR, SLR, Repo Rate and Reverse Repo Rate, Open Market Operations, Margin
requirement.
Unit-3: Determination oflncome and Employment (27 Periods)

Aggregate demand and its components.
Propensity to consume and propensity to save (average and marginal).
Short-run equilibrium output; investment multiplier and its mechanism.
Meaning of full employment and involuntary unemployment.
Problems of excess demand and deficient demand; measures to correct
them-changes in government spending, taxes and money supply.
Unit-4: Government Budget and the Economy (15 Periods)

Government budget-meaning, objectives and components.
Classification of receipts-revenue receipts and capital receipts; classification of
expenditure-revenue expenditure and capital expenditure.
Measures of government deficit-revenue deficit, fiscal deficit, primary
deficit-their meaning.
Unit-5: Balance of Payments ( 15 Periods)

Balance of payments account-meaning and components; balance of payments
deficit-meaning.
Foreign exchange rate-meaning of fixed and flexible rates and managed
floating.
Determination of exchange rate in a free market.
PART-B: INDIAN ECONOMIC DEVELOPMENT
Unit-6: Development Experience (1947-90) and
Economic Reforms since 1991 (28 Periods)
A brief introduction of the state oflndian economy on the eve of independence.
Common goals of Five Year Plans.
Main features, problems and policies of agriculture (institutional aspects and
new agricultural strategy, etc.), industry (industrial licensing, etc.) and foreign
trade.
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Economic Reforms since 199 1:
Features and appraisals of liberalisation, globalisation and privatisation (LPG
policy); Concepts of demonetization and GST.
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Unit-7: Current Challenges facing Indian Economy (60 Periods)
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Poverty-absolute and relative; Main programmes for poverty alleviation: A
critical assessment.
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Rural Development: Key issues-credit and marketing-role of cooperatives;
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agricultural diversification; alternative farming-organic farming.
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Human Capital Formation: How people become resource; Role of human
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capital in economic development; Growth ofEducation Sector in India.
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Employment: Formal and informal growth; problems and policies.

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Infrastructure: Meaning and Types: Case Studies: Energy and Health: Problems
and Policies-A critical assessment.
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Sustainable Economic Development: Meaning, Effects of Economic

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Development on Resources and Environment, including global warming.

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Unit-8: Development Experience oflndia
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A Comparison with Neighbours ( 12 Periods)
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India and Pakistan
India and China
Issues: growth, population, sectoral development and other Human
Development Indicators.
Design of Question Paper
Central Board of Secondary Education, Delhi
Economics
Class XII Theory: 80 Marks
Duration: 3 Hours Project: 20 Marks
s.
No.
Typology of
Questions
Objective Short Short
Type/MCQ Answer I Answer II
II Answer
Long Marks
I Mark 3 Marks 4 Marks 6 Marks

1. Remembering:
Exhibit memory of previously
learned material by recalling 5 1 2 1 22
facts, terms, basic concepts,
and answers.
2. Understanding:
Demonstrate understanding
of facts and ideas by
organizing, comparing, 5 1 2 1 22
translating, interpreting,
giving descriptions, and
stating main ideas.
3. Applying:
Solve problems to new
situations by applying acquired 5 1 1 1 18
knowledge, facts, techniques
and rules in a different way.
4. Analysing and Evaluating:

Examine and break information
into parts by identifying
motives or causes. Make
inferences and find evidence
to support generalizations.
Present and defend opinions
by making judgments about 5 1 1 1 18
information, validity of ideas,
or quality of work based on
a set of criteria.
Creating: Compile information
together in a different way
by combining elements in a
new pattern or proposing
alternative solutions.
Total 20xl=20 4 X 3 = 12 6 X 4= 24 4x 6= 24 80 (34)
Note: There will be Internal Choices in questions of I mark, 3 marks, 4 marks and 6 marks in both sections (A & B).
In all, total 8 internal choices.
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INTRODUCTORY
MACROECONOMICS
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Meaning of Macroeconomics
How Macroeconomics Differs from Microeconomics?
Scope and Significance of Macroeconomics
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I. MEANING OF MACROECONOMICS
The term Macro in English has its origin in the Greek term Makros
which means Large. In the context of macroeconomics, 'large' means
economy as a whole. Thus, macroeconomics is defined as that branch
of economics which studies economic issues or economic problems at
the level of an economy as a whole. It studies such economic questions
that concern the welfare of all residents of a country. These questions
are like of employment for the residents, growth of output in the
economy, the problem of price rise (called inflation) or the problem
of depression (lack of demand for goods and services across different
sectors of the economy) and so on. Macroeconomics also studies how
government can improve the state of economy of a country.
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In the words of M.H. Spencer, "Macroeconomics is concerned with the economy as a whole or
large segments of it. In macroeconomics, attention is focused on such problems as the level of
unemployment, the rate of inflation, the nation's total output and other matters of economy-wide
significance."
2. HOW MACROECONOMICS DIFFERS

FROM MICROECONOMICS?
You have already studied microeconomics at +1 level. Now that you
have understood the meaning of macroeconomics, you can draw a
distinction between micro and macro economics, as under:
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(I) Basis of the Study
Microeconomics studies problems of scarcity and choice at the level
of an individual, a household, a firm or an industry.
Macroeconomics studies problems of scarcity and choice at the level
of an economy as a whole.
Illustration
Microeconomics studies how a consumer exercises his choice of goods
and services so that he maximises his satisfaction with a given income.
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Macroeconomics studies how the national resources are used (for the
production of defence goods or consumer goods) so that the welfare
of all the residents is maximised.
(2) Economic Variables
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Microeconomics uses microeconomic variables such as consumer's
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Macroeconomic
Variables demand or producer's supply.
Macroeconomic variables
are those economic Macroeconomics, on the other hand, uses macroeconomic variables
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variables which are studied such as aggregate demand (referring to demand for all the goods and
at the level of economy as
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services in the economy) and aggregate supply (referring to supply of
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a whole. These variables
are important components all the goods and services in the economy).
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of the subject matter of
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macroeconomics.
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The important ones are: (3) Economic Agents
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• Level of employment in
the economy,
Economic agents refer to the individuals and institutions who take
economic decisions. Individual economic agents include consumers
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• National income,
• Aggregate demand, and producers. They focus on the maximisation of personal gains.
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• Aggregate supply, Institutional economic units include state or statutory bodies [like
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• Consumption RBI (Reserve Bank of India), SEBI (Securities and Exchange Board of
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expenditure in the
economy, and India) and TRAI (Telecom Regulatory Authority of India)]. They focus
• Investment expenditure on the maximisation of social welfare. At the micro level, economic
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in the economy. decisions are taken largely by the individual economic agents, while at
the macro level institutional agents play a significant role.
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(4) Degree of Aggregation

In microeconomics, there is a limited degree of aggregation of
economic variables, compared to macroeconomics.
Illustration
Microeconomics studies equilibrium of an industry; it is an aggregation
of all the firms producing a particular commodity.
Macroeconomics studies equilibrium of the economy as a whole; it is
an aggregation of all economic units in the economy.
4 Introductory Macroeconomics
However, important it is to note that with a view to examine structural
change in the economy, macroeconomics also studies the level of
economic activity in agricultural sector, industrial sector and services
sector, separately.
(5) Different Set of Assumptions

Microeconomics and macroeconomics are based on a different set
of assumptions. Certain variables are assumed to be constant in
microeconomics, whereas they are assumed to be changing in macro;
similarly, certain variables that are assumed to be constant in macro
are assumed to be changing in microeconomics.
Illustration
In microeconomics, total output and employment are taken as
constant while these are important variables in macroeconomics.
In macroeconomics, distribution of output/income is taken as
constant, while it is an important variable in microeconomics.
( 6) Central Issue
Allocation of resources is the central issue in microeconomics.
Determination of the overall level of output (and employment) is the
central issue in macroeconomics.
(7) Method of Study

Method of study in macroeconomics is often described as 'general
equilibrium analysis'. On the other hand, method of study in
microeconomics is often described as 'partial equilibrium analysis'.
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Q. Distinguish between partial equilibrium and general equilibrium.
Ans. Partial equilibrium refers to equilibrium in one market (say, commodity market) on the
assumption that there is no change in other markets (like labour market or capital market).
General equilibrium refers to simultaneous equilibrium in all the markets in the economy. Partial
equilibrium is the method of study in microeconomics. General equilibrium is the method of
study in macroeconomics.
(8) Micro-Macro Paradox

What is logical at the micro level may not be logical at the macro level.
Illustration
- If an individual saves more, he adds to his future prosperity.
Introduction 5
- If all the people in an economy save more (and spend less), demand
for goods and services may decline. Consequently, investment may
decline; production and employment level may fall. The economy
will be driven towards future poverty rather than prosperity.
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Q. Is saving a virtue or a vice?
Ans. From the viewpoint of an individual, saving is a virtue. He can deposit his savings in a bank and can
earn a regular income. But, from the viewpoint of the economy as a whole, saving may prove to be
a vice. When everybody saves more, expenditure tends to decline. It causes a decline in aggregate
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demand. A fall in aggregate demand causes a fall in investment. Implying a fall in production and a
fall in the level of employment. The economy may be driven into the state of depression.
3. SCOPE AND SIGNIFICANCE OF

MACROECONOMICS
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Scope
Scope of macroeconomics refers to the field of study (or area of
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study) of macroeconomics. It includes the following leading issues (in
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accordance with the CBSE syllabus for the +2 graders):
(1) Estimation of National income and Related Aggregates:
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Macroeconomics starts with the concept of national income. It
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deals with the definition and estimation of national income and

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its related aggregates like GDP (Gross Domestic Product) and

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NDP (Net Domestic Product).

(2) Theory of Employment: Macroeconomics studies the theories
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related to employment (or unemployment) in the economy.

Keynesian theory of employment is of notable significance in this
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context. It explains the causes of unemployment, and suggests

the possible remedies to combat it.
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(3) Theory of Money: Creation of money (or creation of credit) by the

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commercial banks is an important component of macroeconomics.

Linked to it, is the role of Central Bank of a country (RBI in India)
in regulating the supply of money in the economy.
(4) Theory of General Price Level-Inflationary and Deflationary Gaps:
This is yet another significant component of macroeconomics.
It reveals the trend path of the general price level leading to
inflationary and deflationary gaps in the economy.
(5) Role of the Government (or Government Budget):
Macroeconomics studies how government budget impacts the
level of economic activity in the economy.
(6) Exchange Rate and Balance of Payments: Determination of
exchange rate and the way it is managed (in the international
money market) is an important element of the scope of
macroeconomics.
Briefly, as a specialised branch of economics, macroeconomics focuses
on such issues which explain (i) how an economy functions, and (ii) how
can it be managed (or regulated), so that social welfare is maximised.
Significance
The following observations highlight the significance of macroeconomics:
(1) Description of the Economy: Macroeconomics offers a deep
description of the economy.
• Estimation of national income (across different sectors) reveals
the nature and level of economic activity in the economy.
• Study of unemployment reveals the magnitude of the problem
and the way it can be handled.
• Government budget reveals the way economy is regulated
by the government.
(2) Roadmap of Growth and Development: Macroeconomics
offers a roadmap of growth and development. Programmes and
policies of economic growth are drawn by assessing the needs
and means of the economy.
(3) Economic Stability: Study of macroeconomics helps achieve
economic stability. This is achieved through appropriate monetary
policy (pursued by the Central Bank of the country) and fiscal
policy/budgetary policy (pursued by the government).
(4) BoP (Balance of Payments) Status: BoP status of a country
reveals performance of the economy in relation to rest of the
world. Balance of trade (Export and Import) shows our capacity
to export and compulsion to import.
(5) Problems of Poverty and Environmental Pollution: Macroeconomics
offers insights into the problems of poverty and environmental
pollution. It is by using macro-models that these problems are
addressed.
(6) Poli cy Formulation: Information relating to macroeconomic
variables (like aggregate demand, aggregate supply, total
consumption and investment expenditure in the economy,
output across different sectors of the economy and the like) is
extremely useful in the formulation of policies for the growth and
development of the country.
lntrod{lction 7
Emerging challenges of the economy become evident only
through macroeconomic data.
In short, we can say that the knowledge of macroeconomic variables
and macroeconomic models is extremely essential in understanding
the performance of the economy, as well as in the formulation of
policies and programmes for its growth and development.
Power Points & Revision Window ------------

Macroeconomics is that branch of economics which studies economic problems (or economic issues) at
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the level of economy as a whole.
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Microeconomics as different from Macroeconomics
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Microeconomics deals with the problem of choice and scarcity at the
individual level, while macroeconomics does it at the level of economy as a
whole.
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Microeconomics uses microeconomic variables (like consumer's demand and
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producer's supply}, while macroeconomics uses macroeconomic variables (like
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AD and AS}.
Microeconomics involves lesser degree of aggregation than the macroeconomics.
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Microeconomics and macroeconomics are based on different set of assumptions.
Allocation of resources is the central issue in microeconomics, while in macroeconomics the central
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issue is the determination of national income and employment.
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What is ideal at the micro level (like, saving by an individual) may not be ideal at the level of an economy
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as a whole.
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Scope and Significance of Macroeconomics
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! Scope: (i) Estimation of national income and related aggregates, (ii) Theory of employment, (iii) Theory
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of money, (iv) Theory of general price level: inflationary and deflationary gaps, (v) Role of the
government (or government budget}, (vi) Exchange rate and balance of payments.
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Significance: (i) Description of the economy, (ii) Roadmap of growth and development, (iii) Economic
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stability, (iv) BoP (Balance of Payments) status, (v) Problems of poverty and environmental pollution,
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(vi) Policy formulation.

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rEXERCISEj
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1. Objective Type Questions (Remembering & Understanding based Questions)
A. Multiple Choice Questions

Choose the correct option:
1. Macroeconomics is concerned with:
(a) the level of output of goods and services in the economy
(b) the general level of prices
(c) GDP growth
(d) all of these
2. Study of general price level is a subject matter of:
(a) microeconomics (b) macroeconomics
(c) both (a) and (b) (d) none of these
3. Aggregation is involved in:
(a) microeconomics (b) macroeconomics
(c) both (a) and (b) (d) none of these
4. Economic agents include:
(a) government (b) consumers
(c) producers (d) all of these
5. Which of the following statements is associated with general equilibrium analysis?
(a) Equilibrium in the market of gold ornaments
(b) Equilibrium across all markets in the economy
(c) Equilibrium price of a good in the competitive market
(d) None of these
Answers
1. (d) 2. (b) 3. (c) 4. (d) 5. (b)
B. Fill in the Blanks
Choose appropriate word and fill in the blank:
1. Aggregate demand is not a variable. (micro/macro)

2. is related to the economy as a whole. (Microeconomics/Macroeconomics)
3. Study of price behaviour in India will come under the preview of
(microeconomics/macroeconomics)
4. Monetary and fiscal policies of the government are a part of analysis.
(microeconomic/macroeconomic)
5. From the viewpoint of economy, saving leads to in aggregate demand. (rise/fall)
6. Allocation of resources is the central issue in . (microeconomics/macroeconomics)
7. Determination of overall level of output is the central issue in
(microeconomics/macroeconomics)
Answers
1. micro 2. Macroeconomics 3. macroeconomics 4. macroeconomic
5. fall 6. microeconomics 7. macroeconomics
C. True or False
State whether the following statements are True or False:

1. Microeconomics studies the problem of scarcity and choice at the level of
economy as a whole. (True/False)
2. General equilibrium relates to macroeconomics. (True/False)
3. Output of a firm is not a macro variable. (True/False)
4. Aggregation is involved only in macroeconomics. (True/False)
Introduction 9
5. If an individual saves more, he adds to his future prosperity. However,
if an economy saves more, it may be driven towards future poverty. (True/False)
6. What is logical at the macro level may not be true at the micro level. (True/False)
7. A profit-maximising firm is not an economic agent. (True/False)
Answers
1. False 2. True 3. True 4. False 5. True 6. True 7. False
D. Matching the Correct Statements
I. From the set of statements given in Column I and Column II, choose the correct pair of statements:
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Column I Column II
(a) General equilibrium (i) Microeconomics
(b) Commodity market (ii) Partial equilibrium
(c) Microeconomics (iii) Total output and employment are taken as constant
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(d) Problem of unemployment in India
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(e) Macroeconomics (v) Study of price behaviour of a firm
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(c) Microeconomics -(iii) Total output and employment are taken as constant
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II. Identify the correct sequence of alternatives given in Column II by matching them with respective
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items in Column I.
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Column I Column II
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(a) Macro (i) Limited degree of aggregation of economic variables

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(b) National income (ii) Central issue of macroeconomics

(c) Partial equilibrium (iii) Means large
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(d) Microeconomics (iv) Equilibrium in one market

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(e) Determination of overall level of output (v) A macroeconomic variable
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(a)-(iii), (b)-(v), (c)-(iv), (d)-(i), (e)-(ii)

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E. 'Very Short Answer' Objective Type Questions

1. Define macroeconomics.
Ans. Macroeconomics is the study of economic relationships, economic problems or economic issues
at the level of economy as a whole, like the problem of inflation or of unemployment.
2. Define microeconomics.
Ans. Microeconomics is the study of economic relationships, economic problems or economic issues at
the level of an individual like a consumer, or a producer.
3. Give two examples of macroeconomic studies.
Ans. (i) Study of price behaviour in India, and
(ii) Study of unemployment in India.
4. Give two examples of microeconomic studies.
Ans. (i) Study of consumer behaviour: consumer equilibrium & law of demand, and
(ii) Study of price determination in the commodity market.
5. Give two examples of macroeconomic variables.
Ans. (i) Aggregate supply, and
(ii) Aggregate demand.
6. What is meant by economic agents?
Ans. Economic agents are the individuals or institutions who take economic decisions.
2 . Reason-based Questions (Com prehension of the Subject- matter)
Read the following statements carefully. Write True or False with a reason.
1. Study of the problem of unemployment in India is considered a microeconomic study.
Ans. False. Problem of unemployment in India is an economic issue at the level of economy as a whole,
hence considered as macroeconomic study.
2. Aggregation is involved only in macroeconomics.
Ans. False. The difference lies in the degree of aggregation. While in microeconomics, aggregation
is done at the level of an individual household, an individual industry or an individual market, in
macroeconomics, aggregation is done at the level of an economy as a whole.
3. Monetary and fiscal policies of the government are a part of macroeconomic analysis.
Ans. True. Both these policies are related to issues of growth and development at the level of the economy
as a whole.
4. Aggregate demand in macroeconomics is identical with market demand in microeconomics.
Ans. False. Aggregate demand is the sum total of demand for all the goods and services in the economy
whereas market demand refers to demand for a particular commodity in the market.
5. 'Save more' is always a virtue.
Ans. False. Saving is a virtue at the micro level but not necessarily at the macro level. Because, greater
saving implies lesser expenditure, lesser demand and therefore lower inducement to invest.
6. Problem of scarcity and choice ceases to exist at the macro level when resources of the entire
nation are pooled together.
Ans. False. Even if resources of the entire nation are pooled together, these continue to be scarce in
relation to the aggregate demand of the economy.
3. H OTS & Applications

1. Macroeconomics is the study of aggregates while microeconomics is not. Comment.
Ans. It is wrong to state that there is no aggregation in microeconomics.
It is in microeconomics that we study concepts like market demand which is the aggregate of
individual demand for a commodity. However, the difference lies in the degree of aggregation. While in
microeconomics, aggregation is done at the level of an individual household, an individual industry or
an individual market, in macroeconomics, aggregation is done at the level of an economy as a whole.
2. What is true at the micro level may be a paradox at the macro level? Explain with an example.
Ans. What is true at the micro level may not be true at the macro level. This is the meaning of paradox.
Example: Saving is a virtue for an individual. If he saves more, he accumulates more wealth and
therefore enhances his ability to earn more. But at the macro level, if everyone starts saving more,
demand for goods and services may decline to the extent that there is no inducement to invest.
Consequently, income and production level may reduce.
Introduction 11
3. Do you think that the general price level is of any relevance at the micro level?
Ans. General price level is a macro issue. But it is of great significance at the micro level. An individual
producer would always monitor the trend path of the general price level. If prices are rising, business
expectations are high. It induces investment. If, on the other hand, prices are falling, business
expectations turn to be sluggish. Inducement to invest is hurt. Accordingly, investment is reduced.
4. Analysis & Evaluation
1. What may happen if savings are encouraged in an economy?

Ans. Increased savings are not good for the economy because (in absence of increased investment) they
cause a fall in the level of AD (aggregate demand), because of which the level of employment or
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output may fall. However, if increased savings are mobilised and converted into capital formation
they become instrumental in the growth of economy by boosting the level of employment or output
or income.
2. What do you think is the significance of macroeconomic agents in the economy? Support your
answer with example.
Ans. Macroeconomic agents refer to the institutions as decision-makers in the economy. RBI (Reserve
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Bank of India) is an example of macroeconomic agent in India.
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The R B I plays a significant role in monitoring the supply of money in the economy. Excess supply of
money may lead to inflation while deficient supply may lead to deflation. By regulating the supply of
money, the RBI combats the situations of inflationary and deflationary gaps in the economy.
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5. N CERT Questions (With H ints to Answers)
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1. What is the difference between microeconomics and macroeconomics?
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[ Hint: (i) Microeconomics studies economic issues or economic problems at the level of an
individual- an individual firm, an individual household or an individual consumer. On the other hand,
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macroeconomics studies economic issues or economic problems at the level of an economy as a

whole.
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(ii) Allocation of resources to different uses is the central issue in microeconomics. On the other hand,
determination of the level of output and employment is the central issue in macroeconomics.
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(iii) There is a smaller degree of aggregation in microeconomics. Example: We study output

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behaviour of an industry which is aggregate of all the firms producing a particular commodity.
On the other hand, there is a larger degree of aggregation in macroeconomics. Example: We
study national output which is aggregate of output of all the producing units in the economy.]
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2. Describe the Great Depression of 1929.

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[ Hint: It was precisely in 1929 that great depression affected developed economies of the capitalistic
world. Its impact continued almost for the entire decade of 30's. During that worldwide depression,
there was a persistent fall in the level of employment and output. In USA, unemployment shot up
from 3% to 25% between the period 1929-33. Fall in employment was accompanied with a fall in
GDP. Between the period 1929-33, GDP in USA fell by about 33%.)
6. M iscellaneous Questions and Reference to the Text for Answers
A. Questions of 3 & 4 marks each

1. What do you mean by macroeconomics? [Page 3)
2. State the scope of macroeconomics. [Page 6, 7)
3. State any four differences between microeconomics and macroeconomics. [Page 3-6]
4. What is the difference between partial equilibrium and general equilibrium? [Page 5]
B. Questions of 6 m a rks each

1. What is meant by macroeconomics? Discuss its scope. [Page 3, 6, 7]
2. Explain the differences between microeconomics and macroeconomics. Give suitable examples.
[Page 3-6]
3. What is the significance of macroeconomics? [Page 7, 8]
DOs and DON'Ts

1. Do n ot ever conclude that there is n o aggregation of economic u n its i n microeconomics (or that, there
is aggregation of economic units only i n macroeconomics) . There is aggregation of economic u n its i n
m icroeconomics a s well, thou gh to a lim ited extent. Thus, when w e study eq u ilibri u m of the i n d u stry
(or m arket eq u ilibri um), we a re foc u s i n g o n aggregation of the firms.
2. Do not ever consider a situation a s good or bad both at the micro and macro levels. What is g ood at
the micro level may not be good at the macro level. Thus, a n ind ividual prod ucer may find prod uction
of liq uor as more profitable busi ness than the prod uction of clean domestic fuel . B ut at the level of the
economy a s a whole, the government may d iscourage the prod uction of liquor through heavy taxation,
and encourage the prod uction of clean domestic fuel through s u bsidy.
...,........ • Emergence of M acroeconom ics as a Separate Branch of Economics

G reat Depression of 1 930's i s a l a n d mark event that led to the emergence
of macroeconom ics as a separate branch of economics. It does n ot mean
that the concept of macroeconomics d id not exi st prior to this event. But
macroeconom ics (prior to the G reat Depressi on) was considered more l i ke an
extension of microeconom ics: it did not exist a s a sepa rate (or specia l i sed)
branch of economics. Of course, there was a reason to it:
It was bel ieved by the (classical) economists that the princi ples of
microeconom i cs were enough to expl a i n the behaviour of the economy as a
whole. The a rg u ment runs l i ke th is:
• M i croeconomics teaches us that (i n pursuit of self-i nterest) every i ndivi d u a l
(i n a ma rket economy or a free economy) maximi ses his sati sfaction with
h i s g iven income.
• Maxim isation of i n d ivi d u a l sati sfaction (or welfare) i m p l ies the maxi misation
of welfare of all the i n d ividuals i n the economy. It i m p l ies maxi m i sation of
soc i a l welfare.
• I f social welfare is maxi mised, the scarce resou rces i n the economy must
have been opt i ma l ly uti l ised.
• M i croeconom ics fu rther teaches us that i n a free economy (or u nder
perfect com petition), all ma rkets tend to be in a state of eq u i l i bri u m . Thus,
i n the l a bou r ma rket S L = D L (su pply of labour = demand for l a bour) . It i s a
situation of fu l l employment.
Introduction 13
• There cou l d be unemployment when S L > D L . But, i n such a situation wage
rate wou l d fa l l , lea d i n g to a fa l l i n S L and rise i n D L . Eventu a l ly, the situation
of fu l l emp loyment wou l d a utomatica l ly be restored . T h u s, fu l l employment
i s a norm a l featu re of a ma rket economy.
Briefly, the pri ncip les of microeconom i cs expla i n that i n a free econ omy:
(i) social welfare is maxi m i sed,
(ii) resou rces a re opti m a l ly uti l i sed, a n d
(ii i) fu l l employment is a norma l situ ation.
Accord i n g ly, the classical econom i sts conclu ded that the pri nciples of
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microeconom i cs were enou gh to exp l a i n the behaviour of the economic
activity at the macro leve l . There was no need to consider macroeconomics as
a sepa rate bra n ch of economics.
• G reat Depression of 1 930's contradicted the Classical Thought

During the depression of 30's, economic events u nfol d ed i n such a manner
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that the c l assica l thought was tota lly contradicted . Fo l lowi n g poi nts a re of
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notable s i g n ifica nce in this reg ard:
(i) The depression of 30's led to huge unemp loyment i n the developed
cou ntries of the worl d (North America and Europe) .
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(i i) I n USA, unemployment shot up from 3 % to 25% between the period 1 929-33.
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(i i i) Fa l l in employment was accompan ied with a fa l l in GDP, Between the
period 1 929-33, G D P in USA fel l by about 33%.
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(iv) Fa l l in G D P led to a fa l l i n AD (agg regate dema nd) . Accord i n g ly, there were
d rastic cuts i n output a s planned by the producers across a l l sectors of
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the economy.
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(v) Cut i n p l a n ned output i m p l ied a fu rther fa l l i n employment a n d G D P i n the

economy.
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Th us, during the depression of 30's, the western econom ies were d riven i nto
the vicious circle of low demand and low G D P. Th i s circle operated as under:
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Low AD � Low p l a n ned output � Low level of employment � Low G D P

� Low AD
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This is ca l led 'Low Level Equ i l ibri u m Tra p' .

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The classical econom ists fa i l ed to fi nd any a n swer to this low level eq u i l i bri u m
tra p . Ma rket forces o f s u p p l y a n d d e m a n d fa i l ed t o brea k i t . It is i n s u c h a
situation that macroeconomics emerged as a sepa rate branch of econom ics.
Prof. Keynes was the pioneer i n the field of mod ern macroeconomics. He
invented severa l macroeconomic vari a b l es (l i ke AD a n d AS) a n d form u lated a
macroeconom i c model to b reak the vicious c i rcle of 'low level eq u i librium tra p'.
He diagnosed lack of AD as the root cause of the problem, and suggested large
scale expend itu re by the govern ment as a remedy.
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•
•
Classification of Goods:
(i) Final Goods and Intermediate Goods
(ii) Consumption Goods and Capital Goods
Concept and Components of Consumption Expenditure
,,
• Concept and Components of Investment
• Stocks and Flows
• Four Sectors of the Economy
• lntersectora/ Flows-Rea/ Flows and Money Flows
• Circular Flow of Income
I. CLASSIFICATION OF GOODS
Countless number of goods are produced and consumed in the economy.
These are like shoes and shirts for the school children, machines and
tools for the farms and firms, guns and ammunition for the defence
forces, ships and airplanes for tourists, and so on. Different goods show
different characteristics. Broadly, goods are classified in two ways:
(i) Final Goods and Intermediate Goods, and
(ii) Consumption Goods and Capital Goods.
Classification of Goods
Consumption Goods
0 Final Goods � or
Consumer Goods
& &
Intermediate Goods Capital Goods
15
Following is a brief description of these categories:
Final Goods
These are those goods which have crossed the boundary line of
production and are ready for use by their final users. Who are the final
users? These are (i) consumers, and (ii) producers. Accordingly, final
goods are often classified as: (i) final consumer goods, and (ii) final
producer goods. Final consumer goods are finally purchased by the
consumers for the satisfaction of their wants. Final producer goods
are finally purchased by the producers and are generally used as fixed
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assets in the process of production.
F®CUS Final consumer goods are the goods which are ready for use by their final users, and
consumers are their final users. Example: Bread and butter, as used by the consumers.
ZONE Final producer goods are the goods which are ready for use by their final users,
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and producers are their final users. Example: Tractors and harvesters, as used by
the farmers.
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Expenditure on final consumer goods by the households is called
consumption expenditure. Expenditure on final producer goods by the
or
producers is called investment expenditure. Accordingly,
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Expenditure on Final Goods = Consumption expenditure+ Investment
expenditure.
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Expenditure on Final Goods = Consumption expenditure + Investment expenditure
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What do we mean when we say that final goods have crossed

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the boundary line of production? We mean that these goods are

out of the process of production or the process of value addition.
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Example: A shirt in a retail showroom is all set for sale to its final
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user. No value is to be added to the shirt by way of stitching,

ironing, packaging, etc. The only value addition left now is when it
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is actually sold to the consumer, who is its final user. If the retailer
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purchases this shirt for � 900 from the wholesaler and sells for
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� 1,000 to the consumer, there is value addition of �100 (= � 1,000

- � 900). This is the final stage of value addition to the shirt. Once it
is sold to the consumer (the final user) the shirt will be treated as out
of the boundary line of production, and shirt worth � 1,000 counted
as a final good. You may note that only final goods are included in the
estimation of national product or national income.
Intermediate Goods
Intermediate goods are those goods (i) which have yet not crossed
the boundary line of production, (ii) value is still to be added to
these goods, and (iii) which are yet not ready for use by their final
users. In other words, intermediate goods are those goods which
are purchased by one firm from the other firm: (i) as raw material, or
(ii) as goods for resale. Example: Shirts purchased by firm X from firm Y
for resale are intermediate goods. Because, value is to be added to
the shirts through resale. Likewise, wood purchased by a carpenter
(from a timber merchant) for making chairs is an intermediate good.
Because, wood is used as a raw material for making chairs. Value is to
be added to wood by converting it into chairs.
Intermediate goods are those goods which are within the boundary line of production, value is yet
to be added to these goods, and these goods are yet not ready for use by their final users.
Or
Intermediate goods are those goods which are purchased by one firm from the other either for
resale or for use as a raw material.
Value of intermediate goods ultimately becomes a part of the

value of final goods. Example: When a carpenter buys wood worth
� 10,000 and converts it into chairs worth � 20,000, then the value
of chairs (final goods) includes the value of wood (intermediate
good). Accordingly, intermediate goods are not included in the
estimation of national product or national income. Otherwise,
there would be duplication in the estimation of national product, called
'Double Counting' (counting the value of a good more than once).
Expenditure on intermediate goods by the producers during an accounting year is called
intermediate consumption or intermediate cost. If intermediate consumption is F@CUS
deducted from the value of output, we get 'gross value addition' (also called Gross Value ZONE
Added, or Gross Product of the producer). Thus,
Value of Output (say chairs)
- Intermediate consumption (cost of wood and other material used in the production
of chairs)
= Gross value addition or gross product of the producer.
The Same Good May be Final or Intermediate

It is not possible to name one set of goods as final goods and
another set as intermediate goods. The same good may be final or
intermediate good. The distinction depends on the end-use of the
goods. To illustrate, sugar used as a raw material in the production of
biscuits is an intermediate good. But, sugar used by the households
in milk or tea is a final good. Likewise, paper purchased by a student
is a final good. But when purchased by a publisher (for making
books), it is an intermediate good.
Some Basic Concepts of Macroeconomics 17

What Matters is the End-use of Goods
Note While classifying goods as final or intermediate, what matters is the
End-use of the goods end-use of goods. You are to check what end-use a good is put to.
is the principal basis of
classifying the goods as
If it is used by the producers as a raw material, it is to be treated
intermediate goods and as an intermediate good. Also, if it is purchased and resold by the
final goods. producers, it is to be treated as an intermediate good. But if it is used
by the producer as a fixed asset (like a tractor used by the farmer), it
is to be treated as a final good. And, of course, goods purchased by
the households for final consumption, are to be treated as final goods.
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Thus, a good as such is not to be named as final or intermediary. Milk
as such is not to be taken as final or intermediary. It is to be treated as
final or intermediary depending on its end-use. It may also be noted
that a good may be used partly as an intermediary and partly as final.
Thus, the entire milk sold by the dairy farmers in a village may not
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be a final good. Only that part of it is to be treated as final good
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which is sold to the consumer households. The other part which is
sold to the producers for making sweets (and which is used as a raw
material) is to be treated as an intermediate good.
or
Intermediate and Final Goods-The Difference
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1-------•n _t _e _rm_e_d _ia _ t_ e_G_o_o_d_s___-+--____F_ ni _a_l_G_ o_o_d_s____----1
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{i} These goods remain within the {i) These goods are outside the
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boundary line of production, and boundary line of production, and
are not ready for use by their final are ready for use by their final
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users. users.
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{ii) These goods may be used as raw {ii} These goods are not used as raw
material for the production of material for the production of
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other goods during the accounting other goods during the accounting
year. year.
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(iii) These goods may be resold by {iii) These goods are not resold by
the firms for profit during the the firms for profit during the
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accounting year. accounting year.

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(iv) Value is yet to be added to these (iv) Value is not to be added to these
goods. goods.
(v) Expenditure on these goods is (v) Expenditure on these goods is
called intermediate consumption called final expenditure(= C + l}.
or intermediate cost.
(vi) These goods are not included in (vi) These goods are included in the
the estimation of national product estimation of national product or
or national income. national income.
[Note: Accounting year is the year during which production of goods and
services is estimated in the domestic economy. Or, it is the year during
which national product/national income is estimated for the country.]
t>TS
Q. 1. How would you find out whether a particular expenditure is an expenditure on intermediate goods
or on final goods?
Ans. Expenditure on final goods must lead to: (i) final consumption expenditure (C), or (ii) investment
expenditure (I). The expenditure which does not lead to C and I (like the expenditure on raw material)
is to be treated as an expenditure on intermediate goods. Expenditure on intermediate goods leads
to intermediate consumption or intermediate cost.
Q. 2. Purchase of a car always means the purchase of a final good. Do you agree?
Ans. No. It depends on the end-use of the car. If it is purchased by a household, it is a final good. It is like
a consumer durable.
If it is purchased by taxi-operators, then again it is a final good, as it is to be finally used by the
producer as a fixed asset.
However, if the car is purchased by a retail dealer from the factory for the purpose of resale, it is to
be treated as intermediate good.
Consumption Goods or Consumer Goods

Consumption goods (or consumer goods) are those goods which are
directly used for the satisfaction of human wants. Example: Ice cream
and milk as used by the households. These goods are consumed by
the households when purchased.
Consumption goods are broadly classified into four categories, as
under:
Consumption Goods/Consumer Goods
Durable Semi-durable Non-durable Non-material

Goods Goods or
Goods Goods Services
(1) Durable Consumption Goods: Durable consumption goods are

those goods which can be used for several years and are of
relatively high value. These goods are repeatedly used before
being discarded as useless. TV, radio, car, scooter, washing
machine are some examples of durable consumption goods.
(2) Semi-durable Consumption Goods: Semi-durable consumption
goods are those goods which can be used for a period of one
year or slightly more. These goods are not of very high value.
Clothes, furniture, crockery, electric goods, etc., are the examples
of semi-durable consumption goods.
(3) Non-durable or Single-use Consumption Goods: Non-durable or
single-use consumption goods are those goods which are used-up

in a single act of consumption. For example, the bread that
you eat is used-up in a single act of consumption. The same
bread cannot be used again. Also these goods are of relatively
low value. Ink, domestic LPG, milk and petrol are some other
examples of non-durable or single-use consumption goods.
(4) Services: Services are those non-material goods which directly
satisfy human wants. A few examples of services are the services
of a doctor, lawyer, domestic servant, etc.
Capital Goods
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Capital goods are fixed assets of the producers. Plant and machinery
are the examples of capital goods. These goods are used by the
producers either for (i) the replacement of the capital stock, or for
(ii) addition to the capital stock. As fixed assets, capital goods are
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repeatedly used in the process of production for several years and are
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of high value. Even nuts and bolts (or nails and screws) are used for
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All Machines are not
several years, but these are not capital goods. Because these are of
Capital Goods low value. Thus, only those fixed assets of the producers are taken
or
It must be borne in as capital goods which are used in the process of production for
mind that all machines
several years and which are of high value. Also, capital goods involve
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are not capital goods.
A sewing machine in a depreciation. It refers to loss of value of fixed assets (in use) owing to
tailoring shop is a fixed
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their wear and tear.
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asset of the tailor; it is
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F®CUS
a capital good. But the
same machine with a Capital goods are fixed assets of the producers. These
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consumer household goods are used in the process of production for several
is not a capital good.
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years and are of high value. Use of these goods leads to

It is simply a durable
use consumer good. depreciation (loss of value of fixed assets when these are
Likewise, a car with repeatedly used). Example: Plant and machinery.
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a tourist company is
a capital good. But
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the same car with a All Capital Goods are Producer Goods,
consumer household is
a durable-use consumer
But all Producer Goods are not Capital Goods
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good. Thus, while Producer goods are those goods which are used in the production
identifying goods as
of other goods. These goods include: (i) goods used as raw material
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capital goods, we must

make sure about their by the producers, like wood used to make furniture, and (ii) goods
end-user. If the end-user
of a durable good is a
used as fixed assets by the producers, like plant and machinery.
household consumer, it Unlike fixed assets of the producers, goods used as raw material
is durable-use consumer
good. On the other
are not durable-use goods. These are single-use producer goods:
hand, if the end-user these cannot be repeatedly used in the process of production. Thus,
of a durable good is a
producer, it is a capital
the same wood cannot be repeatedly used to make furniture. Fixed
good. Capital goods assets (or capital goods), on the other hand, are repeatedly used in
are only those durable the process of production. These are durable-use producer goods.
goods which are used
as producer goods, not Thus, while all capital goods are producer goods, all producer goods
as consumer goods.
are not capital goods.
Consumption Goods and Capital Goods-The Difference
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t_ _o__ds
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________c ta
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_d_s____ f@CUS
(i) Consumption goods lead to direct-
satisfaction of human wants.
(i) Capita/ goods do not lead to direct-
satisfaction ofhuman wants.
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(ii) These goods are consumed by the (ii) These goods are not consumed by
households when purchased. the households. Instead, these are
used by the producers for further
production.
(iii) Expenditure on consumption (iii) Expenditure on capital goods is
goods is called consumption called in vestment expenditure.
expenditure.
(i vJ Higher production of consumption (i v) Higher production of capital
goods leads to higher le vel of goods leads to higher production
welfare of the people. It raises capacity in the economy. It is the
their quality of life. backbone of GDP growth.
[Note: Both consumption goods and capital goods have one common
characteristic: that are final goods, and therefore, included in the
estimation of national income.]
t>TS
Q. All producer goods are not capital goods. Why?
Ans. 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 dura ble-use producer goods. On the other hand, goods used as raw materia l a re
single-use producer goods. These are not repeated ly used in the process of production. Accordingly,
all producer goods a re not capital goods.
2. CONCEPT AN D COM PO N E NTS OF

CONSU M PTIO N EXPE N D ITURE
In macroeconomics, consumption expenditure refers to aggregate
consumption expenditure in the economy. Who are the consumers
in an economy? These are broadly classified as: (i) households,
(ii) the government, and (iii) non-profit private institutions (like
NGO, temples, mosques, gurudwaras, and others). Households buy
consumer goods for the satisfaction of their wants. The government
buys consumer goods for distribution among defence forces, for mid
day meals in the government schools, and such other purposes. Non
profit private institutions buy consumer goods for charity. If we add up
expenditure on the purchase of consumer goods by the households,
government and non-profit private institutions, we get an estimate of
total consumption expenditure in the economy. Thus:

F®CUS Aggregate Consumption Expenditure
= Consumption expenditure by the households + Consumption expenditure by the
ZONE government + Consumption expenditure by the non-profit private institutions
(NGO, temples, mosques, gurudwaras, and others)
3 . C O N C EPT AN D CO M PO N E NTS O F I NVESTM ENT

What is I nvestm e nt?
Investment refers to increase in the stock of capital. Thus:
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I = Investment
K = Capital stock
LlK = Change in capital stock
during the year.
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Change in the stock of capital is called 'capital formation'. Accordingly,
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investment is also defined as capital formation.
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From the viewpoint of the economy as a whole, investment refers to
total production of capital goods during an accounting year. As noted
or
earlier, these goods may be used either for the replacement of existing
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capital stock or for adding to the existing capital stock.
I Investment refers to capital formation, or a process that increases the stock of capital.
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Fixed I nvestm ent a n d I nvento ry I nvestment

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Investment has two components:

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(i) Fixed investment, and

(ii) Inventory investment.
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Following are the details:

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Fixed Investment
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Fixed investment refers to increase in the stock of fixed assets (like

plant and machinery) of the producers during an accounting year.
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Example: If at the beginning of the year 2019, a producer has stock

of 8 machines and at the end of 2019, he has a stock of 10 machines,
then the stock of his fixed assets increases by 2 machines during the
year 2019.
Fixed investment of the producer during the year 2019 = 2 machines.
F®CUS Fixed Investment

= Stock of fixed assets with the producers at the end of the accounting year
ZONE - Stock of fixed assets with the producers at the beginning of the accounting year
= Increase in the stock of fixed assets with the producers during an accounting year
Fixed investment is also called fixed capital formation. This implies
increase in the stock of capital in terms of fixed assets (or capital
goods) which are repeatedly used in the process of production for
several years.
Significance of Fixed Investment
Following observations bring out the significance of fixed investment:
(i) Fixed investment raises production capacity of the producers.
(ii) By raising production capacity of the producers, fixed investment
leads to higher level of output in the economy.
(iii) Higher level of output (because of fixed investment) leads to
higher rate of economic growth, popularly known as GDP growth.
Inventory Investment
At a point of time, producers hold the stock of (i) finished goods
(unsold goods), (ii) semi-finished goods (goods which are in the
process of production), and (iii) raw material. This is called ' inventory
stock'. Change in inventory stock during the year is called inventory
investment of the producers.
Inventory Investment
= Inventory stock at the end of the accounting year F®C U S
- Inventory stock at the beginning of the accounting year ZONE
= Change in inventory stock during an accounting year
Significance of Inventory Investment
Inventory investment primarily consists of investment in terms of the
stock of (i) raw material, and (ii) finished goods.
The stock of raw material is significant because:
(i) It ensures uninterrupted supply of inputs to the producers.
(ii) With enough stock of raw material, the producers can avoid day
to-day purchases from the market. Accordingly, uncertainties of
the market (relating to price and availability of the raw material)
are avoided.
The stock of finished goods is significant because it enables the
producers to meet the potential (future) demand for their product.
Here, it may be noted that the actual inventory stock at a time may
not be the desired inventory stock. A part of it may be undesired. A
producer may have expected to sell 1,000 units of washing machines.
But, actually he could sell 500 units owing to the lack of demand.
In such a case, 500 units of washing machines (unsold stock) are an
undesired inventory stock. Such a stock leads to losses.

Desired inventory stock refers to planned inventory stock. This is maintained by the producers to
meet the future demand.
Undesired inventory stock, on the other hand, refers to unplanned inventory stock. It arises because
demand for the product turns out to be lower than expected. Unplanned inventory stock leads
to losses.
G ross I nvestm ent, N et I nvestment and

The Concept of Depreciati o n
Gross investment refers to total production of capital goods during
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the year. This includes (i) capital goods used for the replacement of
existing capital stock (which is worn-out), and (ii) capital goods used
as a net addition to the existing capital stock.
• Capital goods used for the replacement of existing capital stock
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refers to 'depreciation'.
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• Capital goods used as net addition to the existing capital stock is
called 'net investment'.
• Gross Investment = Net investment + Depreciation (also called
or
replacement investment)
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• Net Investment Gross investment - Depreciation (also called
=
replacement investment)
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Gross Investment = Net investmen t + Depreciation (expenditure on the replacement of worn -out
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fixed assets or replacement investment)

Net Investment = Gross investment - Depreciation
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Significance of Net Investment

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Following observations highlight the significance of net investment:

Only net investment
leads to addition to (i) It raises the stock of capital in the economy. Higher stock of
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the stock of capital capital increases the availability of capital per unit of labour.
Depreciation (a part of
Accordingly, efficiency of labour rises.
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gross investment) only

replaces the worn-out (ii) It helps generate opportunities of employment. Because,
fixed assets. It helps to
maintain the existing unemployment in India is largely due to the lack of capital.
stock of cap ital
(iii) Net investment is a net rise in production capacity of the
economy. Accordingly, GDP growth is accelerated.
Briefly, net investment enhances production capacity, generates
opportunities of employment, promotes efficiency of labour and
accelerates GDP growth.
Gross Investment and Net Investment-The Difference
G ross I nvest me nt Net I nvest me nt
F@CUS
(i) It includes expenditure by the
producers on the purchase of new
(i) It includes expenditure by the
producers on the purchase of new ZONE
assets as well as expenditure on assets only. More specifically, it
the replacement of existing assets does not include expenditure by
during an accounting year. the producers on the replacement
of existing assets.
(ii) It includes replacement investment (ii) It does not include replacement
(= depreciation offixed assets). investment.
(iii) It does not show net addition to (iii) It shows net addition to the
the existing capital stock. existing capital stock.
[ N ote: Both gross investment as wel l as net investment include: ( i ) fixed

investment, and ( i i ) inventory investment. ]
f>TS
Q. How does higher rate of net capital formation lead to higher level of productivity/efficiency of labour?
Ans. Higher rate of net capital formation implies greater availabil ity of capital (in terms of machines)
per unit of labour. Aided by machines, efficiency of labour definitely increases. This precisely is
the reason why labour in developed countries (like USA) is more efficient than in less developed
countries like India.
Concept of Depreciation
While fixed assets (like plant and machinery) are in use, they go
down in value owing to (i) normal wear and tear, and (ii) accidental
damages (beyond their routine repairs and maintenance). They go
down in value also when they become obsolete (or outdated) due to
change in technology or change in demand. This is called 'expected
obsolescence' (which the producers normally expect to happen).
Depreciation is the loss of value of fixed assets in use on account of:
(i) normal wear and tear,
(ii) accidental damages, and
(iii) expected obsolescence.
Depreciation is also called consumption of fixed capital. Because of
depreciation, fixed assets need to be replaced from time to time.
Replacement of fixed assets requires funds. Provision for the funds
is made on annual basis. To illustrate, if a machine is purchased
for � 10,00,000 and its expected lifetime of use is 10 years,
then the annual provision for funds (to replace the machine after

� 10, 00, 000
10 years) = = � 1,00,000. This is called Depreciation
10
Reserve Fund.
I Depreciation reserve fund refers to that fund which the producers keep for replacement
investment.
Significance of Depreciation Reserve Fund

Depreciation reserve fund is a fund to replace the worn-out fixed
low
assets. It fulfills the need for replacement investment. Lack of
depreciation reserve fund implies the lack of replacement investment.
Accordingly, overall investment (gross investment) in the economy
tends to fall. This leads to a fall in the level of output. The level of
income and employment will also fall. The economy will slip into a
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state of 'economic slowdown'. It might be caught into a low level
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equilibrium trap: a situation when low income causes low demand,
and low demand causes low output; and once again low income.
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Expected and Unexpected Obsolescence
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It is essential to know the difference between 'expected (or foreseen)
obsolescence' and 'unexpected (or unforeseen) obsolescence'.
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Expected obsolescence has two components:
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(i) Loss of value of fixed assets when these become obsolete/
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outdated owing to change in technology. Example: A plant

producing black and white TVs becomes obsolete when
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technology is discovered to produce colour TVs.

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ad
(ii) Loss of value of fixed assets when these become obsolete/

outdated owing to change in demand. Example: A plant
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producing rubber shoes becomes obsolete when demand shifts

from rubber shoes to leather shoes.
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Expected obsolescence is estimated by the producers on the basis of

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their knowledge and experience of the market conditions.

Unexpected obsolescence occurs owing to (i) natural calamities (like
earthquake, floods or fire), and (ii) fall in market value of the assets
when there is economic recession. Loss of value of fixed assets owing
to unexpected obsolescence is called 'capital loss'. These losses are
not a part of depreciation or depreciation reserve fund.
Only expected obsolescence is considered for the estimation of
depreciation, not the unexpected obsolescence.
Expected Obsolescence and Unexpected Obsolescence-The Difference
Exp ec t ed Obs o l esc enc e
(i) It refers to a Jail in the value of
Un ex p ec ted Obs o l esc en c e
(i) It refers to a fall in the value
F®CUS
fixed assets due to change in of fixed assets due to natural ZONE
technology or change in demand. calamities or economic recession.
(ii) It is a part of depreciation. (ii) It is not a part of depreciation.
Instead, it points to capital loss.
(iii) Expected obsolescence is managed (iii) Unexpected obsolescence is
through depreciation reser ve managed through insurance of
Jund. the fixed assets.
Consumption of Fixed Capital and Capital Loss-The Difference

C o n su m p t oi n o f F x
i ed Capi ta l
(i) It refers to loss of value of fixed
Cap i ta l L o ss
(i) It refers to loss of value of fixed
F®CUS
assets (capital goods) while these assets while these are not in use. ZONE
are being continuously used in the
process of production.
(ii) ltisalossdueto(a) normalwearand (ii) It is a loss due to (a) natural
tear, (b) accidental damages, and calamities (earthquake, floods,
(c) expected obsolescence. fire, etc.), and(b) Jail in the market
value of the assets during periods
of economic recession.
(iii) It is managed through depreciation (iii) It is managed through insurance
reser ve Jund. of the fixed assets.
t>TS
Q. 1. Distinguish between depreciation and depreciation reserve fund.
Ans. Depreciation is the loss of fixed assets in use on account of: (i) normal wea r and tear, (ii) accidental
da mages, and (iii) expected or foreseen obsolescence.
On the other hand, depreciation reserve fund is a provision of funds to cope with depreciation losses.
These funds are used for the replacement of fixed assets when these are worn-out or when these
become obsolete/outdated.
Q. 2. What is current replacement cost?
Ans. It refers to the esti mated value of depreciation for all the producing units in the economy, during the
period of an accounting year.
4. STOCKS AN D FLOWS
M ean i ng of Stock
A stock is a quantity measured at a particular point of time. On
January 1, 2020 there may be � 20,000 in your bank account. On

January 1 0, 2020, there may be � 2 5 , 000 i n you r ban k accou nt. All
such val ues are stock val ues, as these are measured at a specific point
of time. Capital and q uantity of money are notable exam p les of stock
variables.
M ean i ng of Flow
A flow i s a q uantity measu red over a specified period of time. You
may be getti ng � 1 , 500 per month as pocket al l owance, you m ay be
Certa i n concepts i n spend i ng � 50 eve ryday in the canteen , you may be getting 8 per cent
econom ics a re stud ied
low
only as flow va riables, not ann ual i nterest on you r bank deposits. All these val ues/q uantities are
as stock va riables. 'flows' as these are m easu red per u n it of time period (an h o u r, a day, a
Example: Exports and
I m ports. month , an year, etc . ) . I ncom e , expend iture, prod uction , consu m ption
and i nterest are n otable exam ples of flow variables.
Here are some more exam ples of Stocks and Flows:
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Stock Flow
1. Wea lth 1 . I ncome
2 . La bour Force 2. Expenditure of Mo ney
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3 . Capital 3 . Cap ita l Formation
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4. Qua ntity/Supply of M o ney i n a 4. Cha nge in the Supply of Money in a
Cou ntry Country
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5 . Ba n k Deposits 5. I nte rest on Ca pita l
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6. Water i n the overhead ta n k 6. Lea kage of water from t h e overhead

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ta n k
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7 . Distance between Del hi a n d 7 . Speed o f a ca r g o i n g from D e l h i to

M u m ba i M u m bai
ou
8. Sales of rice
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8 . Rice stored i n a godown

9. Po pu lation of a cou ntry 9. N u mber of births
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Stock and Flow-The Difference
F®CUS
nd
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S to ck F lo w
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(i) Stock refers to the value of a (i) Flow refers to the value of a
variable at a point of time. variable during a period of time.
(ii) Stock is not time dimensional. It (ii) Flow is time dimensional. It is
is measured at a specific point of measured per hour, per month or
time. per year.
(iii) Stock impacts the flow. Greater (iii) Flow impacts the stock. Greater
the stock of capital, greater is the the flow of income, greater is the
flow ofgoods and services. stock ofwealth with the people.
M utual Dependence between Stock and Flow
Fig. 1 shows deposits of � 20, 000 in your saving bank account on
January 1, 2020. This is a stock of your savings. The withdrawals from
this account (� 1,000 per month) is a flow concept. Likewise, deposits
of � 2,000 per month is a flow concept.
F LOW STOCK FLOW
I� �� BAN K ��,

�l�HD�
0
� -
u u u ·�
r
Saving
Bank Ne � 1 ,000
� t 20,000/-
1 -1 -2020 - Per Month
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A point to be noted is that your stock of savings depends upon your

flow of deposits into your saving account. Likewise, your flow of
withdrawals depends upon your stock of savings. Thus, there is a
mutual dependence between stocks and flows.
Q.
f>TS
Are the following Stocks or Flows?
(i) Investment, (ii) Monetary Expenditu re, (iii) A H undred Rupee Note, (iv) A Family's Consumption of
Sugar, (v) Services of a Tutor, (vi) Production of Cement, (vii) Machinery of a Sugar M ill.
Ans. (i) Investment: It is a fl ow concept because it is related to a period of time.
(ii) Monetary Expenditure: It is a flow concept because it is related to a period of time.
(iii) A Hundred Rupee N ote: It is a stock concept because it is a component of supply of money.
(iv) A Family's Consumption of Sugar: It is a flow concept because consumption relates to a period
of time.
(v) Services of a Tutor: It is a fl ow concept because it is related to a period of time.
(vi) Production of Cement: It is a flow concept because it is related to a period of time.
(vii) Machinery of a Sugar M i l l : It is a stock concept because it relates to a point of time.
5. FOU R SECTO RS OF TH E ECONOMY

From the macro point of view, economy is often divided into four
sectors, viz . ,
(1) Household Sector: It includes consumers of goods and services.
Households are also the owners of the factors of production.

{2) Producer Sector: It includes all producing units (firms) in the
economy. For the production of goods and services, the firms
hire/purchase factors of production (land, labour, capital and
entrepreneurial skill) from the households.
{3) Government Sector: It includes: (i) Government as a welfare
agency, and (ii) Government as a producer. Government as a
welfare agency performs such welfare functions as of law & order
and defence.
{4) The External Sector {also called Rest of the World Sector): It
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includes all such activities which are related to export and import
of goods, and the flow of capital between the domestic economy
and rest of the world.
6. I NTERSECTORAL FLOWS
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Each sector of the economy depends on the other in one way or
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the other. This is called intersectoral interdependence. Following
observations highlight the intersectoral interdependence:
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• The household sector depends on the producer sector for the
supply of goods and services, needed for consumption.
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• The producer sector depends on the household sector for the
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supply of factors of production (also called factor services). These
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are needed for the production of goods and services.
• The government sector depends on the producer and household
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sectors for its tax and non-tax revenue.

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• Producers and households depend on the government for

administrative services, besides law & order and defence.
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ad
lntersectoral interdependence leads to intersectoral flows, either in

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the form of goods and services or in the form of money. lntersectoral

flow in the form of money is called 'Money Flow', and intersectoral
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flow in the form of goods and services is called 'Real Flow'. Following
is a brief description of money flows and real flows.
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Real Flows
Real flows refer to the flow of goods and services among different
sectors of the economy. Flow of factor services from household
sector to the producer sector or the flow of goods and services from
the producer sector to the household sector are examples of real
flows.
Fig. 2 illustrates real flows in case of a simple 2-sector economy,
including (i) household sector, and (ii) producer sector.
Real Flows in a 2-sector Economy
Goods Prod uced a n d Sold by the Firms
HOU SEHOLD PRODUCER
t
SECTOR SECTOR or FI RMS
[ Facto r Se rvices (La nd, La bo u r, Ca pita l a n d Entrepreneu rshi p)

re ndered by the Households
Fig. 2 shows real flows in terms of (i) flow of goods sold by the
firms to the households, and (ii) flow of factor services rendered by
the households to the producers. Both these flows are real as these
involve the movement of goods and services from one sector to the
other. Money does not come into the picture.
Money Flows
Money flows refer to the flow of money across different sectors of
the economy. Flow of factor payments by the producer sector to the
household sector (on account of the purchase of factor services) and
flow of money from the household sector to the producer sector
(on account of the purchase of goods and services) are examples
of money flows. It needs to be noted that the money flows are just
reciprocals of the real flows. Fig. 3 illustrates money flows in case of
a simple 2-sector economy.
Money Flows in a 2-sector Economy

Expenditure on the Purchase of Goods
HOU SEHOLD PRODUCER
t
SECTOR SECTOR or F I RMS
Payments for Factor Services
Fig. 3 shows money flows in terms of (i) flow of money from

households to the producers (firms) for the purchase of goods, and
(ii) flow of money from the producers to the households for the
purchase of factor services. Each money flow is a reciprocal of the real

flow. Thus, money flow from households to the producers (for the
purchase of goods) is a reciprocal of the real flow of goods from the
producers to the households. Likewise, money flow from producers
to the households (as payments for factor services) is a reciprocal of
the real flow of factor services from the households to the producers.
Q.
t>TS
Money flows are opposite to real flows. H ow?
Ans. Money flows are opposite to real flows. Because m oney flows are in response to the real flows.
Example: There is a real flow of goods and services from the producers to the households. It is in
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response to it, that the households make payments to the producers. So that, money flows from
the households to producers in terms of consumption expenditure. Likewise, there is a real flow of
factor services from the households to the producers. It is in response to it, that the producers make
payments to the households. So that, money flows from producers to the households in terms of
factor payments.
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[Note: Students are advised to draw Fig. 2 and 3 in support of their answer.]
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7. C I RCU LAR FLOW O F I N CO M E
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In every economy, three activities never stop: (i) production of goods
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and services, (ii) generation of income (in terms of wages, interest,
rent and profit), and (iii) expenditure (in terms of consumption
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expenditure and investment expenditure). In fact, these activities are
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the lifeline of an economy-the concept of economy does not exist

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without these activities.

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It is difficult to trace the beginning of these activities and it is

impossible to predict their end. Production, income and expenditure
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are flow variables. These have been in existence like a circle without
a beginning or an end. Circular flow of income means the circularity
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of the flows of production, income and expenditure in any economy.

In fact, production, income and expenditure are the three phases of a
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circular flow in the economy.

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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. Each activity is the cause as well as the consequence of the other activity.
Production in the producing sector generates income for the households who are owners of the
factors of production Expenditure by the households generates demand for further production.
Accordingly, production, income generation and expenditure keep chasing each other like three
dots continuously moving in a circle.
Th ree Phases of Circular Flow

Fig. 4 shows the three phases of circular flow in an economy.
Three Phases of Circular Flow
Prod uction
of goods
and services
• Prod uction of goods and services causes generation (or d i stribution)

of income.
• I ncome ca uses expenditure (or d i sposition).
• By generati ng demand, expenditure once again causes production.
Conseq uently, again there is generation of i ncome a n d d i sposition
(or expenditure) of i n come.
• The flows of production, i n come and expenditure form a circularity
with no beg i n n i n g or an end. Which is why it is ca l l ed c i rc u l a r fl ow.
Phase of Production
Production refers to 'value addition'. When wood worth � 5,000 is
converted into chairs worth � 10,000, there is value addition worth
� 5,000 (= � 10,000 - � 5,000). This is what production means.
Phase of production in the circular flow means the process of value
addition by the producing sector.
The 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. Goods and services are produced for the satisfaction of
human wants. There is no end to human wants. Accordingly, there is
no end to the process of production.
Phase of Income Generation (also called the Phase of Distribution)
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.
From the viewpoint of the households, these are factor incomes. Thus,
in phase-2 of circular flow, there is generation of income (or distribution
of income) as a consequence of the production of goods and services in
phase-1. Now value addition is converted into factor income.
Phase of Disposition/Expenditure
Where does income go? It is spent or disposed of on the purchase of
final goods and services. When households buy the final goods, there
is consumption expenditure. When producers buy the final goods,
there is investment expenditure. Thus, in phase-3, there is disposition
(or expenditure) of income as a consequence of the generation of
income in phase-2.
The story does not stop here. Consumption expenditure and
investment expenditure generate demand for goods and services in
low
the economy. This again causes production of goods and services,
and consequently the generation of income. Thus, there is a non-stop
flow of production of goods and services, generation of income and
disposition of income. Each flow keeps chasing the other flow. Which
is why it is called circular flow.
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Considering the three phases together, we find that in a two sector
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economy:
Production (the value of goods and services)
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= Income generated
= Expenditure (in terms of C and I)
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This is called triple identity. This is illustrated through a 2-sector circular
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flow model as in Fig. 5.
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C i rcular Flow Model in a Two Sector Economy
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A closed economy is the

one which does not have
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economic relations with

rest of the world. There
are no exports/im ports of
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ad
goods and services.

An open economy is the Prod ucers/
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one which has economic Firms Households

relations with rest of the
world. It exports goods
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and services to rest of

the world and also ma kes
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i m port of goods and

services.
Assumptions of the Model

The circular flow model, as in Fig. 5, 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.
(iii) The domestic economy is a closed economy, so that there are no
exports and imports.
(iv) There is no government in the domestic economy.
Observations
This model offers the following observations:
(i) Factor payments by firms = Value addition by the firms. Thus,
value addition is converted into factor incomes (= ? 10 crore).
(ii) Total production of goods and services by firms = Total
expenditure on goods and services by the household sector.
Thus, all income is converted into expenditure on goods and
services (= ? 10 crore).
(iii) Value addition = Income generated = Expenditure on goods and
services
Hence, the triple identity.
Money flows are just the monetary expression of real flows. Briefly,
one can observe from the Circular Flow Model that: value added is
converted into income and income is converted into expenditure. It is
this conversion process which keeps the circular flow always in a state
of circularity.
Significance of Ci rcular Flow Model

Study of the circular flow of income is important due to the following
reasons:
(1 ) Estimation of National Income: Circular flow model facilitates
the estimation of national income. National income is the sum
total of factor incomes (rent+ profit+ wages+ interest) flowing
from producers to households of a country. It may also be
defined as the market value of the goods and services flowing
from producers to other sectors of the economy. Further, it may
be defined as the sum total of expenditure on the goods and
services produced by the producer sector.
(2) Knowledge of lntersectoral Interdependence: A circular flow
model helps understand interdependence among different
sectors of the economy. We learn how consumers are dependent
on producers and vice versa.
[Note: Circular flow of income is also called circular flow of money.]

Power Poi nts
I
c1assification of Goods
& Revision Window -----------
' Final Goods a re those goods w h i c h h ave crossed the bo u n d a ry l i ne of p rod u ction, a n d
a re rea dy for u s e b y t h e i r fi n a l users. Example: Shoes u sed b y the househol ds, o r tracto r
u sed by the fa rmers . F i n a l goods m u st lead to either fi n a l con s u m pti o n expe n d i t u re o r
i nvest m e nt expe n d i t u re i n t h e eco n omy.
I ntermediate Goods a re those goods w h i c h a re p u rchased by one fi rm from the oth e r fo r
resale o r for use as raw material i n the production of other goods. Example: Wood used i n the
prod uction of cha i rs.
Consu mption Goods a re th ose goods wh ich a re d i rectly u sed for the satisfa cti o n of h u m a n wants.
low
Exa m ple: M i l k and ice crea m used by the h o u seho l d s .
Capita l Goods a re fixed assets o f the p rod ucers a n d a re re peated ly u s e d i n the p rocess o f p rod u cti o n .
These a re d u ra ble-use p ro d u cer goods a n d a re o f h igh va l ue. Example: P l a nt a n d mach i nery.
Consumption Expenditure is the aggregate cons u m ption expen d i t u re i n the eco n o my.
!components: ( i ) Cons u m ption expe n d i t u re by the h o useholds, ( i i ) Co nsu m pti o n expen d i t u re by the
j 1 •
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government, (iii) Co nsu m ption expe n d i t u re by the n o n - p rofit private i n stitutions.
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Investment is a p rocess of a d d i ng to the stock of ca p ita l .
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Components: ( i ) F ixed i nvestment, a n d ( i i ) I nvento ry i n vest m e nt .
Fixed I nvestment i s a d d iti o n to the stock af fixed assets o f the p rod ucers d u ri n g a n acco u nti n g yea r.
or
I nventory Investment is add ition to t h e stock of i nvento ry with the prod u cers d u ring a n acco u nti ng yea r.
Gross Investment i s the expe n d itu re o n the p u rchase of fixed assets a n d expe nd itu re o n the i nve ntory
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stock of the p rod ucers d u ri ng the accou nti ng yea r.
Net I nvestment refers to i n c rease i n the stock of ca pita l d u ri ng a n accounting yea r.
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Net I nvestment = G ross i nvestment - Depreci ati o n
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Depreciation (also ca l led consu m ption af fixed ca pital) refers t o loss o f value o f fixed assets in use, on account
l of ( i ) normal wea r and tear, (ii) accidenta l damages, and (iii) expected (or foreseen ) o bsolescence.
B
Depreciation Reserve Fund refe rs to that fu nd w h i c h the p rod ucers kee p to cope with d e p reci ation l osses
re
in the p rocess of prod u cti o n .

Stocks a re the q ua nti ties wh ich a re mea s u red at a point o f ti m e . Example: You r bala nce i n the ba n k
l
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ad
acco u nt as o n J a n u a ry 1, 2020.
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Flows a re the q uantities which a re measu red over a specified period of time. Example: You r i n come per month .
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Four Sectors of the Economy

Household Sector refers to consumers engaged i n the consu m ption of goods and services.
nd
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Producing Sector refers to a l l p rod ucing u n its ( o r fi rms) in the eco n omy.
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Government Sector refe rs to govern ment as a welfa re agency (engaged in m a i nta i n i ng law a n d
order, defence, a n d oth er services o f p u b l i c we lfa re). It a lso refe rs to govern m e nt as a pro d u cer.
The External Sector a lso ca l led ' Rest of the World Sector', i s engaged i n the export a n d i m port of goods
and the flow of ca pita l between the d o mesti c eco n o my and rest of the worl d .
Ijl
Circular Flow of Income refers to t h e ci rcu la rity o f the fl ows o f p rod uction, i ncome a n d expe n d i t u re
across d i ffe rent sectors of the eco n o my.
Rea l Flows refe r to the flow of goods a n d services across d iffe re nt secto rs of the eco n omy.
Money Flows refer to the flow of money ( i n terms of recei pts a n d payments) across d iffe re nt
secto rs of the eco n omy.
Significance : C i rcu l a r flow m o d e l s a re sign ificant as they:
(i) facil itate esti m ation of nati o n a l i ncome.
(ii) s h ow i nterdepende nce a mong d i fferent sectors hig h l ighti ng circu la rity of i ntersectora l flows.
lfEX E RC I S Ej
1 . Obj ective Type Questions (Remembering & U ndersta n d i n g based Questions)
A. M u ltiple Choice Questi o n s

Choose t h e correct option:
1 . Con sum ption of all goods and se rvices in the economy d u ring the period of a n a ccou nting yea r is
known a s:
(a) aggregate demand ( b ) aggregate s u p p ly
(c) aggregate cons u m ption ( d ) none of these
2 . Classification of goods depend on the:
(a) cons u m ption of goods (b) prod u ction of goods
(c) fi rst-use of goods (d) end-use of goods
3 . Final goods a re used by the:
(a) consu mers ( b ) produ cers
(c) government ( d ) a l l of these
4. Those goods which satisfy h u m a n wa nts d i rectly a re ca l l e d :
(a) i nte rmed iate goods (b) consumer goods
(c) ca pita l goods (d) none of these
5. Ca pita l goods a re those goods:
(a) which a re used i n the prod u ction p rocess for severa l yea rs
(b) which a re used in the prod u ction p rocess for few yea rs
(c) which i nvolve depreciation l osses
(d) bot h (a) a n d (c)
6. Food processor used by the households i n their kitchen is an exa m p l e of:
(a) ca pita l goods (b) i ntermediate goods
(c) cons u m ption goods (d) none of these
7 . In the prod uction of suga r, suga rca ne is:
(a) a fi n a l good ( b ) a capita l good
(c) an i ntermed iate good ( d ) none of these
8. If a ca r is p u rchased by a taxi-operator, it w i l l be rega rded as a :
( a ) ca pita l good (b) i ntermediate good
(c) fi n a l good ( d ) both ( a ) a n d (c)
9 . T.V., rad i o, was hi n g machi ne, etc., a re exa m ples of:
(a) d u ra b l e consu mer goods ( b ) sem i-d u ra b l e consumer goods
(c) single-use consumer goods (d) capita l goods
10. Which of the fol l owing is a semi-d u ra b l e good ?
(a) Radio ( b ) Clothes
(c) M i l k ( d ) Petrol
1 1 . I n crease i n the stock o f ca pita l is known as:
(a) ca pita l loss (b) capita l ga i n
( c ) ca pita l formation (d) none of these

12. N et i nvestment is eq ual to:
(a) gross i nvestment + depreciation ( b ) gross i nvestment - depreciation
(c) gross i nvestment x depreciation ( d ) gross i nvestment + depreciation
13. N et ca pita l formation causes:
(a) increase i n p rod uctio n ca pacity ( b ) increase i n depreciation
(c) increase i n p rofits (d) increase in cost
14. Which of the fol l owing leads to dep reciation?
(a) Normal wea r and tea r ( b ) Damages d u e to floods
(c) Damages due to market-crash (d) None of these
15. Which of the fol l owing leads to u n expected obsolescence?
low
(a) Cha nge in demand ( b ) Nat u ra l ca lam ities
(c) Cha nge i n tec h n o l ogy ( d ) None of these
16. Which of the fol l owing is the cause of expected obsolescence?
(a) N atu ra l ca l a m ities ( b ) Cha nge i n demand
(c) Cha nge i n tec h n o l ogy ( d ) Both ( b ) a n d (c)
ee
17. Depreciation reserve fu n d is needed for:
rF
Fr
(a) i nventory stock ( b ) advertisement
(c) replacement i nvestment ( d ) none of these
or
18. A stock va ri a b l e :
(a) has n o ti me d i mension (b) is a static concept
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u
(c) both (a) a n d ( b ) ( d ) none of these
19. A qua ntity measu red per u n it of time period is known as:
k
Yo
(a) stock va ria b l e ( b ) fl o w va ria ble
oo
(c) i nventory ( d ) none of these

B
20. 'I ncome of the fa m i ly' is the exa m p l e of which va ria ble?
re
(a) Stock (b) Flow

(c) Both stock a n d flow ( d ) Neither stock nor flow
ou
ad
2 1 . Which of the fol l owing is a stock va riable?

(a) I nterest on capita l ( b ) Dista nce between Del h i a n d M a n a l i
Y
( c ) Expe n d itu re of money ( d ) A l l of these

22. Which of the fol l owing is not a flow va riable?
nd
Re
(a) I ncome ( b ) Ca pita l formation

Fi
(c) Supply of money i n a cou ntry ( d ) Lea kage of water from the overhead tan k
2 3 . A ca r ru n n i ng between Del h i a n d Agra a t a speed o f 120 km/h includes:
(a) o n ly stock va riables ( b ) only flow va ria b l es
(c) both a stock a n d a flow va riable ( d ) none of these
24. Factor services rendered by the households to the fi rms lead to:
(a) rea l flow ( b ) money flow
(c) services flow ( d ) both ( a ) a n d (c)
25. Reason for the circu lar flow of income is:
(a) govern ment i ntervention
( b ) p rod uction of goods a n d services
(c) m utual i nterdependence of p rod ucer a n d household sector
( d ) i nvention of money
Answers
1. (c) 2. (d) 3. (d) 4. (b) 5 . (d) 6. (c) 7. (c) 8. (d) 9. (a) 10. (b)
11. (c) 12. (b) 13. (a) 14. (a) 15. (b) 16. (d) 17. (c) 18. (c) 19. (b) 20. (b)
21. (b) 22. (c) 23. (c) 24. (a) 25. (c)
B. F i l l in the Bla n ks
Choose appropriate word and fi ll in the blank:
1. _______ goods a re those goods which have crossed the bou n d a ry l i n e of p rod uction a n d
a re ready for u s e b y their fi n a l users. ( F i n a l/I ntermed iate)
2. In the estimation of national i n come, o n ly the va l u e of goods is taken i nto
accou nt. ( i ntermediate/fi n a l )
3 . I n the classification of a good as a n i ntermed iate good or fi n a l good, only its is
taken i nto consideration. ( i n iti a l-use/end-use)
4. is the yea r d u ring which prod uction of goods a n d services is estimated i n the
domestic economy. (Accou nti ng yea r/Ca lender yea r)
5 . D u ra b l e consum ption goods have relatively va l u e than the si ngle-use
consu m ption goods. ( h igh/low)
6. E lectric goods a re an exa m p l e of _______ consum ption goods. (sem i-d u ra ble/d u ra ble)
7. Non-d u ra b l e consum ption goods a re a lso known as_______ consu m ption goods.
( d u a l-use/si ngle-use)
8. H igher prod u ction of goods leads to higher level of welfa re of the economy.
( consum ption/ca pita l )
9. refers t o the prod u ction of ca pita l goods d u ring t h e yea r.
( G ross i nvestment/N et i nvestment)
10. e n h a n ces p rod uction capacity i n the economy.
( G ross i nvestment/N et i nvestment)
11. O n ly obsol escence is considered for the esti mation of depreciation.
(expected/u nexpected )
12. refers to the l oss of va l u e of fixed assets w h i l e they a re not i n use.
(Consu m ption of fixed ca pita l/Ca pita l loss)
13. A stock is a va ria ble mea s u red of ti me. (over a period/at a poi nt)
14. Loss of va l u e of fixed assets owing to u n expected obsolescence is ca lled
(capita l l oss/depreciation)
15. refers to the flow of money across d i fferent sectors of the economy.
(Money fl ow/Real flow)
Answers
1. Final 2. final 3 . end-use 4. Accounting yea r 5 . h igh
6. semi-d u rable 7. single-use 8. consu m ption 9. G ross i nvestment
10. N et i nvestment 11. expected 12. Ca pita l loss 13. at a point
14. ca pita l loss 15. Money flow

C. True or Fa lse

1. Expenditure on fi nal prod ucer goods by the prod ucers is ca l l ed i nvestment expenditure. (True/Fa lse)
2. Va l u e of i ntermed iate good u lti mately becomes a part of fi n a l goods. (Tru e/Fa lse)
3 . The d isti nction between fi n a l goods and i ntermed iate goods depends u pon
the i n itia l-use of the goods. (True/Fa lse)
4. Goods that a re used - u p i n a single act of consum ption a re ca l led non-d u ra b l e
cons u m ption goods. (True/Fa lse)
5 . I nventory i nvestment ra ises the prod uction capacity of the prod ucers. (True/Fa lse)
low
6. The stoc k of raw materia l is sign ifica nt beca use it ensu res u n i nterru pted
s u p p ly of raw materia ls to the prod ucers. (True/Fa lse)
7. G ross i nvestment = N et I nvestment - Depreciati o n . (True/Fa lse)
8. Expected obsolescence refers t o a fa l l i n the va l u e o f fixed assets d u e to
natu ra l ca l a m ities or economic recession. (True/Fa lse)
ee
9. Cons u m ption of fixed ca pital is managed t h rough depreciation reserve fu n d . (True/Fa lse)
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10. A flow is a q u a ntity that is measu red a t a particu l a r point o f ti me. (True/Fa lse)
11. Stock i m pacts the fl ow: greater the stock of ca pita l, greater is the flow
of goods a n d services. (True/Fa lse)
or
12. Stock of ma n-made goods which a re used for fu rther prod u ction is ca l led
ca pita l formati o n . (True/Fa lse)
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u
13. Ci rc u l a r fl ow o f i ncome refers t o the u ne n d i ng flow o f the activiti es o f p rod uction,
k
i n come generation and expend itu re i nvolvi ng d ifferent sectors of the economy. (True/Fa lse)
Yo
oo
14. Va l u e Add ition = Va l u e of output - Expenditure o n i ntermed iate goods
and services. (True/Fa lse)
B
15. There is n o government in the two-sector economy of consumers and prod ucers. (True/Fa lse)
re
Answers
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ad
1. True 2. True 3. Fa lse 4. True 5 . Fa lse 6. True 7. False 8. Fa lse 9. True 10. Fa lse
11. True 12. Fa lse 13. True 14. True 15. True
Y
nd
D. Matc h i n g the Correct Statements

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I . From the set of statements given in Column I and Column II, choose the correct pair of statements:
Fi
Column I Column I I -
(a) I ntermediate goods (i) S h i rts p u rchased by firm X from firm Y fo r fi n a l con s u m ption
(b) F i n a l goods ( i i ) H ave crossed the boundary l i n e of prod uction
(c) H igher prod uction of ca pital goods ( i i i ) H igher leve l of welfare of the people
(d) G ross i nvestment (iv) Net addition to the existi ng capital stock
(e) Moneta ry expenditure (v) A stock con cept
Answer
(b) Final goods - (ii) Have crossed the bou ndary line of production
II. Identify the correct sequence of alternatives given i n Column II by matching them with respective
items in Column I.
Column I Column I I
(a) Cement production (i) Raises prod uctive capacity of the produ cers
( b) Fi na l goods ( i i ) Resold by the fi rms for profit d u ring the acco u nting yea r
(c) Fixed i nvestment ( i i i ) Fixed assets of the producers
( d ) I ntermed iate goods (iv) Included i n the estimation of national pro d uct
(e) Capital goods (v) A flow va ria b l e
Answers
(a) - (v), (b) - (iv), (c) - (i), (d) - (ii), (e) - (iii)
E . 'Very S h o rt Answer' Objective Type Questions

1. What a re fi nal goods?
Ans. F i n a l goods a re those goods which have crossed the bou n d a ry l i n e of prod u ction and a re ready for
use by their fi n a l users.
2. Define intermediate goods.
Ans. I ntermed iate goods a re those goods which a re wit h i n the bou n d a ry l i n e of p rod uction and not ready
for use by their fi n a l users.
3 . Define intermediate consu m ption.
Ans. I ntermed iate consu m ption refers to expenditure by the prod ucers on the p u rchase of i ntermed iate
goods.
4. G ive two exa m ples of fi nal goods.
Ans. (i) Pens used by stu d ents, a n d
( i i ) M i l k used b y households.
5 . G ive two exa m ples of i ntermed iate goods.
Ans. (i) Pa per used by a p u b l isher i n book-pri nti ng, a n d
( i i ) M i l k used b y a confectioner i n m a k i n g chocolates.
6. What do you mea n by consum ption goods?
Ans. Cons u m ption goods (a lso known as consumer goods) a re those goods which a re d i rectly used for the
satisfaction of h u m a n wants. Exa m ple: I ce crea m and m i l k used by the households.
7. Define si ngle-use consumer goods or non-d u rable consumer goods.
Ans. Single-use or non-d u ra b l e consumer goods a re those goods which ca n not be repeatedly used for
pu rpose of cons u m ptio n .
8. What a re semi-d u rable consumer goods?
Ans. Semi-d u ra b l e consumer goods a re those goods which ca n be used for a period of one yea r or sl ightly
more. These a re not of very h igh va l u e .
9. What is meant b y prod ucer goods?
Ans. Prod ucer goods a re those goods which a re used for fu rther p rod ucti o n . These may be used either as
raw material ( l i ke wood used i n making c h a i rs) or as fixed assets ( l i ke a tractor used i n fa rming).
10. What is meant by ca pita l goods?
Ans. Ca pita l goods a re those goods which a re u sed i n the process of prod u ctio n for severa l yea rs a n d
w h i c h a re o f h igh va l u e . These goods a re fixed assets o f the p rod ucers.
Some Basic Concepts o fMacroeconomics 41

1 1 . What is i nvestment?
Ans. I nvestment is a p rocess of i ncrease in the stock of ca pita l .
1 2 . What i s fixed i nvestment?
Ans. Fixed i nvestment refers to increase in the stock of fixed assets or capita l goods ( l i ke p l a nt a n d
machinery) o f the prod ucers d u ring a n accou nti ng yea r.
13. What do you mea n by i nventory i nvestment?
Ans. Cha nge in i nventory stock d u ring the yea r is ca l led i nventory i nvestment of the prod ucers.
14. What is gross i nvestment?
Ans. G ross i nvestment is the expenditure incu rred by the p rod ucers on the p u rchase of ca pita l goods d u ring
a n accou nting year. It includes: (i) net i nvestment, and (ii) replacement i nvestment (or depreciation).
low
15. W h a t is n e t i nvestment?
Ans. N et i nvestment is the expend itu re i ncu rred by the p rod ucers on the p u rchase of such ca pita l goods
which lead to increase in his capita l stock.
16. What is meant by consum ption of fixed ca pita l ?
A n s . Cons u m ption o f fixed capita l or depreciation refers to l oss o f va l u e o f fixed assets i n u s e on accou nt
of: (i) norm a l wea r and tea r, ( i i ) accidenta l d a mages, and ( i i i ) expected or foreseen obsolescence.
ee
17. Defin e depreciation reserve fu n d .
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Fr
A n s . Depreciation reserve fu nd is a provision of fu nds to cope with depreciation l osses. These fu nds a re
used for the rep lacement of fixed assets when these a re worn-out or when these become obsolete/
outdated .
or
18. Defin e ca p ita l loss.
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Ans. Ca pita l l oss is a loss of va l u e of fixed assets w h i l e these a re not in use. It occ u rs on acco u nt of:
u
( i ) natu ra l ca l a m ities, and ( i i ) fa l l in ma rket va l u e of the assets d u ring periods of economic recession.
k
Yo
1 9 . W h a t is cu rrent replacement cost?
oo
Ans. Cu rrent replacement cost refers to the esti mated va l u e of depreciation for a l l the prod ucing u n its i n
t h e economy d u ring the period o f a n accou nting yea r.
B
20. Defin e stock.

re
Ans. Stock is that q u a ntity of a n economic va ria ble which is measured at a pa rticu l a r point of ti me.
2 1 . Defin e flow.
ou
ad
Ans. Flow is that q u a ntity of a n economic va ria ble which is measu red d u ri ng the period of ti me.
22. G ive two exa m p les o f stock.
Y
Ans. (i) Wea lth, a n d

( i i ) Qu antity o f money.
nd
Re
23. G ive two exa m p les of flow.

Ans. ( i ) Consum ption, a n d
Fi
( i i ) I nvestment.
24. N a m e the fou r sectors of the economy.
Ans. The fou r sectors of the economy a re : ( i ) Household sector, ( i i ) Prod ucer sector, ( i i i ) G overnment
sector, a n d ( iv) The External ( Rest of the worl d ) sector.
25. What is meant by circ u l a r flow of i ncome?
Ans. Ci rc u l a r flow of i n come refers to u ne n d i ng fl ow of the activities of p rod uction, i ncome generation
a n d expenditure i nvolvi ng d i fferent sectors of the economy, prod ucers a n d households i n pa rticu l a r.
26. Defin e rea l flow.
Ans. Rea l flow refers to the flow of factor services from the household sector to the prod ucing sector a n d
the correspon d i ng flow o f goods a n d services from the prod ucing sector t o the household sector.
27. Defi ne money flow.
Ans. Money flow refers to the flow of money across d ifferent sectors of the economy. Beca use, each
sector buys goods and services from the other sector.
2. Reaso n - based Quest i o n s ( C o m p r e h e n s i o n of the S u bject - m atter)
Read the fo l l owi n g state ments ca refu l l y. Write Tru e or Fa lse wit h a reaso n .
1 . N o va lue is t o be added t o the fi n a l goods.
Ans. True. Beca use these goods have crossed the bou n d a ry l i n e of p rod uctio n and a re ready for use by
the fi n a l users.
2 . I ntermed iate goods a re d u ra b l e-use p roducer goods.
Ans. Fa lse. Beca use i ntermed iate goods a re not repeatedly used for severa l yea rs by the prod ucers a n d
a re not o f h i g h va l u e .
3 . F i n a l goods m u st fi n a l ly be consu med b y the households.
Ans. Fa lse. F i n a l goods ca n fi n a l ly be consu med by the households as wel l as by the prod ucers.
4. Vegeta bles used b y the households a re consum ption goods.
Ans. True. Beca use, vegeta bles a re d i rectly used for the satisfaction of h u m a n wa nts.
5 . O n ly fi nal goods and services a re to be considered i n the esti mation of GDP, to avoid double cou nting.
Ans. True. O n ly fi n a l goods a n d services a re to be considered to avoid d o u b l e cou nti ng in the esti mation
of G D P. Beca use, fi n a l goods a n d services d o not req u i re fu rther va l u e add iti o n . These a re outside
the bou n d a ry l i n e of prod u cti o n .
6. P u rchase o f a refrige rator b y a fi rm for its own u s e is included i n the esti mation o f national i ncome
beca use it leads to fi n a l cons u m ption expenditure.
Ans. Fa lse. P u rchase of a refrigerator by a fi rm for its own use is i n c l u d ed in the esti mation of nati o n a l
i n come beca use it l e a d s to fi n a l i nvestment expend itu re.
7 . Capita l goods i nvolve loss o f va l u e on account o f their depreciation.
Ans. True. Capita l goods a re fixed assets of the p rod ucers. They depreciate i n va l u e as these a re repeatedly
used i n the process of prod u cti o n .
8. T h e sa me good m a y be a con s u m ption good or ca pita l good, depending on its end-use.
Ans. True. Exa m ple: Ca r p u rchased by the household is a consumer (or consum pti o n ) good, w h i l e the ca r
p u rchased by a tou rist com p a ny is a ca pita l good .
9. Clothes used by the households a re d u ra b l e consumer goods.
Ans. Fa lse. Clothes used by the households a re sem i-d u ra b l e consumer goods. Beca use (i) clothes a re
used for a period of one yea r or sl ightly more, a n d ( i i ) these a re not of very h igh va l u e .
1 0 . G ross i nvestment m a y occ u r even w h e n net i nvestment is zero.
Ans. True. G ross i nvestment = N et i nvestm ent + Depreciati o n .
G ross i nvestment = Depreciation (= Replacement I nvestment), when n e t i nvestment = 0.
1 1 . G ross i nvestment incl udes the va l u e of expected obsolescence.
Ans. True. G ross i nvestment = N et i nvestment + Depreciati o n . And, expected obsolescence is a part of
depreciati o n .
12. N et i nvestment a lways i m p l ies a n i ncrease i n t h e stock o f ca pita l .
Ans. True. N et i nvestment always i m p l ies increase i n the stock o f ca pita l . Beca use, i t d oes not i n c l u d e
replacement i nvestment.
13. N et i nvestment i n d uces e m p l oyment.
Ans. True. Beca use net i nvestment leads to increase in the stock of capita l . And, more labour ca n be
e m p l oyed when the stock of capita l increases.
Some Basic Concepts ofMacroeconomics 43

14. I nve ntory i nvestment i n c l udes cha nge i n stock of consu m e r goods with the p rod ucers.
Ans. True. I nventory i nvestment i nc l u des stock of a l l types of goods ( i n c l u d i ng consumer goods) with the
p rod ucers.
15. Depreciation may occ u r even when fixed assets a re n ot i n use.
Ans. Fa lse. Depreciation is the loss of va l u e of fixed assets (ca pita l goods) i n use, on acco u nt of their
normal wea r a n d tea r.
16. Expected obsolescence is a 'ca pita l loss'.
Ans. Fa lse. U n expected obsolescence is a 'ca pita l loss'.
17. O bsolescence is a p a rt of dep reciation.
Ans. True. But only expected obsol escence is to be considered as a pa rt of depreciation.
18. Stocks do not cha nge over ti me, while flows d o .
low
Ans. Fa lse. Both stocks as wel l as flows tend to cha nge over ti me.
19. I nventory i nvestment refers to cha nge i n stock and is, therefore, a stock va ria ble.
Ans. Fa lse. I nventory i nvestment is a flow concept beca use it is related to a period of ti me.
2 0 . I ncome is a stock concept.
Ans. Fa lse. It is a fl ow concept. Beca use it is related to a period of ti me.
ee
2 1 . Pop u l ation o f a cou ntry is a flow concept.
rF
Fr
Ans. Fa lse. Pop u l ation of a cou ntry is a stock concept beca use it is related to a point of ti me.
22. Flow o f goods a n d services across d ifferent sectors of the economy is money flow.
or
Ans. Fa lse. Flow of goods a n d services across d ifferent sectors of the economy is rea l fl ow.
23. Dou ble cou nting occ u rs when the both fi n a l a n d i ntermed iate goods a re i nc lu ded in the esti mation
sf
u
of G D P.
Ans. True. Beca use, G D P i n c l u des o n ly fi n a l goods.
k
Yo
oo
3. HOTS & Applications
B
1. G ivi ng reasons, classify the following i nto intermediate goods and fi n a l goods:
(i) Machine purchased by a dea ler.
re
(ii) A ca r purchased by a household.

ou
Ans. ( i ) M a c h i n e p u rchased by a dealer is a n i ntermed iate good beca use a dealer p u rchase a machine
ad
for fu rther sale to its fi n a l users.

Y
( i i ) A ca r p u rchased by a household is a fi n a l good beca use the household is the fi n a l user of the ca r
a n d n o va l u e is to be added to the ca r.
nd
Re
2. Classify the fol l owing goods i nto i ntermed iate goods and final goods:
(i) M i l k purchased by a household.
Fi
(ii) Purchase of rice by a grocery shop.

(iii) Purchase of a n a i r conditioner for use i n shop.
( iv) Cloth used for m a king a sofa-set by the ca rpenter.
Ans. ( i ) M i l k p u rchased by a household is a fi n a l good beca use m i l k d i rectly satisfies the wa nts of the
household(s) or the consu mer(s) .
( i i ) Pu rchase of rice by a grocery shop is a n i ntermed iate good beca use rice is p u rchased for resa le
to its fi n a l u sers.
(iii) Pu rchase of a n a i r con d itioner for use i n shop is a fi n a l good beca use a i r conditioner is a n
i nvestment expenditure as it a d d s t o t h e capita l stock o f t h e shopkeeper.
( iv) Cloth used for m a king a sofa-set by the ca rpenter is a n i ntermed iate good as it is used as a raw
materi a l .
3 . State whether the fol lowi ng statements a re true or fa lse. G ive reasons for you r a n swer:
(i) Capita l formation is a flow.
(ii) Bread is a l ways a consumer good .
Ans. (i) The statement is true. Beca use capita l formation is measu red per u n it of ti me period .
( i i ) The statement is fa lse. Beca use it depends on the end-use of the bread whether it is a p rod ucer
good or a consu mer good . It is a consumer good when used by the households. It is a p rod ucer
good when used by a snacks-ba r to m a ke sandwiches.
4. A kind of goods used as i nte rmed i a ry goods ca n never be fi n a l goods. Defend or refute.
Ans. The given statement is i n correct. The same good may be a fi n a l good or an i ntermed iate good . It a l l
depends on t h e end-use of t h e goods. Exa m ple: Suga r is a fi n a l good when used b y households. I t i s
a n i ntermed iate good when used b y ca ndy-ma kers.
5 . If depreciation reserve fu nd is n ot m a i nta i ned, p rod uction capacity i n the economy wou l d tend to
red uce. Do you agree?
Ans. Yes, the above statement is correct. If depreciation reserve fu nd is n ot m a i nta i ned, p rod uction
capacity i n the economy wou l d tend to red uce. Beca use depreciation reserve fu nd facilitates
replacement i nvestment ( replacement of worn-out assets).
6. State the two basic principles of circu lar flow of i ncome and product.
Ans. The c i rcu l a r flow of i n come and prod uct works o n two basic principles :
( i ) Money flows a re opposite t o the rea l flows ( i n terms o f goods a n d services ) .
( i i ) Flow o f i ncome across d ifferent sectors always i m p l ies the identity between payments and recei pts.
7. With money as a med i u m of excha nge, only money flows preva i l in the economy, not the rea l flows.
Is it true?
Ans. N o, this is fa lse. Money fl ows a re o n ly reci proca l of rea l flows. Rea l flows (flow of goods and services)
a re the essence of consum ption and production activities in the economy.
8. Should purchase of wheat in the wholesa le ma rket be treated as the purchase of final good?
Ans. P u rchase of wheat i n the wholesa le ma rket is often done by the traders. Wheat is a consu m ption
good a n d t raders a re not the fi n a l users of wheat. Therefore, p u rchase of wheat i n the wholesale
ma rket is to be treated as the p u rchase of i nterm ediate good .
H owever, sometimes the households buy wheat i n b u l k from wholesa le ma rket. I n such situations,
p u rchase of wheat should be t reated as p u rchase of fi n a l good .
9. Purchase of shares of Relia nce company by the households in India is not to be treated as i nvestment
i n the economy. J ustify.
Ans. I n economics, investment refers to ca pita l formation. It must lead to i ncrease i n the stock of capital i n the
economy. Purchase of shares of the Relia nce company by the households i n I ndia does not lead to ca pita l
formation. It only causes cha nge i n t h e title of ownership of assets from o n e set o f persons t o t h e other.
10. Al l machi nes a re not ca pita l goods. J ustify.
Ans. The end-use of the machine d etermi nes whether it is a capita l good or not. Capita l goods a re those
fixed assets of the prod ucers which a re used in the process of prod uction for severa l yea rs a n d which
a re of high va l u e . Therefore, o n ly those machi nes which a re used i n the process of prod u ction a re
considered to be ca pita l goods. Those machi nes which a re used by the households a re not capita l
goods. Exa m pl e: Com p uter used a t home is a d u ra b l e-use consu mer good, b u t a com p uter used i n
t h e com p uter coaching class is a ca pita l good .
11. 'Lower ca pita l formation leads to lower rate of G D P growth .' Comment.
Ans. Lower ca pita l formation i m p l ies slower rise i n prod uction capacity of the economy. When p rod uction
capacity rises at a slow rate, output is bou nd to rise at a slow rate. Slow rise i n output i m p l ies a slow
rise i n G D P.

12. Only net investment and not gross investment shows change in stock of capital. Defend or refute.
Ans. The statement is true. G ross i nvestment i nc l u des expenditure on the p u rchase of new assets which
ca uses cha nge i n the stock of capita l a n d expenditure on the replacement of worn-out assets which
does not ca use cha nge i n stock of ca pita l . Th us, from gross i nvestment, we ca n not esti mate net
add ition to the stock of capita l . It is o n ly i n d icated by the net i nvestment.
13. M a rket va lue of you r ca r at the time of purchase i n 2017 was � 5,50,000. I n 2019, its ma rket va lue
is esti mated to be � 3,50,000.
What do you t h i n k is the reason for the fa l l in the va lue of the ca r?
(a) Normal wea r and tea r
(bl Accidenta l damages that the ca r m ight have suffered
(c) Unexpected obsolescence
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(d) Both (a) and (bl
Ans. ( d ) Both norma l wea r a n d tea r a n d the accidenta l damages that the ca r m ight have suffered, a re the
reasons for the fa l l i n the va l u e of the ca r.
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1. As a student of economics, how would you distinguish between capital goods and capital stock?
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Ans. Ca pita l goods a re the d u ra ble-use prod ucer goods a n d i nvolve depreciation l osses w h i l e i n use.
Exa m ple: P l a nt a n d mach i nery.
Ca pita l stock is the stock of a l l man-made goods which ca n be used as a means for fu rther prod u cti o n .
or
Ca pita l goods a re o n ly a part o f capita l stock. Besides ca pita l goods, ca pita l stock a l so i n c l u des t h e
sf
stock o f consu mer goods, sem i-fi n ished goods or even raw materia l w h i c h ca n be used for pu rpose
u
of fu rther prod uction or va l u e add iti o n . Exa m ple: Stock of wheat with the flo u r m i l l is a pa rt of its
i nventory stock, a n d therefore, a pa rt of its capita l stock.
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2. Descri be the economic va lue of the d istinction between gross investment and net investment.
Ans. G ross i nvestment incl udes: (i) net i nvestment, and ( i i ) replacement i nvestment. Replacement
B
i nvestment is fu nded t h rough depreciation reserve fu n d . Beca use, this i nvestment is exactly eq u a l
re
t o depreciation l osses. Thus, replacement i nvestment just restores the va l u e o f fixed assets (which i s
l ost on acco u nt o f t h e i r depreciati o n ) . It d oes n ot l e a d t o a ny increase i n capita l stock ( o r p rod uction
capacity) of the prod ucers.
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N et i nvestment, on the other hand, is a n i nvestment that leads to increase i n capita l stock of the
Y
p rod ucers. It causes increase i n their prod uction ca pacity.

Since net i nvestment is related to increase i n prod uction capacity of the p rod ucers, we ca n say that
nd
it is net i nvestment ( n ot replacement i nvestment) which is needed to accelerate the pace of growth
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a n d d evelop ment.
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Briefly, replacement i nvestment helps m a i nta i n the existi ng level of G D P. N et i nvestment leads to a
shift i n the G D P level, ind icati ng growth and prosperity.
3 . The govern ment asserts that M G N R EGA (Ma hatma Gandhi N ational R u ra l Employment Guara ntee
Act) is to be related to asset creation. How do you eva luate this statement?
Ans. M G N REGA is a social welfa re scheme lau nched by the Government of I ndia. It is to provide a gua ra nteed
job for 100 days to the people in the ru ra l a reas. It has been observed over ti me that this scheme has led
to h uge government expend itu re. But most of it has remai ned u n prod uctive: employment generation
has not led to proportionate asset formation or ca pita l formation ( i n terms of the construction of roads,
dams or ca nals). It is now being emphasised that there must be asset formation a long with generation
of employment. It impl ies that net ca pita l formation ( i n the economy) must a lso i ncrease a long with
increase i n employment.
5. CBSE Questions-Past 5 yea rs
(With Answers or Reference to the Text for Answers)
1. Depreciation of fixed ca pita l assets refers to : (choose the co rrect a lternative) [CBSE Delhi 201 6]
(a) normal wea r and tea r
( b ) foreseen obsol escence
(c) normal wea r and tea r and foreseen obsol escence
(d) u nforeseen obsolescence
[(c)]
2. Defi n e stocks. [CBSE Delhi 201 6]
[ Page 27]
3 . Defi n e flows. [CBSE {Al) 201 6]
Or
Defi n e flow va ria b l es. [CBSE 2019 {58/2/1)]
[ Page 28]
4. U nforeseen obsol escence of fixed ca pita l assets d u ring prod u ction is: (choose the correct
a l ternative) [CBSE {F) 201 6]
(a) cons u m ption of fixed ca pita l ( b ) capita l l oss
(c) i n come l oss ( d ) none of the above
[(b)]
5 . Defi n e gross i nvestment. [CBSE {F) 201 6]
[ Page 24]
6. Disti nguish between fi n a l goods a n d i ntermed iate goods. G ive a n exa m p l e of each.
[ Page 16-18] [CBSE Delhi 201 7]
7. Exp l a i n with the h e l p of a n exa m p l e, the basis of classifying goods i nto fi n a l goods a n d i ntermed iate
goods. [CBSE {Al) 201 7]
[ Page 18]
8. Exp l a i n the c i rcu l a r flow of i ncome. [CBSE {Al) 201 7]
[ Page 32-35]
9. Disti nguish between stocks and fl ows. G ive an exa m p l e of each. [CBSE {Al) 201 7; {F) 201 7]
Or
Disti nguish between stock and fl ow va ria bles with suita ble exa m ples. [CBSE 2018]
[ Page 28]
10. What a re ca pita l goods? H ow a re they d i fferent from consu m ption goods? [CBSE 2018]
[ Page 19-2 1]
11. G ive a ny two exa m ples of flow concept. [CBSE 2019 (58/1/1)]
[ Page 28]
12. Defi n e 'ca pita l goods'. [CBSE 2019 (58/5/1)]
[ Page 20]
6. N C E RT Questions (With H i nts to Answers)

1. Descri be the fou r major sectors in an economy accord ing to the macroeconomic point of view.
[ H i nt : An economy is genera l ly classified i nto the fol l owing fou r sectors:
( i ) H ousehold sector, engaged i n the consu m ption of goods a n d services.
( i i ) Prod ucer sector, engaged i n the prod u ction of goods and services.

( i i i ) Government sector, engaged i n such activities which a re related to taxation a n d su bsidies.
( iv) Rest of the world sector, engaged i n exports a n d i m ports.]
2. Disti nguish between stock and flow. Between net i nvestment and ca pita l, which is a stock and which
is a flow? Com pa re net i nvestment a n d capita l with water i n a ta nk.
[ H i nt : Stock is that q u a ntity of a n economic va ria b l e which is measu red at a particu l a r point of ti me.
Stock has n o ti me d i mension. Flow is that q u a ntity of a n economic va ria ble which is measu red d u ring
the period of ti me. Flow has ti me d i mension as per hou r, per day, per month.
N et i nvestment is a flow va ria b l e a n d ca pita l is a stock va ria ble. Flow of water i n a ta n k is flow
beca use it is measu red per u n it of ti me period . Whereas, stock of water in a ta n k is stock beca use it is
measu red at a point of ti me. Ca pita l is l i ke a stock of water in the ta n k at a point of ti me. I nvestment
o n the other hand, is l i ke a flow of water i n the ta nk.]
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7. M i scel la neous Questions a nd Reference to the Text for Answers
A. Questions of 3 & 4 ma rks each

1. Exp l a i n the concept of i nterm ediate goods. [Page 1 6, 1 7]
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2. Exp l a i n the concept of fi n a l goods. [Page 1 6]
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3. Disti nguish between i ntermed iate prod uct a n d fi n a l prod uct. [Page 1 8]
4. Disti nguish between fi n a l consumer goods a n d fi n a l p rod ucer goods. [Page 1 6]
5. Disti nguish between consum ption goods and ca pita l goods. Which of these a re fi nal goods? [Page 21]
or
6. A l l ca pita l goods a re p rod ucer goods. Why? [Page 20]
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7. Classify the fol l owing goods in d u ra b l e and non-d u ra b l e goods and services :
( i ) Clothes, ( i i ) Refrigerator, ( i i i ) Ed i b l e oil, ( iv) Fu rnitu re, (v) Was h i ng machi ne, (vi ) Tu ition by a teacher,
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(vi i) Visit to patient by the d octor, (vi i i ) Was h i ng soa p, ( ix) Colgate toothpaste, a n d (x) Tel evision.
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[Page 1 9, 20]
8. State whether the fol l owing is a stock or a fl ow:
B
(i) Wea lth, (ii) Cement prod uction, ( i i i ) Money s u p p ly or q u a ntity of money i n the nation, and
re
( iv) Cha nge i n nation's money s u p ply. [Page 2 7-29]

9. Exp l a i n the classification of consu m ption goods. [Page 1 9, 20]
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10. Differentiate between gross i nvestment a n d net i nvestment. [Page 25]

11. W hy is it necessa ry to m a ke a depreciation reserve fu n d ? [Page 26]
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12. W hy a re money fl ows opposite to rea l fl ows? [Page 32]

13. State the sign ifica n ce of c i rc u l a r flow mod e l . [Page 35]
nd
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B . Questions of 6 ma rks each

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1. Disti nguish between i ntermediate a n d fi n a l goods a n d exp l a i n the i m porta nce of this d i sti nction i n
t h e study o f national i ncome. [Page 18, 49, 50]
2. What is mea nt by i nvestment? Exp l a i n its va rious types. [Page 22-25]
3. Disti nguish between stock and flow va ria bles with exa m p l es. [Page 2 7, 28]
4. Exp l a i n ( i ) how i n come is a flow, a n d ( i i ) how the flow of i n come is c i rcu l a r?
[ H i nt : I ncome is a flow concept beca use it is measu red per u n it of ti me period, viz., i n come per
month or per a n n u m . Flow of i n come is c i rcu l a r beca use, ste m m i ng from the prod uction of goods
and services by the prod ucing u n its, it translates i nto i n come of the households (as rewa rds for
their factor services to the prod ucing u n its), a n d i n come translates i nto expenditure on the goods
and services prod u ced in the economy. Thus, prod uction (va l u e add ition), i ncome generation a n d
expenditure propel e a c h other t o form a c i rcu la rity, w h i c h is ca l led 'Ci rc u l a rity o f I ncome'.]
5. Between 'investment' a n d 'capita l', which is a stock a n d which is a flow va ria ble? Explain with a n
il lustration.
[ H i nt: (With I l lustration) Capita l is a stock va ria ble as it is measured at a point o f time. We often find
producers estimating their capita l stock at the end of the yea r, which refers to a point of time or a
pa rticular date.
I nvestment, by definition, means addition to the stock of capita l duri ng an accounting yea r.
It is measured for the yea r. If a firm has a stock of 10 machines as on M arch 3 1, 2018, a n d has
15 machines as on M a rch 3 1, 2019, it has added 5 machines to the stock of its capita l during the yea r.
Th is is its investment.]
DOs and DON'Ts

1. The students m u st u ndersta nd that the expenditure incu rred by a prod ucer/fi rm o n the routine repair
and mai ntenance of fixed assets i s not to be treated as a part of depreciation. Such a n expenditure
is treated as a part of 'i ntermed iate consumption'. Example: Consider a tourist company operating a
fleet of 1 0 cars. These cars a re taken to the service station, (say) after every 6 months for the i r routine
m a i ntenance. The expend iture, thus, i ncurred by the fi rm is not to be treated as depreciation. It is to be
treated as expenditure on repair and mai ntenance. And, all expend iture on 'repai r and mai ntenance' is
considered as a part of 'i ntermediate con s u m ption'.
For this tou rist company, depreciation wou ld be estimated as the loss of value of the ca rs (i n use) over
a period of time. If a car lasts for 5 years and its purchase value is equal to � 5 lakh, then depreciation
may be esti mated approxi mately as � 1 lakh per annum per car. So that the tota l depreciation on 1 0
cars wou l d be eq ual to � 1 0 lakh per a n n u m .
2. W h e n w e t a l k o f t h e prod ucers, w e talk o f 'the producing u n its' i n t h e economy. It i s t h e producing
u n its which h i re/purchase factors of production from their owners. The households are the owners
of factors of prod uction. The households sel l/supply factors of prod uction (land, labour, capita l and
entrepreneurial skill) to the fi rms. As rewards for the use of factors of production (a lso called factor
services), the firms make payments to the households: rent is paid for the use of land, i nterest for the
use of capita l, wages for the use of labour and profit for the use of entrepreneurial ski l l . Briefly, factor
payments a re received by the owners of factors of production (the households) and made by the users
of factors of prod uction (the fi rms) .
.,...__. • S i g n ifi cance of the Dist i n ction between

I ntermed i ate Goods and F i n a l Goods
From the viewpoi nt of national income esti mation, the difference between
i ntermed i ate goods and fi n a l goods is very s i g n ifica nt. We know, i ntermed i ate
goods a re those goods which are purchased by one fi rm from the other either
for resa l e or for use as raw materi a l i n the p roduction of other goods a n d
services. W h e n these goods are u s e d as raw materi a l i n t h e prod uction of
final goods, the va l u e of i ntermed iate goods is refl ected in the va lue of fi nal
good s. To i l l ustrate, fi rm A bought cloth for t 5,000 to be used as raw materi a l
i n the prod uction of s h i rts. T h e s h i rts were sold for t 7,00 0 . Th is va lue of
t 7,000 i ncludes the va l u e of cloth, viz., t 5,000. Therefore, in the calculation of
nati onal i ncome, the va lue of o n ly fi nal goods, that is, s h i rts of t 7,000 wou l d
be i ncl uded. The va l u e o f cloth (t 5,000) is t h e va l u e o f i ntermediate goods
(= i ntermediate cost or i ntermediate cons u m ption) and hence, will not be

inclu ded i n national p roduct/nation a l income. If we include the va l u e of
i ntermed i ate goods also, the va l u e of national prod uct wou l d add up to
< 1 2,000 (< 7,000 + < 5,0 00). It cau ses double cou nti ng. Beca use, the va l u e of
cloth (< 5,000) is a l ready i nclu ded in the va lue of s h i rts (< 7,000) . Thus, in the
calculation of national product/national i ncome, the va l u e of only fi n a l goods
is taken i nto acco u nt.
• Expansion and Contraction of C i rcular Flow: I njections and Leakages
A c i rcular fl ow (a lso cal led c i rc u l a r flow of i ncome) may expand or contract.
Expa nsion of c i rcu l a r flow of income i m p l ies a rise in the level of i ncome/
output i n the economy. Contraction of circu l a r flow, on the other hand, i m p l ies
low
a fa l l in the level of i n come/output in the economy.
Expa nsion of c i rcular fl ow occu rs owi ng to 'injections', w h i l e contraction
occurs owing to 'withd rawa l s' .
Injections
These are those macro va ri a b l es, a rise in the l evel of which leads to a rise i n
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t h e level o f output i n t h e economy. These i n c l ude ( i ) government con s u m ption
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expend iture, (ii) government i nvestment expend itu re, and (i i i) exports (expend iture
on domestic prod uct by the foreigners) . A rise i n the level of any of these
vari ables i m p l ies a rise i n the l evel of demand for the goods p roduced in the
or
domestic economy. This is expected to cause a rise i n the level of output i n the
economy. Th is i s ca l led expa nsion of circular flow
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Leakages/Withdrawals
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These are those macro vari a b l es, a rise in the level of which leads to a fa l l
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i n the l evel o f output i n the economy. These include (i) saving (oppos ite of
con s u m ption), (ii) government taxes (op pos ite of govern ment investment), a n d
B
(i i i) i m ports (oppos ite o f exports) . A r i s e i n the level of any of these vari a b l es

i m p l ies a fa l l i n the level of demand for the domestica l ly p roduced goods. This
re
leads to a fa l l i n the l evel of output i n the economy. Th i s is cal led contraction

of c i rcular fl ow
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The c i rc u l a r flow of income rema ins stable if 'leakages' a re exactly eq u a l to

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' i njections'.
• Why does the C i rcular Flow of Money never Stop?
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T h i s may be exp l a i ned in terms of the 'tw i n dema n d-s upply relation s h i p'
between prod ucers and the hou seholds. Households w i l l a l ways demand
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good s a n d services from the prod ucers, and will always su pply them their
factor services. It is by sel l i ng their factor services that the households ea rn
money to buy goods and services. On the other hand, prod ucers w i l l always
demand factor services from the households, a n d w i l l always sup ply them
the good s and services. It is only by sel l i n g the goods and services to the
households that the prod ucers earn money to buy factor services. Th is 'twi n
demand-su pply relation s h i p' w i l l n ever cease t o exi st, as it is related t o t h e very
survival of h u m a n bei ngs. Accord i ngly, the circu l a r flow of money never stops.
Ill
•
•
•
•
Concept of National Income
Domestic and National Concepts of Income
Gross and Net Concepts of Domestic Product
Domestic Product at Market Price and at Factor Cost
,,
• Aggregates Related to National Income
• Nominal and Real GDP
• GDP and Welfare
I. CONCEPT OF NATIONAL INCOME

National income is the sum total of factor incomes earned by normal
residents of a country during the period of an accounting year. This
definition of national income conveys two important points:
(i) national income includes factor incomes only, and
(ii) national income includes income of only the normal residents of
a country.
Let us go deeper into the concepts of (i) factor incomes, and
(ii) normal residents.
(I) Factor Incomes

Factor incomes are the payments made by the producing units (firms)
to the households (owners of the factors of production) for the use of
their factor services.
Factor incomes (or factor payments) are broadly classified as
under:
(i) Compensation of employees (received by the households for
rendering their services as employees of the producing units).
51
(ii) Rent (received by the households for the use of their land by the
producing units).
(iii) Interest (received by the households for the use of their capital
by the producing units).
(iv) Profit (received by the households for the use of their
entrepreneurial skills by the producing units).
In the estimation of national income, we include only these factor
incomes (or factor payments).
Factor Incomes are Different from Transfer Incomes
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It may be noted that factor incomes are different from transfer
incomes. Transfer incomes are those incomes which are received by
a person as help, donation or charity, etc. , whereas factor incomes
are those incomes which are received by the factors of production
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by rendering their factor services. In other words, while factor
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income is 'earned income', transfer income is 'unearned income'.
Since, transfer incomes are not earned as rewards for rendering
factor services, these are not included in the estimation of national
or
income.
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F®CUS National income is the sum total of factor incomes. Transfer incomes are not included
in the estimation of national income as these are not earned as rewards for rendering
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factor services.
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(2) Normal Residents

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Who are normal residents of a country?

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A normal resident is said to be one (i) who ordinarily resides in the

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country concerned, and (ii) whose centre of economic interest lies in

that country. Here, note these observations carefully:
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(i) A person residing in a country for a period of one year (or more)
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is taken as 'ordinarily residing' in that country. This person may

or may not be the citizen of that country.
(ii) A person is said to have his economic interest in a country
when he carry out all his economic activities such as production,
consumption or investment in that country.
(Check the Focus Zone for certain examples on residents and non
residents of a country.)
Normal Residents and Non-residents-Some Examples
Normal Residents of India
(i) Indians working in foreign embassies in
Non-residents of India
(i) Foreigners working in Indian F®CUS
India. embassies in Canada and Japan. ZONE
(ii) Indians employed in World Health (ii) Foreigners working in World Health
Organisation located in India. Organisation located in India.
(iii) Local people working in the office of (iii) The German working as Director of
International Monetary Fund in India. the office of International Monetary
Fund located in India.
(iv) Ambassador for India in rest of the (iv) Ambassador in India from rest of the
world. world.
(v) The foreign citizens living in India for a (v) The foreign technical experts working
period ofmore than one year (other than in India for a period of less than one
those for studies or medical treatment). year.
National income includes income of only the normal residents of a country. It does not
include income of the non-residents, even when they happen to be the citizens of our
country.
2. DOMESTIC AND NATIONAL

CONCEPTS OF INCOME
At the macro level, the concept of income is used both as a domestic
concept and a national concept. When used as a domestic concept,
we call it domestic income, and when used as a national concept, we
call it national income. Both domestic income and national income
include the four basic elements of factor income, viz., (i) compensation
of employees, (ii) rent, (iii) interest, and (iv) profit. But there is a
difference. It is as this:
Domestic income is the sum total of factor incomes (compensation of
employees + rent + interest + profit) generated within the domestic
territory of a country (no matter who generates it: normal residents
or non-residents).
National income is the sum total of factor incomes (compensation
of employees + rent + interest + profit) earned by normal residents
of a country (no matter where it is generated: within the domestic
territory or outside).
Here, it becomes important to understand the concept of domestic
territory of a country.
Domestic Territory of a Country
In common language, the domestic territory of a country is understood
to mean political territory of a nation. But, in economics, it refers
National Income and Related Aggregates 53

to 'economic territory' which is a much wider concept than political
territory. According to United Nations, "Economic territory is the
geographical territory administered by a government within which
persons, goods and capital circulate freely." Do we have this freedom
of circulation (of persons, goods and capital) in the embassies of
foreign countries located in India? No should be the answer. Do we
have this freedom of circulation (of persons, goods and capital) in
Indian embassies located abroad? Yes should be the answer. Implying
that, foreign embassies located in India are not a part of domestic/
economic territory of India. On the other hand, Indian embassies
low
located abroad are a part of domestic/economic territory of India.
Thus, while defining the term domestic territory, the focus is NOT to
be on political boundaries of a nation. The focus is to be on such a
geographical area where our persons, our goods and our capital enjoy
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the freedom of circulation. [see Ability Zone for the components of
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domestic territory.]
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Conversion of Domestic Income into National Income
or
Domestic income is the sum total of factor incomes generated within
the domestic territory of a country during the period of an accounting
sf
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a country includes
factor incomes of year. It includes factor income of both the residents as well as non-residents
both the residents and
k
in the domestic territory of a country. It needs emphasis that:
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non-residents working
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within the domestic
territory of a country.
(i) our domestic income does include factor income earned by non
residents within the domestic territory of our country,
B
2. Net factor income

from abroad is the (ii) our domestic income does not include factor income earned by
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difference between
(i) factor income our residents from the domestic territories of other countries.
earned by our
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Accordingly, domestic income becomes national income provided:

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residents who are

temporarily residing (i) we exclude from domestic income that part of factor income
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abroad, and (ii) factor

income earned by which belongs to non-residents within our domestic territory, and
non-residents who are (ii) we add to domestic income that part of factor income which
nd
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temporarily residing in
our country. our residents earn from rest of the world (or from the domestic
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territories of other countries).
F�CUS Conversion of Domestic Income into National Income

Domestic income + Net factor income from abroad = National Income
ZONE Here, Net factor income from abroad
= Factor income earned by our residents from rest of the world
- Factor income earned by non-residents in our domestic territory
For converting national income into domestic income, we use the following
equation:
National income - Net factor income from abroad = Domestic Income
Domestic Income and Domestic Product are Identical
Concepts [Domestic Income= Domestic Product]
There is no difference between the concepts of 'domestic income' and
'domestic product'. In fact, the two terms are identical to each other.
Because, all production is ultimately converted into factor incomes. In
the first round, the firms produce goods by hiring/purchasing factors
of production from the households. In the second round, the firms
distribute their revenue (from the sale of final goods) among the
owners of the factors of production (households). The households are
paid (i) compensation of employees (for labour), (ii) rent (for land),
(iii) interest (for capital), and (iv) profit (for entrepreneurial skill).
Thus, domestic income (the sum total of factor incomes) is obviously
equal to domestic product. We can write that:
Domestic Income = Domestic Product
Accordingly, the equation that:
Domestic income + Net factor income from abroad= National Income
can also be written as:
Domestic product+ Net factor income from abroad= National Product
t>TS
Q. Write two observations indicating the difference between domestic income and national income.
Ans. Following observations indicate the difference between domestic income and national income:
Domestic Income (NDPFcl National Income (NNPrcl
(i) It is the sum total of factor incomes (i) It is the sum total of factor incomes accruing to
generated within the domestic territory of normal residents of a country, no matter where
a country, no matter who generates this this income is generated-within the domestic
income-residents or non-residents. territory or in rest of the world.
(ii) It does not include net factor income from (ii) It includes net factor income from abroad.
abroad.
3. GROSS AND NET CONCEPTS OF

DOMESTIC PRODUCT
Domestic product is measured as (i) Gross Domestic Product (GDP) or
(ii) Net Domestic Product (NDP).
Depreciation (Consumption of Fixed Capital) causes the difference
between the two. While GDP includes depreciation, NDP does not.
Thus,
GDP (Gross Domestic Product) - Depreciation = NOP
Or
NOP (Net Domestic Product) + Depreciation = GDP

Likewise,
GNP (Gross National Product) - Depreciation = NNP
Or
NNP (Net National Product) + Depreciation = GNP
4. DOMESTIC PRODUCT AT MARKET PRICE

AND AT FACTOR COST
There is no difference between domestic product at market price
and domestic product at factor cost so long as we are considering a
low
two sector economy including: (i) producer sector, and (ii) household
sector and there is no 'government sector' in the economy (implying
that there are no taxes or subsidies related to the production of goods
and services).
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I rF
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Domestic product at market price is identical with domestic product at factor cost, provided there is
no government and there are no taxes and subsidies related to the production of goods and services
in the economy
or
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Once, the government sector is introduced, taxes and subsidies start
playing their role, and domestic product at market price and domestic
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product at factor cost become different aggregates. This is how it
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happens:
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• Taxes on goods (called indirect taxes) tend to raise the market

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price of the goods. Accordingly, domestic product at market price

is increased.
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ad
• Subsidies tend to lower the market price of the goods. Accordingly,

domestic product at market price is reduced.
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• To restore the parity between domestic product at market price

and domestic product at factor cost:
nd
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(i) we deduct the value of indirect taxes from domestic product

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at market price, and

(ii) we add the value of subsidies to domestic product at market
price.
It is with this adjustment that the two aggregates become equal.
Thus, 'domestic product at market price' and 'domestic product at
factor cost' are related to each other as in the following equations:
Domestic product (gross/net) at market price
- Net indirect taxes
F®CUS
= Domestic Product (gross/net) at factor cost ZONE
[Note: Net indirect taxes = Indirect taxes - Subsidies]
Likewise, we can write that,
National product (gross/net) at market price
- Net indirect taxes
= National Product (gross/net) at factor cost
5. AGGREGATES RELATED TO NATIONAL INCOME

We now give a brief description of the various aggregates related to
national income, as under:
(I) Gross Domestic Product at Market Price [GDPMP]

Gross domestic product at market price is the market value of final
goods and services produced within the domestic territory of a country
during the period of an accounting year, inclusive of depreciation.
(2) Net Domestic Product at Market Price [NDPMPl

Net domestic product at market price is the market value of the final
goods and services produced within the domestic territory of a country
during the period of an accounting year, exclusive of depreciation.
Relating (1) and (2), we can write that:
GDPMP =
NDPMP + Depreciation
and NDPM P =
GDPM P - Depreciation
(3) Gross National Product at Market Price [GNPMPl

Gross national product at market price is the sum total of gross
domestic product at market price and net factor income from abroad.
GNPM P = GDPMP + Net factor income from abroad
(4) Net National Product at Market Price [NNPMP]

Net national product at market price is the sum total of net domestic
product at market price and net factor income from abroad.
NNPMP = NDPM P + Net factor income from abroad

(5) Gross Domestic Product at Factor Cost [GDPFcJ
Gross domestic product at factor cost is the sum total of factor cost
incurred on the production of final goods and services within the
domestic territory of a country (during an accounting year), inclusive
of depreciation.
GDP F e = Compensation of employees + Rent + Interest + Profit
+ Depreciation
(6) Net Domestic Product at Factor Cost [NDPFcJ
low
Or Net Domestic Income
Net domestic product at factor cost is the sum total of factor cost
incurred on the production of final goods and services with the
domestic territory of a country, during an accounting year.
ee
NDP Fc = Compensation of employees + Rent + Interest + Profit
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Relating (5) and (6), we can write that:
GDP F c = NDP Fc + Depreciation
or
and NDP F c = GDP Fc - Depreciation
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(7) Gross National Product at Factor Cost [GNPFcJ
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Gross national product at factor cost is the sum total of gross domestic
product at factor cost and net factor income from abroad.
B
GNP F c = GDP F c + Net factor income from abroad

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(8) Net National Product at Factor Cost [NNPFcJ

ou
ad
Net national product at factor cost is the sum total of net domestic
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product at factor cost and net factor income from abroad.

nd
NNP F c = NDP F c + Net factor income from abroad

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We know that,
Fi
NDP Fc = Compensation of employees + Rent + Interest

+ Profit
Accordingly,
NNP F c = Compensation of employees + Rent + Interest
+ Profit + Net factor income from abroad
Following table sums up how various aggregates of national income
are related to each other.
Aggregates Related to National Income-A Glance
1 . G ross Domestic Prod uct a t Market
Price (GDP M P )
M a r ket va lue of fi n a l goods and services
produced with in the domestic territory of a F®CUS
co u ntry in a n accou nti ng yea r ZONE
2. Net Domestic Prod uct a t Market G D P M P - Depreci ation or Consum ption of
Price ( N D P M p ) fixed cap ita l
3 . G ross Nation a l Product a t M a r ket G D P M P + N et facto r i n come fro m a broad
Price ( G N P M P )
4. Net Nation a l Prod uct at M a r ket G N P MP - Depreciation
Price ( N N P M P )
5 . G ross Domestic Prod uct a t Factor G D P M P - I n d i rect taxes + S u bsid ies
Cost ( G D P Fcl
6. Net Dom esti c P roduct at Factor GDP Fe - Depreciation

Cost o r Net Domesti c I n come
( N D P Fc)
7. G ross Natio na l Product at Facto r G D P Fe + Net facto r i ncome fro m a b road
Cost ( G N P Fcl
8. Net Natio n al Product at Factor GNP Fe - Depreci ation
Cost o r Natio na l I n come ( N N P Fcl
See flow chart of these aggregates below:

AGG REGATES RELATED TO NATIONAL I N COM E-A F LOW CHART
F®CUS
ZONE
Understand this chart conceptually w/o Formulas! GNP - net factor
(factor coSt) income from abroad GDP
(factor cost)
\ n
\g n
\f Q 0
\• -o
3 -g. ::::, I
"'
,.., C n OJ
\, �-
o� 3 -o
\? -0 ;:::;·
... OJ
GNP 5· -
(market price)
!=a:,,J�"r------:----- • + net factor
in co m e fro m NDP
· ···· ·
�?.�:?.'.:?.......• (factor cost)
e'> .-------�• ,
C
_ o
ro ·.;::::;
� / /
:t:' Q_
e , ,/ e
'-e;c..,"'- . 0·, ',,
'> '>
o. E / ,'o-f
[3 �
+ .,06'c, "S)/
0
'>;/
/ec..,"'-- · e"
C
0 / x/ ,,/6,, {_/}
NDP ,,/ X' · 0 ',0'<:l
u
(ma rket price) ·/ /

''',,,,'' .;._
NNP
(market price) + net factor
income from
I
abroad

6. NOMI NAL AN D REAL G D P
Nominal G DP
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. Current year prices are the prices prevailing during the
year of estimation.
Thus:
Here, Q = Quantity of final goods and
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services produced during an
accounting year
Nominal GDP = Q x P
P = Prices prevailing during the
accounting year.
ee
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The above equation shows that nominal GDP can increase when there
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is increase in either Q or P. If it increases owing to increase in Q
(P remaining constant), it shows increase in nominal GDP owing to
or
increase in output. On the other hand, if it increases owing to increase
in P (0 remaining constant), it shows increase in nominal GDP owing
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to increase in the general price level. It is merely a monetary increase
in GDP, and is of little significance. It does not cause any increase in
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the flow of goods and services in the economy. It only causes 'money
illusion'-the illusion of a higher market value of the given output.
B
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Real GDP
It refers to GDP at constant prices. It i s the market value of the
ou
ad
final goods and services produced within the domestic territory of a

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country during an accounting year, as estimated using the base year

• When nominal G D P
rises, the flow of prices. Base year is the year of comparison. It is the year when macro
nd
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goods a n d services in variables (like production and general price level) are believed to be
the economy may or
within their normal range.
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may not rise during an

accounting year
Thus:
• When real G D P rises,
the flow of goods Here, Q = Quantity of final goods and
and services in the
economy must rise services produced during an
d u ring an accou nting Real GDP = Q x P* accounting year
year. P*= Prices prevailing during the
base year.
The above equation shows that real GDP increases only when
Q increases. Simply because P* is constant. So that when real GDP
increases, there is an increase in the flow of goods and services in the
economy. Other things remaining constant, higher the level of real
GDP, greater should be the availability of goods and services to the
residents of a country. Implying that the quality of life should improve.
Table 1 on the estimation of nominal GDP illustrates how nominal GDP
can rise even when output is constant.
Table 1 . Estimation of Nominal GDP
[Assumptions: (i) The economy produces wheat, cloth and sugar
only, and (ii) Output remains constant]
(� in crore)
Yea r Commod ity Quantity Price GDP MP ( Nomina l )
2011-12 Wh eat 20 tonnes 100 per ton n e 2,000
C l oth 100 metres 5 per metre + 500
Suga r 5 ton nes 500 per ton n e + 2,500
= 5,000
2018-19 Wh eat 20 to n nes 1, 000 per tonne 20,000
C l oth 100 metres 20 per metre + 2,000
Suga r 5 ton nes 1, 600 per tonne + 8,000
= 30,000
Thus, nominal GDP rises from � 5,000 crore to � 30,000 crore

even when output is constant. Here, rise in nominal GDP is driven
exclusively by the rise in price level.
Table 2 on the estimation of real GDP shows that real GDP rises only
when output rises.
Table 2 . Estimation of Real GDP
[Assumptions: (i) The economy produces wheat, cloth and sugar
only, and (ii) Prices remain constant]
(� in crore)
Yea r Commod ity Quantity Price GDP MP ( Real )

2011-12 Wh eat 20 to n nes 100 per tonne 2,000
C l oth 100 metres 5 per m et re + 500
Sugar 5 ton nes 500 per t o n n e + 2,500
= 5,000
2018-19 Wh eat 30 to n n e s 1 0 0 per tonne 3,000
C l oth 200 metres 5 per m et re + 1,000
Suga r 10 tonnes 500 per tonne + 5,000
= 9,000
Thus, real GDP rises from � 5,000 crore to � 9,000 crore, even when
price level is constant. Here, rise in real GDP is driven exclusively by
the rise in output.

F®CUS GDP at current prices (also called monetary GDP or nominal GDP) refers to market
value of the final goods and services produced within the domestic territory of a country
ZONE during an accounting year, as estimated using the current year prices. It may increase
without any increase in the quantum of output in the economy.
GDP at constant prices (also called real GDP) refers to 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. It increases only when there is increase in the
quantum of output in the economy.
The index of real GDP always reflects a change in the level of output,
low
while the index of nominal GDP may or may not. Which is why real
GDP is considered as a better index of economic growth than the
nominal GDP.
t>TS
ee
Write observations indicating the difference between G D P at current prices and G D P at consta nt
Q.
rF
Fr
prices.
Ans. Following observations indicate the d iffe ren ce between G D P at cu rrent prices a n d G D P at consta nt
prices :
or
GDP at Cu rrent Prices GDP at Constant Prices
sf
u
( i ) It is the market va l ue of the fi n a l goods and ( i ) It is the m a r ket va l u e of the fi n a l goods a n d
services produced with i n the domestic territory services produ ced wit h i n t h e domestic territo ry
k
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of a cou ntry d u ring a n acco u nting yea r, as of a cou ntry d u ri ng a n acco u nting yea r, as
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estimated at c u rrent yea r prices. esti mated at base yea r prices.
B
( i i ) It can i n crease if price leve l rises eve n when (ii) It can i ncrease only when the flow of goods a n d
there is no i ncrease i n the flow of goods a n d services i ncrease i n the econo my.
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se rvices i n the economy.

( i i i ) It is known as n o m i n a l G D P. ( i ii) It is known as rea l G D P.
ou
ad
(iv) It is not a good measure of welfare of people. (iv) It is a good measu re of welfa re of people.
Y
Conversion of Nominal GDP into Real GDP

nd
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If GDP at current prices is divided by the price index of the current

year and multiplied by the price index of base year (which is always
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equal to 100), we obtain GDP at constant prices or real GDP.

.
ReaI G D P or G D P at Const an t P nces = G D P at Cur rent Prices x 1 00
P nee
. 1 n dex
I l l ustration
If in 2011, GDP is � 100 crore, and in 2019 it is � 200 crore at the
current prices. And, if price index rises from 100 to 400 within the
same period, then GDP at current prices is converted into real GDP
(or GDP at constant prices) as in Table 3.
Table 3 . Conversion of Nom inal GDP into Real GD P
Year G DP at Index Number or G DP at Constant Prices
Current Prices Cu rrent Price (or Base Year Prices)
(t in crore) Index (t in crore)
100
2019 200 400 2QQ X = SQ
400
It may be noted that GDP at current prices in 2019 is twice the GDP
in 2011. But, GDP at constant prices has reduced from 100 in 2011 to
50 in 2019. This is because the index of price in the year 2019 has
risen to 400 (compared to 100 in 2011).
We may also estimate nominal GDP, if real GDP and price index are
known to us, using the following formula:
Pric dex
Nominal GDP = Real GDP X ��
Exam ple.
Find nominal GDP if real GDP = 240 and price index = 1 20.
Solution :
Price Index
Nomma. I GDP = Rea I GDP x
100
120
= 240 X = 288
1 OO
Ans. Nomi nal G DP = 288.
GDP Deflator
It refers to the ratio between GDP at current prices and GDP at constant prices. It is F@CUS
expressed as under: ZO NE
GDP at Current Prices
GDP Deffator = x 1 00
GDP at Constant Prices
It shows change in GDP due to change in price level. It is the same as price index.
Example. If real GDP = 600 and nominal GDP = 660, f,nd GDP deflator (price index).
. Nominal GDP
Solution: GDP Deflator (Price Index) = Real GDP
x I 00
660
= 600 x / 00 = I J O
It shows increase in the general price level by I 0%.
Note: GDP deflator should not be confused with Consumer Price Index, even when both indicate
change in the price level. The basic difference is as under:
GDP deflator indicates change in price index or change in price level related to ALL goods
and services produced within the domestic territory of a country.
Consumer Price Index indicates change in price index or change in price level related to only
a specific basket of goods bought by the consumers, and these may be produced
within the domestic territory or in rest of the world.
7. G D P AN D WELFARE
Real GDP is considered as an index of welfare of the people. Welfare
of the people is measured in terms of the availability of goods and

services per person. Increase in real GDP means increase in the level of
output in the economy. Other things remaining constant, this means
greater availability of goods per person implying higher level of welfare
(popularly known as social welfare). It is because of this reason that
the planners and politicians in a country always lay emphasis on the
growth rate of GDP. Higher the growth of GDP, greater is the flow of
goods and services. Greater is the availability of goods and services
per person.
Limitations
low
But there are certain limitations related to the positive relationship
between GDP and welfare. Or, we can say that 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,
ee
GDP growth fails to reflect a rise in social welfare. India is facing this
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situation at present. While per capita GDP is rising, starvation
deaths are hitting the headlines more often than ever before.
Reason: Distribution of income is becoming increasingly unequal.
or
(2) Composition of GDP: Composition of GDP may not be welfare
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oriented. Example: Increase in the production of defence goods
does not lead to any direct increase in welfare of the people.
k
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[Of course, strong defence offers a peaceful environment in the
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country. But, it contributes to social welfare only indirectly. ]
B
There are many activities that are left out from the (3) Non-monetary Exchanges: In rural economies, barter system of
re
estimation of National Income. These activities are

non-monetary and non market transactions. For
example,
exchange still prevails to some extent. Payments for farm labour
are often made in kind rather than in cash. All such transactions
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Services of Housewife
remain unrecorded. This causes underestimation of GDP. To the
ad
Kitchen gardening
services of family members to each other
own account production
extent GDP remains underestimated, it remains an inappropriate
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leisure time activities etc.

These non-exchange and non-monetary production
activities are left out from GDP on account of the index of welfare.
non-availability of data and the problem of evaluation.
(4) Externalities: Externalities refer to good and bad impact of an
nd
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economic activity without paying the price or penalty for that.

However, such activites contribute to the economic
welfare.
Fi
So, if we depend only on GDP, we are underestimating There are both positive and negative externalities. Positive
the economic welfare.
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 or industrial waste is driven into rivers causing water
pollution. It causes a loss of social welfare. But, most farmers
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.
Thus, there are serious limitations of GDP as an index of welfare. These
limitations reduce the significance of GDP as an index of welfare.
t>TS
Q. What lowers the significance of G D P as an index of welfare?
Ans. The following observations explain how the significance of G D P as an index of welfare is lowered:
(i) Distribution of I ncome: G D P as an index of welfare loses significance if the distribution of
income turns uneq ual.
(ii) Composition of GDP: If luxu ries are prod uced for richer sections of the society and the poor
suffer dep rivation, G D P growth becomes meaningless.
(iii) Non-monetary Excha nges/Transactions: Larger the non-monetary transactions, greater the
underestimation of G D P as an index of welfare.
(iv) Externalities: G D P index does not account for externalities: the good and bad impact of
economic activities without the price or penalty. Environmental pollution related to p roduction
activity is an i m portant example. This also lowers the significance of G D P as an index of welfare.
Power Poi nts & Revision Window ------------
l
Nationa1 Income is the s u m tota l of fa cto r i n comes accru i n g to n ormal resi d e nts of a cou ntry. It does not
acco u n t fo r tra n sfe r i ncomes.
j Factor I ncomes a re the rewa rds of the factor of p rod uction, viz., co m pensati o n of e m p l oyees,
re nt, inte rest a n d profit.
Tra nsfer I ncomes a re u n ea rned i n co mes. These i nclu d e gifts in cash, schola rs h i ps to the stu d e nts,
old-age pensions to the senior, etc. These a re n ot i n c l uded in the esti mation of the national i n come.
Normal Residents of a Country a re the peo ple who (i) n o r m a l l y res i d e in the cou ntry concerned, a n d
( i i ) w h ose centre o f eco n o m i c i nte rest l ies in t h e cou ntry con cerned .
Domestic Income is the s u m tota l of facto r i n comes ge nerated with i n the d o m estic territo ry of the cou ntry
j l ( n o m atte r it i s the income accruing to resi d e nts o r n o n - residents of the co u ntry) .

Conversion of Domestic I ncome i nto National Income:
Domestic i ncome + Net fa cto r i ncome from a b road = Nati on a l I n come
Domestic Territory of a Country is the eco n o m i c te rrito ry of the co u ntry i n w h i c h economic a ctivities of
the cou ntry ge nerate its domestic i n co m e .
Net Factor Income from Abroad (NFIA) i s the d iffe re n ce between the fa cto r i n come earned b y o u r
res i d e nts from a b road a n d facto r i n co m e earned by non-residents
j
j
1n o u r cou ntry.
Domestic I ncome d oes not i nc l u d e net fa cto r i nco me from a b roa d .
National I ncome includ es net fa cto r i ncome from abroa d .
j
G ross a n d Net Concepts
! G ross Domestic Product is the m a rket va l u e of fi n a l goods a n d services pro d u ced within the
domestic territory of the cou ntry d u ri ng a n acco u nting yea r, i n c l us ive of d e p reciation .
Net Domestic Product is the ma rket va l u e of fi nal goods a n d services p ro d u ced with i n the domestic
te rrito ry of the cou ntry d u ring a n acco u nti n g yea r, excl us ive of depreciati o n .
Conversion o f GDP into NDP:
GDP - Depreciation = N DP

j j
Market Price and Factor Cost
! Market Price incl udes the impact of indirect taxes (taxes on goods and se rvices) and
subsid ies.
I ndirect Tax ra ises the ma rket p rice, subsidies tend to l ower it.
Factor Cost is the cost of factors of prod u ction. It is eq u a l to factor payments .
Conversion of GDP M P i nto GDP Fc:
G D P M P - N et indirect taxes = G D P F c
j l
( H e re, N et ind i rect tax = Indirect tax - Subsidies.)
Nominal GDP is the ma rket va l u e of goods and se rvices p rod uced within the d omestic territory of a
country d u ring an accounting yea r, as estimated using the current yea r prices.
low
Real GDP is the ma rket va l u e of goods and services prod uced within the d omestic territory
of a country d u ring an accounting yea r, as estimated using the base yea r p rices.
Conversion of Nominal GDP into Real GDP:
N omina l G D P
x 100 = Rea l G D P
Price Index
ee
G D P Deflater is the ratio between nomina l G D P and rea l G D P. It shows change in G D P owing to the
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change in the price l eve l . It is a lso ca l l ed p rice index.
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N
G D P Deflator = �:��ii x 100
p
GDP and Welfa re
or
! Rea l GDP is a widely used ind ex of welfa re . But, it suffers from ce rtain limitations as it ignores :
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(i) d i stributi on of income, ( ii) composition of G D P, (iii) non-moneta ry transactions, ( iv) exte rna l ities.
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1 . Objective Type Questions ( Re m e m bering & U ndersta n d i ng based Questions)

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A. M u lt i p l e C h oice Quest i ons

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1. Market price of the final goods and services (incl uding depreciation) produced within the domestic
nd
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territory of a country during an accounting year, is ca lled:

(a) G D P at ma rket p rice (b) G N P at ma rket price
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(c) GDP at factor cost (d) G N P at factor cost

2. N ational income is often estimated as:
(a) N D P F c (b) N N P M P
(c) N D P M P (d) N N P Fc
3 . Domestic product is equal to:
(a) Nationa l p rod u ct + Net factor income from abroad
(b) Nationa l p rod u ct - Net factor income from abroad
(c) Nationa l p rod u ct + Net factor income from abroad
(d) Nationa l p rod u ct x Net factor income from abroad
4. Net indirect taxes are estimated as:
(a) Indirect taxes + Subsid ies (b) Subsidies - Ind irect taxes
(c) Indirect taxes - Subsid ies ( d ) both (b) and (c)
5 . Which of the fol lowing is not correct?
(a) N N P at Market Price = G N P at market price + De preciation
(b) N O P at Market Price = N N P at market price - N et factor income from abroa d
(c) N O P at Factor Cost = N O P at market price - Indirect taxes + Subsidies
(d) G D P at Factor Cost = N O P at factor cost + Depreciation
6. Which one is correct?
(a) Nationa l Income = N O P at factor cost - N et factor income from abroad
(b) G N P at Factor Cost = G N P at mar ket price + Net indirect tax
(c) Nationa l Income = Domestic income + N et factor income from abroad
(d) G D P at Factor Cost = N O P at factor cost - Depreciation
7. Basis of the difference between the concepts of market price and factor cost is :
(a) direct taxes (b) indirect taxes
(c) subsidies ( d ) net indirect taxes
8. Which one leads to factor cost?
(a) Market price - Indirect taxes (b) Market price - N et indirect taxes
(c) Market price + Indirect taxes ( d ) Market price + N et indirect taxes
9. Which one incl udes depreciation?
(a) G N P at market price (b) N N P at market price
(c) N N P at factor cost ( d ) None of these
10. Which of the fol l owing is a n exa m ple of norma l reside nts of I nd i a ?
(a) Foreign worker working in WHO located in Ind ia
(b) The German working as Director in I M F office located in India
(c) Ambassador in Ind ia from rest of the world
(d) Ambassador of Ind ia in rest of the world
1 1 . National i n come incl udes:
(a) old-age pensions (b) money sent by an N R I to his family in Ind ia
(c) transfer payments from rest of the world ( d ) none of these
12. Financial help to a victi m is:
(a) transfer payment (b) factor income
(c) net factor income from abroad ( d ) none of these
13. The d iffe rence between national i n come a n d domestic income is that of:
(a) net ind irect taxes (b) net factor income from abroad
(c) consumption of fixed ca pita l (d) both (a) and (b)
14. G N P at market price is mea s u red as:
(a) GDP at market price - Depreciation (b) GDP at market price + N et factor income from abroad
(c) G N P at market price + Subsidies ( d ) N O P at factor cost + N et factor income from abroad
15. N ational income refers to:
(a) factor incomes only
(b) income of only norma l resid ents of the country
(c) the sum tota l of d omestic income and net factor income from abroad
(d) a l l of these

16. N ational income ( N N P Fcl is equal to:
(a) G N P Fc + Depreciation ( b ) G N P Fc - Depreciation
(c) N N P M P - Net indirect taxes (d) both ( b ) and (c)
17. Which of the following ma kes GDP an ina ppropriate index of welfare?
(a) Non-mo neta ry tra nsactions ( b ) Externalities
(c) Composition a nd distribution of G D P ( d ) A l l o f these
18. The impact of an external ity is:
(a) positive ( b ) negative
(c) either positive or negative (d) neither positive nor negative
19. Rea l national income mea ns:
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(a) national income at cu rrent prices ( b ) national i ncome at factor prices
(c) national income at consta nt prices (d) national income at average prices of the past 10 yea rs
20. G D P Deflator =
Rea l income x N omina l income x
(a) 100 (b) 100
N omi n a l income Real income
ee
Real i ncome
(c) x 100 (d) None of these
Population
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21. I n crease i n price of com mod ities du e t o i ncrease in taxes assu mes releva nce in the estimation of
N N P M P beca use:
(a) taxes a re compulsory payments
or
(b) taxes a re tra nsfer payments
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(c) taxes a re paid out of i ncome of the households
(d) taxes cause a rise i n ma rket p rice of the commod ities which otherwise wou ld have been sold at
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a l ower price
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Answers
B
1. (a) 2. (d) 3. (b) 4. (c) 5 . (a) 6. (c) 7. (d) 8. (b) 9. (a) 10. (d)
11. (d) 12. (a) 13. (b) 14. (b) 15. (d) 16. (d) 17. (d) 18. (c) 19. (c)
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20. (b)
21. (d)
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B. Fill in the Blanks

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Choose appropriate word and fi l l in the blank:

1. Domestic I ncome = National income - . ( N et exports/Net facto r income from a b road )
nd
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2. ca uses the difference between gross d omestic prod u ct and net domestic
p rod uct. ( Dep reciation/I ndirect tax)
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3. A base yea r is the _______ yea r of a se ries of yea rs in an economic index. (fi rst/last)
4. _______ o n goods te nd to ra ise the ma rket p rice of the goods. ( Direct taxes/I ndirect taxes)
5 . GDP at Factor Cost = G D P at ma rket price - . ( Depreciation/Net i ndirect taxes)
6. ca n increase only when the flow of goods and services increases in the
economy. ( N ominal G D P/Real G D P )
7. Domestic factor income i s greater than national income w h e n n e t factor income from a b road is
( positive/negative)
Answers
1. Net factor income from a b road 2. Depreciation 3. first 4. Indirect taxes
5 . Net i n d i rect taxes 6. Rea l G D P 7. negative
C. True or Fa lse
1. N ational income incl udes income of only the normal residents of a country. (True/False)
2. Ind ians employed in W H O l ocated in India is norma l residents of Ind i a . (True/False)
3 . Transfer incomes are incl uded in t h e estimation o f national income as these are
rewards for rendering factor services. (Tru e/False)
4. Interest is received by the households for the use of their ca pital by the prod ucing units. (True/Fa lse)
. Real G D P
5 . Nominal GDP = . x 100 . (True/False)
P nee 1 n d ex
6. G D P at current prices may lead to increase in the flow of goods and services
in the economy. (True/False)
7. G D P deflator shows change in G D P owing to the change in the price leve l . (True/False)
Answers
1. True 2. True 3. Fa lse 4. True 5 . False 6. True 7. True
D. Match ing the Correct Statements

I. From the set of statements given in Column I and Column II, choose the correct pair of statements:
Column I Column II
(a) N N P M P (i) GNP MP + De preciati on
(b) G D P at constant prices (ii) A good measure of welfa re of peo ple
(c) Tra nsfe r i n come (iii) Earned i n come
( d) Crew members of fo reign vesse ls (iv) Normal residents of a cou ntry
(e) Environmental po l l ution (v) An exa m p l e of positive externality
Answer
(b) G D P at constant prices - (ii) A good measure of welfare of people
items in Column I:
Col u mn I Colu mn II
( a) Factor i ncome (i) Economic territory
(b) Domestic i n come ( i i ) NNP + Depreci ation
(c) G ross nati ona l product ( i i i ) Esti mated using the base yea r prices
(d) Domestic territory of a country (iv) Included i n the estimation of national i ncome
(e) Rea l G D P (v) Generated within t h e domestic territo ry o f a country
Answers
(a) - (iv) , (b) - (v), (c) - (ii) , (d) - (i) , (e) - (iii)
E . 'Very Short Answer' Objective Type Questions

1. Define gross domestic product at market price.
Ans. Gross domestic product at market price refers to market value of fina l goods and services prod uced
within the domestic territory of the country within one year, inclusive of depreciation.

2 . Defi ne net domestic product at market price.
Ans. N et d omestic prod uct at market price refers to market va l u e of fi nal goods and services prod u ced
wit h i n the d omestic territory of the cou ntry within one year, exclusive of depreciati o n .
3 . Defi ne domestic prod uct a t factor cost or domestic i n come.
Ans. Domestic product at factor cost or d omestic income is the sum total of factor incomes generated
wit h i n the domestic territory of the cou ntry d uring the period of one year along with depreciation or
consumption of fixed ca pital.
4. When is gross domestic product of an economy equal to its gross national product?
Ans. Gross domestic prod uct of a n economy is equal to its gross national product when net factor income
from a broad is zero .
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5 . Defi ne factor income.
Ans. Factor i ncome is the income received by owners of the factors of production i n the form of re nt,
wages, interest a n d profit for the services rendered in the prod uction process.
6. What is mea nt by tra n sfe r i n comes?
Ans. Tra nsfer incomes are those i ncomes corresponding to which there is no value a ddition in the
economy. Example: Gifts and donations.
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7 . W h a t is mea nt by n o m i n a l G D P ?
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Ans. Nominal G D P refers to market value of the fi nal goods a n d services prod u ced within the domestic
territory of a cou ntry d uring a n acco u nti n g year, as estimated using the curre nt year prices. It may
increase without a ny increase in the q u a ntum of output in the economy.
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8. What is mea nt by rea l G DP?
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Ans. Rea l G D P refers to market value of the fi n a l goods and services produced wit h i n the domestic
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territory of a cou ntry d uring a n acco u nti n g year, as estimated using the base year prices. It increases
only when there is increase in the q u a ntum of output in the eco nomy.
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2. Reason - based Questions (Co m prehension of the S u bject - matte r)

B
Read the fol l owi ng statements ca refu l l y. Write Tru e or Fa lse with a reaso n .
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1. Domestic product refers t o va l ue addition only b y the resident producers.

Ans. False. Domestic product/i ncome refers to value addition or income generated in the domestic territory
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of a country by a ll producers (resident and non-resident) during one year.

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2. Net factor income from abroad is treated as a component of income from domestic product
accruing to the government sector.
nd
Re
Ans. Fa lse. Net factor income from a broad is a component of nati o n a l income . It is added to domestic
income to get nati o n a l income.
Fi
3 . There is no difference between G D P at market price and G D P at factor cost in a two sector economy
including household sector and producer sector.
Ans. True. Difference between G D P at market price and G D P at factor cost is the net ind irect taxes.
Net i ndirect taxes = I ndirect taxes - Su bsid ies
The parameters of tax and su bsidies emerge only when we are considering a three sector economy
inc l u ding households, producers a n d the government.
4. GDP growth as an index of welfare loses its significance if there is a deep economic divide in the
economy.
Ans. True. Economic d ivide indicates the increasing g u lf between the rich a n d poor people. If the gulf
increases, G D P growth l oses its significa nce.
5 . N ational income at current prices can increase even when the quantum of goods and services
produced during the year remains constant.
Ans. True. Increase in the price level can cause an increase in national income at current prices without
increase in the q u antum of goods and services.
6. N ational income is a lways greater than domestic income.
Ans. Fa lse. National income can be less than d omestic income . National income is greater than domestic
income only when net factor income from a broad is some positive number.
7. Increase in national income a lways implies increase in domestic income.
Ans. Fa lse. Nationa l income = Domestic income + N et factor income from a broad .
Th is eq u ation shows that national income can increase when net factor income from a broad
increases even when d omestic income is constant.
8. N ational income at market price is always greater than national income at factor cost.
Ans. Fa lse. Nationa l income at market price = National income at factor cost + N et indirect taxes.
N ational income at market price can be less than national income at factor cost in case net indirect
taxes is a negative number.
9. Domestic income as well as nationa l income include only factor incomes.
Ans. True. National income is the sum tota l of factor incomes earned by normal residents of a country
d uring a given year. Domestic income is the sum total of factor incomes generated within the
domestic territory of a country.
10. Market price inclu des the impact of indirect taxes, but not of subsidies.
Ans. Fa lse. Market price incl udes the impact of both indirect taxes and su bsidies. Indirect taxes raise the
market price while su bsidies lower it.
11. Net indirect taxes are never equal to zero.
Ans. Fa lse. Net indirect taxes are eq u al to zero in case indirect taxes are eq u al to su bsidies.
12. Increase in national income implies increase in the flow of goods and services in the economy.
Ans. True. Provided that, nationa l income (as the market va l u e of final goods and services prod u ced
d uring the year) is estimated at constant prices, N OT at current prices.

1. When wil l domestic factor income be greater than national income?
Ans. Domestic factor income is greater than national income when net factor income from a broad is
negative.
2. In the determination of social welfare, what matters is the quantum of output rather than the
composition of output. Defend or refute.
Ans. The above statement is incorrect. Social welfare depends both on the q uantum of output as we l l
a s the composition o f output. I f goods are prod u ced primarily for richer sections o f the society
(ignoring the interest of poorer sections of the society), social welfare is bound to remain low even
when the q uantum of output is rising.
3 . Profits earned by a company in India, which is owned by a non-resident is included in national
income of India? Is it true?
Ans. No. Beca use this is the income which does not belong to the normal residents of India .
[Note : Profits earned by a company in Ind ia, which is owned by a non-resident is a part of domestic
factor income of India, beca use the company is generating profit within the domestic territory of
Ind i a . But these profits are a part of income from d omestic prod uct a ccruing to rest of the world .
Therefore, these are not reflected in the estimation of national income. These are ded ucted from
domestic income to find nationa l income . ]

4. Why is the income earned by foreigners working in a branch of a foreign bank in India a part of the
domestic factor income of India?
Ans. Th is is beca use the foreign bank is located within the domestic territory of India . Domestic factor
income incl udes all factor incomes generated within the domestic territory of a country.
5. Production of defence goods is a limitation of G D P as an index of socia l welfare. How?
Ans. Production of defence goods is a limitation of G D P as an index of soc i a l we lfare. Beca use, defence
goods do not ma ke any direct contribution to the welfare of the individ u als and households of a country.
6. Only one product D is produced in the country. Its output during the year 2018 and 2019 was 200
and 220 units respectively. The market price of the product during the year was � 100 and � 110 per
unit respectively. Calculate the percentage change in real G D P and nominal G D P in year 2019 using
2018 as the base yea r.
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Ans. Year Units Market Price Real G DP Nomina l G DP
2018 200 100 20,000 20,000
2019 220 110 2 2,000 24,200
Change in real G D P
x 100
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Percentage Change i n Rea l G D P = [ Base year: 2018 = 100]
B ase year G D P
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22, 000 - 20, 000
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X lQO
20, 000
2, 000
= 20, 000 X lQO = lQ%
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Change in nominal G D P
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Percentage Change in Nominal G D P = x 100
B ase year G D P
24, 200 - 20, 000
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X lQO
20, 000
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4, 200
B
= 20, 000 X 100 = 21%

Percentage change in rea l G D P = 10%.
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Percentage change in nominal G D P = 2 1%.

7. If the Real G D P is � 520 and Nominal G D P is � 650, calculate the price index (base = 100) .
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Ans. . Index = Nominal G D P x 100

Price
Real G D P
Y
650
= X 100 = 125
520
nd
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Price index = 125.

8. Should the fol l owing be treated as normal resident of India? G ive reason for you r a nswer.
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(i) Foreigner working i n I n d i a n embassy i n Ta iwa n .

(ii) I n d i a n working i n Asi a n Development Ba n k i n P h i l l i pines.
(iii) Indian student i n USA who has been l iving there for five yea rs.
Ans. ( i ) Foreigner working in Indian embassy in Taiwan is not a norma l resident of India .
Reaso n : (a) H e is not norma lly residing in India, and ( b ) His centre of interest does not lie in India .
( i i ) Indian working in Asian Deve l opment Bank in P hillipines is a normal resident of India .
Reaso n : H i s centre o f interest lies in India .
(ii i ) Indian student in USA who has been living there for five years is a norma l resident of India .
Reaso n : H i s centre of interest lies in India . Also, as a rule of th umb, students studying a broad (no
matter for how long) are treated as normal residents of the country they belong to.
9. An a m bassador in US embassy in India stays in his job for a period exceed i n g one yea r.
Would he be treated as a resident or non-resident of India? G ive reason .
A n s . Resid e nt o f a country i s defi n ed as a perso n who normally resides in the country (or d o e s not
leave the cou ntry for a pe riod exceeding one yea r) and whose centre of i nterest lies in the cou ntry
concerned . H owever, there a re certain rules of thumb in nati o n a l income accou nti ng ( based on
sta ndard practices rather than a ny logic). One such rule of th umb is that the foreign diplomats like
ambassadors conti n u e to be treated as non-reside nts even if their stay exceeds one yea r. Moreover,
centre of interest of such diplomats conti n ues to be in the cou ntry they belong to. Accord i n gly, US
ambassador i n I ndia wou ld be treated as non-resident of I ndia, even when his stay in I nd i a exceeds
the pe riod of one yea r.
10. The government has withdrawn subsidy on petrol in the domestic market. But petrol is now selling
chea per than before.
Do you think the withdrawal of subsidy has led to a rise in real income of the people in India ? Frame
your answer in the context of price of petrol in the international market.
Ans. Other things remain i n g consta nt, withd rawal of su bsidy should lead to a rise in ma rket p rice of
the commod ity. Implying a fa l l in real i ncome of the people . H owever, petrol is a d i sti nct case. The
bulk of d omestic s u p p ly of petrol is met through imports. The p rice of petrol in the i nternati o n a l
market has so significa ntly red uced that, even after withd rawal o f su bsidy i n the d omestic ma rket,
petrol is availa b l e to the people at a rate cheaper than before. Thus, real income of the peo ple has
risen not beca use of withd rawal of su bsidy, but beca use of a su bsta nti a l fall i n price of petrol in the
international ma rket, lead i n g to a fall in price in the d omestic ma rket.

1. The Government of India has launched a scheme of 'cash transfers' to the people below poverty
line. Would you consider these transfers as a part of domestic income of the country?
Ans. No. Beca use these a re just transfer payments, not related to factor services rendered by the beneficiaries.
2. Do you think higher level of real G D P always leads to higher availability of goods per person in the
domestic economy? If not, what lesson do you draw from such a situation?
Ans. No. H igher leve l of rea l G D P may not a lways lead to higher availa bility of goods per person in the
domestic economy. It depends on the growth rate of pop u l atio n . I n case growth rate of population is
ve ry h igh, the avail a bility of goods per person may not increase. It may in fact decrease ove r time in
case population grows faster t h a n the G D P.
A situation when population grows faste r than G D P ( a nd per ca pita availa bility of goods declines)
suggests that the GDP growth wou l d become effective only when population growth is cu rbed
(checked ) . We must devise a policy of Birth Control. O n ly then, a rise in G D P wou ld lead to a rise in
q uality of l ife of the people .
3 . Does increase in domestic income always lead to increase in national income? If not, give an il l ustration
in support of your answer. Also, write two suggestions to accelerate the growth of domestic income.
Ans. No. I n c rease i n domestic income may not always lead to increase in natio nal i ncome.
Ill ustration:
N ational I ncome = Domestic income + Net facto r income from a b road
Let us assume that d omestic income increases from � 160 cro re to � 200 crore. But net factor income
from a b road decreases from � 60 crore to � 15 crore. Thus, domestic income increases by � 40 cro re
(� 200 cro re - � 160 cro re = � 40 crore ) . But net factor i ncome from a b road decreases by � 45 cro re
[� 15 crore - � 60 crore = (-) � 45 crore] . So that, the sum total of d omestic income and net factor
income from a b road decreases by � 5 crore [� 40 crore - � 45 crore = (-) � 5 crore] . This leads to a
fall in natio nal income by � 5 crore.

Suggestions:
(i) The government must ma ke su bstantial investment in infrastructu ral development. This is
expected to ind uce d omestic investment across all prod uction activities. Accordingly, growth of
domestic income will accelerate.
( i i ) The gove rnment should remove red-ta pism (administrative-h u rdles), and p romptly grant green
clea rances (clea rances related to environment) for FDI ( Foreign Direct Investment). If FDI picks
u p, growth of d omestic income will accelerate.
4. The government cla ims that demonetisation of 500 and 1,000 ru pee notes will lead to G D P growth.
Do you agree?
Ans. Demonetisati on wil l sh rink the shadow economy ( black money economy) . Unaccounted G D P would
now become accounted G D P. Accordingly, G D P growth would look to be higher than before, even
low
when real output in the economy remains the same.
5. C B S E Questions-Past 5 yea rs
(With Answers o r Reference to the Text for Answers)
1. If real G D P is � 200 and p rice index (with base = 100) is 1 10, ca lculate nominal G D P.
ee
[ Page 399] [CBSE Delhi 2015]
rF
Fr
2. If the nominal G D P is � 1,200 and price index (with base 100) is 120, calculate rea l G D P.
=

3 . If the real G D P is � 300 and nominal G D P is � 330, calc u l ate price index ( base 100).
or
=

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4. If the real G D P is � 400 and nominal G D P is � 450, calc u l ate the p rice index ( base = 100).
[ Page 401] [CBSE {Al) 2015]
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5 . If the real G D P is � 500 and price index ( base = 100) is 125, calc u l ate the nomina l G D P.
oo
[ Page 399] [CBSE {Al) 2015]

B
6. If the nominal G D P is 600 and price index ( base 100) is 120, calc u l ate the real G D P.
=
[ Page 400] [CBSE {Al) 2015]

re
7. If the nominal gross domestic prod uct � 4,400 and the price index (base 100) 1 10, ca lculate the
= = =
real gross d omestic product. [CBSE {F) 2015]

ou
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[ Page 400]
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8. If the real gross d omestic prod uct is � 200 and the nominal gross domestic p roduct is
� 2 10, calc u l ate the p rice ind ex ( base = 100). [CBSE {F) 2015]
nd
[ Page 401]
Re
9. If the real gross d omestic product is � 250 and the price index ( base = 100) is 1 20, ca lculate the
Fi
nominal gross domestic prod uct. [CBSE {F) 2015]

[ Page 399]
10. Government incu rs expend itu re to popula rize yoga among the masses. Analyse its impact on gross
domestic prod uct and welfa re of the people. [CBSE Delhi 201 6]
[(a) I m pact on G ross Domestic Prod uct (G D P ) : Government expenditure adds to aggregate demand
in the economy. It has a multi plier effect on G D P when there is excess capacity ( unutilised
prod uction capacity) in the economy.
(b) I m pact on We lfa re : Expenditure on yoga is expected to improve physical and mental health of
the people. Accordingly, skill formation as we ll as efficiency a re expected to rise. Rise in efficiency
leads to rise in income and therefore, rise in we lfa re.]
11. National income is the sum of factor incomes a ccruing to: (choose the correct alternative)
[CBSE (Al) 201 6]
(a) nationa ls ( b ) economic territory
(c) residents ( d ) both residents and non-residents
[(c)]
12. Sa le of petrol and diese l cars is rising particularly in big cities. Analyse its impact on gross domestic
product and welfare . [CBSE (Al) 201 6]
[(a) Impact on Gross Domestic Product (G DP): G D P = Sales, in case there is no change in stocks
d uring the year. Accordingly, increase in sale of cars d uring the year ind icates increase in G D P.
(b) Impact on Welfare: Rise in sa le of cars leads to a rise in the consumption of petrol and diese l .
Both these fuels ( parti c u l arly diese l ) cause emission o f carbon dioxide. I t increases environmenta l
pollution. It adversely impacts we lfare of the people. Beca use increase in environmenta l
pollution ca uses increase in expenditure on the maintenance of healt h . It a lso red u ces the leve l
of sustaina b l e development. Implying l oss of welfare of future generations.]
13. Assuming real income to be � 200 crore and price index to be 135, ca lculate nominal income.
[ Page 399, 400] [CBSE (Al) 201 6]
14. If nominal income is � 500 and price index is 125, calc u l ate real income . [CBSE (Al) 201 6]
[ Page 401]
15. If real income is � 400 and price index is 105, calc u l ate nominal income. [CBSE (Al) 201 6]
[ Page 400]
16. Governments spends on ch ild immunization programme. Ana lyse its impact on Gross Domestic
Product and welfare of the people . [CBSE (F) 201 6]
[(a) Impact on G ross Domestic P roduct (G D P ) : Government expenditure adds to aggregate
demand in the economy. It has a multi plier effect on G D P when there is excess capacity ( unutilised
production capacity) in the economy.
(b) Impact on Welfare: Expenditure on c h i l d immunization programme is expected to improve
health of the chil dren. Accord ingly, younger generation becomes hea lthy as well as efficient.
This would improve welfare of the people . ]
17. Given real income t o be 400 and price index be 100, calc u l ate nominal income . [CBSE (F) 201 6]
[ Page 400]
18. Given nominal income to be � 375 and price index 125, calculate rea l income. [CBSE (F) 201 6]
[ Page 401]
19. If nominal income is � 600 and price index is 100, find real income. [CBSE (F) 201 6]
[ Page 401]
20. Explain 'non-monetary exchanges' as a l imitation of using gross domestic product as an index of
welfare of a country. [CBSE Delhi 201 7]
[ Page 64]
21. Distinguish between d omestic prod uct and national product. [CBSE (F) 201 7]
[ Page 55]
22. Given one example of negative externalities. [CBSE 201 8]
[ Page 64]
23. "Gross Domestic Product ( G D P ) does not give us a clear indication of economic we lfare of a country."
Defend or refute the given statement with valid reason. [CBSE 2019 (58/1/1)]
[ Page 63, 64]

24. "Higher Gross Domestic Prod uct ( G D P ) means greater per ca pita avail a bility of goods in the
economy." Do you agree with the given statement? G ive valid reason in s u p port of your answer.
[CBSE 2019 (58/2/1}]
[One needs to distinguish between G D P at current prices and G D P at constant prices (also ca lled rea l
G D P ) . Higher G D P wou l d mean greater ava ila bil ity of goods in the economy only when there is a rise
in real G D P, not when G D P rise is ca used by a rise in the general price level. A rise in real G D P is a
situation when the level of output in the economy tends to rise, leading to a rise in the flow of goods
and services in the economy.]
25. Explain the meaning of Real Gross Domestic Prod uct and Nominal Gross Domestic Prod uct, using a
numerical example. [CBSE 2019 (58/2/1}]
[ Page 60-62
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S u ppose, the output of commodity-X d uring the year 2019 was 500 units and is constant compared
to the base yea r. The market price of the commodity d uring the year 2019 is � 50 per unit while the
price in the base year was � 40 per unit. Given this information,
Nominal G D P = 500 x � 50 = � 25,000 (as estimated using the current price)
Rea l G D P = 500 x � 40 = � 20,000 (as estimated using the base year price ) . ]
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26. Define gross d omestic prod u ct. [CBSE 2019 (58/2/1)]
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[ Page 57]
27. If in a loca lity, a new park is developed by the municipa l corporation, it will have externalities, both positive
and negative. State one example each of both types of externalities with reason. [CBSE 2019 (58/3/1}]
or
[ Exa m ple of a Positive Exte rna l ity: When the new park developed by munici pal corporation raises
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welfare of people of the locality.
Exa m ple of a Negative Exte rna l ity: When the new park develo ped by municipal cor poration is used
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by anti-social elements and leads to insecurity of the residents.]
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28. How is Rea l Gross Domestic Prod u ct ( G D P ) d ifferent from Nominal Gross Domestic Prod uct ( G D P ) ?
Explain using a numerica l example.
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[CBSE 2019 (58/4/1)]

[ Page 60-62]
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29. What are 'non-monetary exchanges' ? Discuss with suita b l e example. [CBSE 2019 (58/5/1)]
[ Page 64]
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6. NCERT Questions (With Hints to Answers)

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1. The value of the nomina l G N P of an economy was � 2,500 crore in a particu lar year. The value of G N P
nd
of that country d uring the same year, evalu ated a t t h e base year prices was � 3,000 crore. Calc u l ate
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the value of the G N P deflator of the year in percentage terms. Has the price level risen between the
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base year and the current year?

Nominal G N P 2, 500
[Hint: G N P Deflator = X 100 = X 100 = 83.33%
Real G N P 3, 000
Fall in the value of deflator points to a fa ll in the price level between the base year and the current year.]
2. Write d own some of the limitations of using GDP as an index of welfare of a country.
[Hint: Following are the limitations of using G D P as an index of welfare of a country:
( i ) Distribution of G D P is not ta ken into account.
(ii) Composition of GDP is not a ccounted for.
(iii) Non-monetary exchanges remain un-recorded, to which extent GDP remains underestimated .
(iv) Externa lities are not considered, even when these have considera ble impact on social welfare.]
7. M isce l l a neous Questions a n d Reference to t h e Text for A n swers

1. Disti nguish between national income a nd d omestic i ncome. [Page 55]
2. Disti nguish between gross domestic prod u ct at market price a nd net d omestic prod uct at market
price. [Page 5 7]
3 . Disti nguish between gross d omestic prod u ct at factor cost a nd net d omestic prod u ct at factor cost.
[Page 58]
4. What d o you mea n by net nation a l prod u ct at market price? H ow will you estimate it on the basis of
gross national prod u ct? [Page 5 7, 59]
5 . What is the relation between net national prod uct at market price and net national prod uct at factor
cost? [Page 5 7, 58]
6. What d o you mea n by domestic territory of a cou ntry? [Page 53, 54]
7. What is mea nt by norma l residents of a cou ntry? [Page 52]
8. What does G D P deflator show? H ow is it estimated ? [Page 63]
9. Explain the concepts of nominal G D P a nd real G D P. [Page 60-62]
B . Questions of 6 ma rks eac h
1. Explain the concepts of net national prod u ct at market price and net natio nal prod uct at factor cost.
H ighlight the differe nce between these concepts. [Page 5 7, 58]
2. Explain the concept of d omestic prod u ct. Disti nguish between gross domestic prod uct and gross
nation a l prod uct. [Page 53, 5 7]
3 . State the components of domestic factor income. To fi nd out national income, what is added to it
a nd why? [Page 53, 54]
4. Disti nguish between d omestic i ncome a nd national i ncome by giving suita ble example i n s u p port of
your a nswer. [Page 53-55]
5 . Explain the concept of d omestic territory of a cou ntry. [Page 53, 54]
6. Explain the term normal resid ents of a cou ntry. Are the following norma l residents of I ndia ?
( i ) I nd i a n s employed in Wor ld H ealth Orga nisation located in I ndia .
( i i ) An America n tourist staying in I ndia . [Page 52, 53, 78, 79]
7. Explain briefly the d isti nction between :
( i ) National income a nd Domestic i ncome.
( i i ) G D P at curre nt prices and G D P at consta nt prices. [Page 55, 62]
8. How far ca n GDP be ta ken as an index of welfare? [Page 63-65]
DOs and DON'Ts

1. Do not consider X - M (export - i mport) as a component of net factor i n come from abroad. It is simply
net of exports. What we export i s a part of our domestic prod uct. It i s to be con s i dered as a part of tota l
expenditure on domestic product. It i s not a factor i n come: Recei pts from exports a re l i ke recei pts from
the sale of output. I mports are j ust the opposite of exports.
2. Never consider ' G D P at current prices' as the i ndex of welfare. Because, GDP at current prices m ay rise
even when the production of goods and services i n the economy is constant. GDP at current prices
may rise simply beca use prices have ri sen. Welfa re of the people rises only when the ava i l a b i l ity of
goods and services rises.

.,...__. • Normal Residents of a Cou ntry
It i s not necessary that norma l res ident of a cou ntry is also a citizen of that
cou ntry. A person may be a norm a l resident of one cou ntry even when he is a
citizen of other cou ntry.
Normal Residents of a country include:
(i) C itizens (a nd institutions) of the cou ntry who norma l ly res ide i n the
cou ntry and whose centre of economic i nterest l i es i n the cou ntry.
(i i) Citizens of other nations who continue to l ive i n the cou ntry beyond a period
of one year and whose centre of economic i nterest l ies in the country. For
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exa m p l e, if an I nd i a n is living in USA for more than one year a n d h i s centre
of economic i nterest l i es in that country, he wou l d be deemed as a norma l
res i dent of USA even when he contin ues to be a citizen of I n d i a .
(ii i) Citizens o f a cou ntry worki ng i n i nternationa l org a n isation s (l i ke World
Bank a n d I M F) or foreign embassies l ocated i n that cou ntry. For examp le,
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an I n d i a n worki n g i n the World Bank offi ce located in New Del h i wou l d be
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consi dered as a norma l res ident of I n d i a .
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(iv) C itizens o f a cou ntry w h o a re l iving abroad, b u t not for a period exceed ing
one year and whose centre of econom ic i nterest l i es i n thei r home country.
or
(v) Border worke rs or persons who cross the border between two cou ntries
d a i ly or reg u l a rly i n order to work in one cou ntry are the res idents of the
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cou ntry i n which they l i ve, n ot of the cou ntry in which they are worki ng.
(vi) Officia l s, d i p l omats, a n d mem bers of the armed forces of a fore i g n cou ntry
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a re treated as the normal residents of the cou ntry to which they belong,
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a n d not of the cou ntry i n which they are em p l oyed .
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Normal Residents of a country d o not include:

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(i) The foreig ners who visit a cou ntry for trave l l i n g , recreation, h o l i d ays,
med ical treatment, studies, conferences, sports, etc.
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(ii) The offi c i a l s, d i p lomats a n d members of a rmed forces of a foreign cou ntry
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posted i n the country.

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( i i i) I nternational organisations l ocated in the cou ntry.

(iv) Crew mem bers of foreign vessels.
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(v) Foreig ners who are employees of non-resi dent enterprises a n d who have
come to the country for pu rpose of i nsta l l i ng machinery i n these enterprises.
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All these people w i l l be treated as non-res idents as genera l ly they stay for less
than one year in the concerned cou ntry and thei r centre of economic i nterest
does not l i e in it.
• Components of Domestic Territory
(i) Territory lyi n g with i n the pol itical fronti ers i n c l ud i ng territori a l waters of a
country.
(i i) S h i ps and a i rcrafts operated by res idents of the cou ntry across d i fferent
parts of the worl d . For exa m p l e, I n d i a n s h i ps movi ng between J a pan
a n d Korea reg u l a rly or passenger pla nes operated by Air I n d i a between
Eng land and Canada a re a part of the domestic territory of I nd i a .
( i i i) Fi s h i n g vessels, o i l a n d n at u ra l gas r i g s a n d float i n g platforms operated
by the res id ents of the cou ntry in the i ntern ation a l waters or e n g aged
in extraction in a reas in w h i c h the cou ntry has the exc l u sive right of
exp l oitati o n . For exa m p l e, the fis h i n g boats o perated by I nd i a n fi shermen
i n the i nternatio n a l waters of the I n d i a n ocea n a re a p a rt of the domestic
territo ry of I n d i a .
(iv) Em bassies, cons u l ates a n d m i l itary esta b l i s h ments o f t h e cou ntry located
a b road . For exa m p le, the I nd i a n embassy in the U n ited States of America
i s a part of t h e domestic territo ry of I nd i a and the embassy of U SA in I n d i a
i s a p a rt o f the domestic territory o f U n ited States o f America .
[Note: It may be noted i n t h i s context that do mestic territory does not refe r to the a reas
of owners h i p beyond po l itical frontiers of a nation. It only refers to a reas of
operation where our persons, our goods and our capita l can c i rc u l ate freely to
serve our economic i n terest. T h u s , factor i ncome generated within the domestic
territory of a nation a m ou nts to d omestic i ncome ]
• Components of N et Factor I ncome from Abroad

(i) Net Compensation of Employees: It i s the d i fference between
compensation (of e m p l oyees) received by resi dent workers, temporari ly
e m p l oyed a b road and a s i m i l a r payment made to non-resident workers
who a re employed tem porarily with i n the domestic territo ry of a country.
[Co m pen sation of e m p l oyees refers to payments made by the e m p l oyers
to the e m p l oyees both in cash a n d ki n d . It a l so i n c l u des payments made by
the employers on beha lf of the employees (l i ke contri bution to employees'
provident fu nd).]
(ii) Net Income from Property and Entrepreneurship (other than Retained
Earnings of Resident Companies Abroad) : It i s the d i fference between the
i n come i n the form of rent, i nterest and p rofit received by the res i d e nts of
a country a n d s i m i l a r payments made to the rest of the worl d .
(iii) Net Retai ned Earnings o f Resident Companies Abroad: It i s t h e d i fference
between the reta i ned earn i n g s of res i dent com p a n ies located a b road
and reta i ned ea rn i n g s of fore i g n compa n i es located with i n the domesti c
territory of a cou ntry.
• Estimation of G N P Deflater
U s i n g hypothet i c a l fi g u res, G N P deflato r i s ca l c u l ated as u n der:
Goods Current Year
Quantities
I Current
Year Prices
I Nominal GNP
(Current Yea r )
Base Year
Prices
I Real GNP
(Current Year )
(2) X (3) (2) X (5)
(�) (�) (�) (�)
.___ ( 1) (2) (3) (4) (5) (6) -
Shirts 5 14 70 7 35
Shoes 3 30 90 10 30
Bricks 8 4 32 2 16
Sum : 192 Sum : 81

= N o m i n a l G N P for Cu rrent Year
G N P Defl ator for Cu rrent Yea r x 1 00
Rea l G N P for Cu rrent Yea r
= 1 92 X
1 00
81
=
237.04
• Concept of G reen G N P
GNP (at cu rrent or constant prices) is est i mated with no rega rd to
(i) env i ronmenta l pol l ution, a n d (i i) exploitation of natural resources. If G N P
increases a long with increase in environ menta l pol l ution, the q u a l ity of l i fe
wou ld be far less than i n d icated by the i ndex of G N P. Li kewise, if G N P increases
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along with excessive exp l oitation of the natu ra l resou rces (so excessive that
it red uces ava i l a b i l ity of resources for the future generations), the i ncrease in
G N P wou l d only be m i s lead ing a s it can not be susta i ned in the years to come.
Accord i n g ly, it is suggested that G N P i ndex should account for (i) cost in term s
of env i ronmenta l pol l ution, a n d (ii) cost i n terms of excessive exploitation of
natural resources . Esti mation of G N P that accou nts for these parameters
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(environ menta l pol l ution a n d excessive exp l oitation of natura l resou rces) is
called G reen G N P.
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• New Concepts I ntrod uced by CSO (Central Statistics Office)
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In I n d ia, national income and related aggregates are d efi ned and esti mated by
CSO Since 20 1 5, CSO has i ntroduced some new concepts as under:
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Net Production Taxes
N et Prod uction Taxes = Production taxes - Production subsid ies
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I m portant it is to note that the receipt and payment of prod uction taxes a n d
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prod uction subsid ies are related t o t h e product. not t h e volume o f prod uctio n .
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La nd revenue a n d reg i stration fee m a y be cited a s exa m p les.

Net Product Taxes
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N et P roduct Taxes = Prod uct taxes - Prod uct subsidies

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To be noted, p roduct taxes and prod uct subsid ies are pa i d and received per
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u n it of prod uct Exc i se tax, service tax may be cited as exa m p l es .

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Basic Price
Basic p rice i nclu des p rod uction taxes and prod uction subsid ies on ly.
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Categorica l ly, basic price does not incl ude p roduct taxes and product subsid ies.
GVA at Basic Price
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CSO now est i mates GVA (g ross va l u e added) at basic price.

To be noted, GVA at basic price accou nts only for production taxes and production
subsid ies. It does not accou nt for prod uct taxes and prod uct subsidies.
Difference among GVA at Factor Cost, GVA at Basic Price and GVA at
Market Price
GVA at factor cost + N et p roduction taxes
= GVA at Basic Price
GVA at basic price + Net prod uct taxes
= GVA at Ma rket Price
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•
•
•
Meaning and Evolution of Money
Forms of Money
Supply of Money-
Concept of Money Supply and Measurement of Money Supply
,,
I. MEANING AND EVOLUTION OF MONEY
A thing which is commonly accepted as a medium of exchange is
called money. Example: A rupee in India is money, as it is a commonly
accepted medium of exchange here. Likewise, a dollar in USA is
money, as it is a commonly accepted medium of exchange there.
In olden days, goods were exchanged for goods. There was no money.
Thus, a cobbler would make shoes in return for wheat from the farmer;
a farm worker would get grains as a reward for his labour, and so on.
This system of exchange was known as barter system. But with the
multiplicity of wants (and greater need for exchange), barter system
(a system where goods were exchanged for goods) proved to be an
inefficient system of exchange. It is then that we invented money-a
common medium of exchange. Now goods were not sold for goods.
Instead, goods were sold for money.
Initially, coins of gold and silver were introduced as money.
Subsequently, alloy metal was used for coinage, along with paper
money. And, now is the age of plastic money (in the form of cash
cards), or e-money in the form of 'electronic transfer of money' by
way of credit/debit entries in the bank accounts. Thus, the origin (and
evolution) of money is related to the need to facilitate exchange.
I
Origin of Money
Origin (and evolution) of money is related to the need to facilitate exchange. Therefore, money is
generally defined as a thing that is commonly accepted as a medium of exchange.
133
Though initially invented as a medium of exchange, gradually money
found its other uses as well:
• Money is used as a store of value. Or, money is used as an
instrument of saving.
• Money is used as a measure of value. Value of goods and services
is expressed in terms of money.
• Money is used as a standard for deferred payments (deferred
payments are those payments which are made sometimes in the
future).
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Owing to its multiple functions, money has acquired a wider definition
than merely a medium of exchange. It is defined as an instrument that
serves as a medium of exchange, store of value, measure of value and
standard for deferred payments. Briefly, it is said that 'money is what
money does'.
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Definition of Money
Money is what money does. It is defined as an instrument that serves as a medium of exchange,
store of value, a measure of value and a standard for deferred payments.
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Basic Functions of Money
The definition of money conveys the basic functions of money These are: (i) Money acts as a medium
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of exchange, (ii) Money serves as a store of value (people save in terms of money), (iii) Money is a
measure of value: market price of goods and services is expressed in terms of money, and (iv) Money
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serves as a standard for deferred payments (future payments)· when business contracts are signed
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on the basis of future payments, money acts as an instrument for those payments.
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Barter System of Exchange

Barter system of exchange is a system in which goods are exchanged
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for goods. If (as a farmer) you have surplus production of rice, you are
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to look for a person who needs rice, and at the same time has (say)
cloth, which you need for yourself. It means 'double coincidence of
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wants': your want for cloth must coincide with somebody's want for
rice, and you must have surplus of rice and somebody must have the
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surplus of cloth. How difficult it is! What do you do these days? As

a farmer, you sell rice for money, and as a cloth merchant, you sell
your cloth for money. With money in hand, you buy whatever you
wish to buy. Thus, rice is exchanged for money, cloth is exchanged
for money. Money acts as a common medium of exchange. No such
common medium of exchange exists in the C-C economy (commodity
for commodity exchange economy) where goods are exchanged for
goods.

I
C-C Economy
C stands for commodity C-C economy is the one in which commodities are exchanged for
commodities or in which goods are exchanged for goods. C-C exchange refers to Barter System of
Exchange. Hence, C-C economy is an economy dominated by Barter System of Exchange.
Drawbacks of the Barter System and their Elimination

Following are the principal drawbacks of barter system of exchange.
It is with the introduction of money that these drawbacks have been
eliminated.
(1) Double Coincidence of Wants: Double coincidence of wants is
a core characteristic of the barter system of exchange. Double
coincidence of wants implies that (at a point of time), the
two individuals are in possession of such goods which they are
willing to exchange for the satisfaction of their wants. But it is not
always so simple. It is not so simple to find a person who wants
your horse and at the same time has a cow that you want to
buy. Accordingly, under the barter system, exchange remained
extremely limited. With the emergence of money (as a medium
of exchange), the problem of double coincidence of wants has
vanished. Money as a medium of exchange has separated the
acts of sale and purchase.
(2) Lack of a Common Unit of Value: What is the value of your
car? You can reply: � 5 lakh. Can you give the same answer in a
• Money has led to
barter system of exchange? Certainly not. Under such a system, the expansion of
your car would be valued in terms of horses, cows or buffaloes, exchange.
simply because there is no money (or a common unit of value). • Expansion of
exchange has led
Evolution of money has given us a common unit of value and to expansion of the
therefore, a system of accounting. markets for goods and
services.
(3) Difficulty of Future Payments or Contractual Payments: These
• Expansion of market
days you hire a worker and strike a contract to pay him (say) has led to expansion
� 10,000 p.m. What do you do in a barter system? Would you of the scale of output.
decide to pay him in terms of tables or chairs, in terms of rice or • Expansion of the
scale of output has
wheat, in terms of drugs or chocolates? Contractual payments led to GDP growth.
or future payments would certainly be very difficult under Implying growth of the
economy.
barter system of exchange. Evolution of money has facilitated
contractual payments.
(4) Difficulty of Storage of Value (Saving) and Transfer of Value: In
the C-C economy, saving is possible only by way of storage of
goods. It involves substantial storage cost as well as the fear of
capital loss (owing to natural disasters). Further, what happens
if you are to transfer your saving from one place to the other?
Money 135
Obviously, you are to transfer the goods. Which again is a
difficult task, besides being expensive. Evolution of money has
made storage and transfer of value much easier.
t>TS
Q. Introduction of money has separated the acts of 'sale' and 'purchase'. How?
Ans. 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
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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.
2. FORMS OF MONEY
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Some important forms of money are described as under:
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(i) Fiat money and fiduciary money, and
(ii) Full bodied money and credit money.
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(i) Fiat Money and Fiduciary Money
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Fiat money refers to that money which is issued by order/ authority of
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the government. It includes all notes and coins which the people in a
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country are legally bound to accept as a medium of exchange.
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Fiduciary money is that money which is accepted as a medium of

exchange because of the trust between the payer and the payee.
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Example: Cheques are fiduciary money as these are accepted as a

means of payment on the basis of trust, not on the basis of any order
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of the government.
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(ii) Full Bodied Money and Credit Money

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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.
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Example: A rupee coin during the British period in India was made of
silver. Commodity value of the coin was equal to its money value at
the time of its issuing. Or, the market value of the silver contained in
the coin was equal to � 1.
Credit money refers to that money of which money value is more than
commodity value. Example: What is the market value of the metal
that the rupee coin is made of in India? Obviously, much lower than
the money value of the rupee coin. Otherwise, people would have
melted the coins and sold the metal in the market at a price greater
than one rupee.

I
Full Bodied Money:
Money Value = Commodity Value
Credit Money:
Money Value> Commodity Value
f>TS
Q. 1. Distinguish between money value of money and commodity value of money.
Ans. Money value of money refers to the value which is inscribed on a coin or written on a paper note.
Thus, money value of a paper note is what is written on it: one hundred rupees, two hundred rupees,
etc. With a two hundred rupee note, you can buy goods and services worth two hundred rupees in
the market.
Commodity value of money refers to value of the commodity (like metal) that the money is made of.
Thus, if coins are made of gold or silver (as was the practice in old days), commodity value of money
refers to the market value of the gold or silver contained in the coin.
Q. 2. Can you think of a situation when money plays no role whatsoever?
Ans. Money plays no role in a situation when there is no exchange. Example: An individual or a family
surviving on an island without any exchange (or sale and purchase of goods and services).
Q. 3. Why people hold notes and coins when it is clear that the intrinsic value (commodity value) of notes
and coins is almost negligible?
Ans. Because notes and coins are legal tenders. These are fiat money or the money backed with
authority of the government. It is unlawful not to accept notes and coins for receipts/payments.
3. SUPPLY OF MONEY
Supply of money is a stock concept. It refers to total stock of money
( of all types) held by the people of a country at a point of time.
It is important to note that the supply of money does not include:
(i) stock of money held by the government, and (ii) stock of money
held by the banking system of a country. Because, government and
the banking system of a country are suppliers of money, and the stock
of money held by the suppliers of money is never treated as a part of
the supply of money in the country.
Supply of money includes only that stock of money which is held by people, other than
suppliers of money themselves. In other words, supply of money refers to that stock of F®CUS
money which is held by those, who demand money, not by those, who supply money. ZONE
f>TS
Q. Who are the producers of money?
Ans. Producers of money refer to suppliers of money. They include:
(i) the government of the country, and
(ii) the banking system of a country, including both the central bank (which is the note issuing
authority) and the commercial banks (who add to the supply of money through demand
deposits).
Money 137
Measures of Money Supply
In India, there are four alternative measures of money supply, popularly
known as M 1, M2, M 3, and M4. Of these, only M 1 measure is discussed
here, as prescribed in the syllabus. M2, M3 and M4 measures are given
in 'Ability Zone' of the chapter for general reference.
M 1 Measure of Money Supply

According to M 1 measurement, money supply includes the following
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components:
M 1 = C +DD+ OD
Here,
C: It refers to currency held by the public. It includes coins as well
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as paper notes.
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DD: It refers to demand deposits of the people with the commercial
banks. These are chequeable deposits which can be withdrawn
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or transferred on demand.
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OD: These are other deposits which include:
(i) Demand deposits with RBI of public financial institutions like
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NABARD (National Bank for Agriculture and Rural Development).
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(ii) Demand deposits with RBI of foreign central banks and of the
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foreign governments.
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(iii) Demand deposits of international financial institutions like IMF

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and World Bank.

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Specifically, OD does not include:

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(i) deposits of the government of the country with RBI,

nd
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(ii) deposits of the country's banking system with RBI.

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Net Demand Deposits and Gross Demand Deposits

Distinction may be drawn between gross demand deposits and net demand deposits with the
commercial banks. 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 the people
Note of Caution
Only net demand deposits are taken as a part of money supply

Term Deposits and Demand Deposits
Term deposits are different from demand deposits:
(i) Term deposits are always for a specific period of time, like fixed deposits for a period of one
year or two years. Demand deposits are not for any specific period of time.
(ii) Depositors cannot withdraw money (in fixed deposits) as and when needed. Money in demand
deposits can be withdrawn as and when needed.
(iii) Term deposits are not chequeable deposits. Depositors cannot sign a cheque against these
deposits. Demand deposits are chequeable deposits. These are: (a) saving account deposits,
and (b) current account deposits. Depositors can sign a cheque and withdraw/transfer money
from these accounts.
Note of Caution
In the context of M 1 measurement of money supply, only demand deposits are considered as a part
of money supply, NOT the term deposits [Demand Deposits = Saving Account Deposits + Current
Account Deposits].
'
Measure of Money Supply (M 1 lJ
Cu rrency with
f
Demand Deposits of the People
i
Other Deposits
the Public with the Com mercial Banks with Reserve Ba n k
(i) Demand Deposits (ii) Demand Deposits (i ii) Demand Deposits

with Reserve Ba n k with Reserve Ba n k of of I nternational
o f Public Fina ncial Foreign Central Banks Fi nancial I n stitutions
I n stitutions (like NABARD) a n d Govern ments (like IMF and World Ba n k)
[Note: The standard practice is to consider (i) Cu rrency with the publ ic, and (ii) Demand deposits of the people
with the com mercial banks as the two principal com ponents of money supply in the economy.]
Who Su p plies Money ?

Suppliers of money include: (i) central bank of the country (RBI in
India), (ii) commercial banks, and (iii) the government.
In India, RBI is the principal supplier of money. RBI issues currency on
the basis of Minimum Reserve System. Under this system, Reserve Bank
maintains a minimum reserve of � 200 crore in the form of gold and
foreign securities. Of this reserve, value of the gold must be � 115 crore.
Commercial banks are the second significant source of money supply.
Unlike the central bank, commercial banks do not have the authority
of issuing currency. The commercial banks cannot issue 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.
Money 13 9
Government is the th i rd sou rce of money su pply i n the cou ntry. I n
I n d ia, the Min istry o f Finance issues o n e ru pee notes and coins o f al l
deno m i nation.
Bank Money and High Powered Money
Bank money refers to demand deposits (or chequeable deposits) of the people with the commercial
banks.
High powered money is the sum total of. (a) currency held by the people, (b) vault cash of the
commercial banks, and (c) cash reserves of the commercial banks with the RBI. This is called
'Monetary Base' or 'Base Money' in the economy.
Note: While currency held by the people is a part of money supply, vault cash of the commercial banks as well as
low
cash reserves of the commercial banks with RBI are NOT a part of money supply. As already noted, stock of
money held by the suppliers of money is never treated as a part of money supply.
i>TS
Q. 1. State the principa l com ponents of money supply.
Ans. The p ri nci pa l com ponents of money s u pply are:
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( i ) Currency ( notes + coi ns) held by the pu blic.
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(ii) Demand deposits of the people with the com mercia l ba nks, and
( i i i ) Other deposits (demand deposits with RBI of domestic and foreign i n stitutions other than of
the government of the country a nd com mercia l ba n ks with in the country).
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Q. 2. Why are cash deposits of the government and of the commercial ba n ks with the RBI not treated as a
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part of money supply?
Ans. Because government and commercia l banks a re creators/suppliers of money. And, money held by
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the creators/suppliers of money is never treated as a part of money supply.
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Power Points & Revision Window -----------

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Money i s a nyth i n g w h i c h i s co m m o n ly acce pted as a med i u m of exc h a n ge. I t has been i nvented to
re
overco me the difficu lties of barte r system of exch a nge.

Barter System of Exchange is the syste m i n w h i c h co m mod ities a re excha nged fo r co m mod ities. This is
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also ca l led co m mod ity fo r com mod ity exc h a n ge economy or 'C-C economy'.
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Drawbacks ( i ) It req u i res d o u b l e coi ncidence of wa nts which is h a rd to fi n d .

( i i ) I t lacks a com m on u n it o f excha nge.
nd
( i i i ) I t lacks the syste m of futu re payments or defe rred payments.

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( iv) I t lacks the syste m of sto rage and tran sfer of va l ue.
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Forms of Money
Fiat Money is that mo ney which is issued by ord e r (a utho rity) of the govern ment.
Fiduciary Money i s that money which is acce pted as a med i u m of excha nge beca use of the
trust between the paye r and the payee .
Full Bodied Money: M oney va l u e = Com m od ity va l u e of money.
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Credit Money: Money va l u e of coi n s a n d notes > Com m od ity va l u e of coi n s a n d notes .
Suppl y o f Money is a stock concept. I t refers to stock of money availa ble with the pu blic/people a t a poi nt o f time.
• stock of Money with the govern ment a n d the b a n k i n g system of the co u ntry is not considered as
a part of money s u p ply.
Components of Money Supply: Cu rrency with P u b l ic + De m a n d Deposits with Com m e rcial Ba n ks + Other
Deposits with the Rese rve Ba nk.

rEX E RC I S Ej
1 . Objective Type Questions (Remem bering & U ndersta n d i n g based Quest i ons)
A. M u lt i p l e Choice Questions
1. Barter system refers to that system wherei n :
( a ) goods a re excha nged for goods
(b) goods a re not excha nged at a l l
( c ) goods a re excha nged for domesti c currency
( d ) goods a re excha nged for foreign cu rrency
2 . Which of the following is a typical cha racteristic of the barter system ?
(a) A com mon med i u m o f excha nge (b) Dou b l e coincidence of wants
(c) A com mon u n it of accou nt (d) A sta n d a rd for d eferred payments
3. Which of the following is a com monly accepted d efi n ition of money?
(a) Any good which is com m o n ly used as a store of va l u e
( b ) Any good w h i c h is excha nged for g o l d a t a fixed rate
(c) Any good which is accepta ble to a ba n k
( d ) Any good which is com m o n ly accepted a s a med i u m of excha nge
4. Money which is accepted as a med i u m of excha nge beca u se of the trust between the paye r and the
payee is ca l led :
(a) fu l l bodied money ( b ) cred it money
(c) fiat money ( d ) fiduciary money
5 . F u l l bodied money is that money whose money va l u e a n d com mod ity va l u e a re :
(a) eq u a l i n the ma rket ( b ) declared as eq u a l by the government
(c) d i fferent i n the market ( d ) declared as eq u a l by the R B I
6. Money that is issued by the a uthority o f the government is ca l l e d :
(a) fu l l bodied money ( b ) cred it money
7. When money va l u e of money exceeds commod ity va l u e of money, it is ca l l ed :
( a ) fu l l bodied money ( b ) cred it money
8. Money as a sta n da rd for deferred payme nts has led to the emergence of:
(a) com mod ity ma rket ( b ) fi n a ncial ma rket
(c) both (a) a n d ( b ) ( d ) n o n e o f these
9 . Which of the fol l owing is the com ponent of M 1 measu re of money su p p ly?
(a) Term deposit (b) Demand deposits
(c) Cash reserves of the com m e rcial ba n ks ( d ) None of these
10. Ba n k money is that money which is:
(a) pri nted by RBI ( b ) pri nted by the governm ent
(c) generated i n the form of cred it creation ( d ) none of these
Money 141
11. Who supplies money i n I n d ia ?
(a) T h e RBI ( b ) The com mercia l b a n ks
(c) The governm ent ( d ) All of these
12. Dema nd de posits i n c l u d e :
(a) cheq ueable deposits ( b ) d eposits which ca n be withd rawn on d e m a n d
(c) fixed d eposits for a period of ti me ( d ) both (a) a n d ( b )
13. I n I n d ia, there a re fou r a lte rnative measures o f money su pply: M 1, M 2 , M 3 a n d M 4, o f these M 1 =
(a) Cu rrency with people
(b) Cu rrency with people + Demand d eposits
(c) Cu rrency with people + Demand d eposits + Other deposits with the Reserve Ba n k
low
(d) N o n e o f these
14. Supply of money is a :
( a ) flow va ria b l e (b) stock va riable
( c ) rea l fl ow ( d ) none of these
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15. I n I n d ia , coins a re issued by:
(a) State Ba n k of I n d ia
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(c) M i n istry of Fina nce ( d ) M i nistry o f U rban Develop ment
16. I ntrod uction of money has:
or
(a) sepa rated the acts of sale and p u rchase of a n i n d ivid u a l
(b) com bi ned t h e acts o f s a l e a n d p u rchase o f a n i n d ivid u a l
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(c) expa n d ed the scope o f sale a n d p u rchase
(d) both (a) a n d (c)
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17. Which of the fol l owing systems is followed by Reserve Ba n k of I n d ia for issuing cu rrency?
(a) Proportionate system ( b ) S i m p l e d e posit syste m
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(c) M i n i m u m reserve system ( d ) Fixed fid uciary issue system

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18. H igh powered money is equ a l to :

(a) money s u p p l ied by the RBI only
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ad
(b) tota l s u p ply of money i n the economy

(c) notes a n d coi n s held by the people
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(d) money ( n otes a n d coi ns) held by the people, va u lt cash of the com m e rcial ba n ks as wel l as cash
reserves of the com mercia l b a n ks with the RBI
nd
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Answers
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1. (a) 2. (b ) 3 . (d) 4. (d ) 5 . (a) 6. (c) 7. ( b) 8. (b ) 9. ( b) 10. (c)

11. (d) 12. (d) 13. (c) 14. ( b) 15. (c) 16. (d ) 17. (c) 18. (d)
B . Fill i n the B la n ks

1. A t h i ng which is com m o n ly accepted as a med i u m of excha nge is ca l led
(co m m od ity/m oney)
2 . A system where goods a re excha nged for goods is known as
( b a rter system of exchange/moneta ry system of excha nge)

3. Evo l u tion of money has fac i l itated _______ (cu rre nt payments/contractual payments)
4. M a i n cha racteristic of money is _______ ( l i q u id ity/sol i d ness)
5. _______ va l u e of a paper n ote is what is written o n it. ( M oney/Commod ity)
6. _______ money is accepted as a med i u m of excha nge beca use of the trust between the
payer a n d the payee. ( Fiat/Fiduciary)
7. U nder the barte r system of exchange, acts of sa le a n d pu rchase of an i n d ivid u a l occu r at the
_______ point (s) of ti me. (sa me/d ifferent)
8. _______ refers to tota l stock of money held by the people of a cou ntry at a poi nt of
ti me. (Su pply of money/De m a n d for money)
Answers
1. money 2 . ba rter system of excha nge 3 . contractual payments 4. liquidity
5 . M oney 6. Fiduciary 7. sa me 8. Supply of money
C. Tru e or Fa lse
State whether the fol lowing statements are True or False:
1. C-C economy is a n economy d o m i n ated by ba rter syste m of excha nge. (True/Fa lse)
2. In ba rter system, defe rred payments a re made i n the form of goods. (True/Fa lse)
3. I n case of cred it money, money va l u e is less than com m od ity va l u e . (True/Fa lse)
4. Expa nsion of excha nge has led to expa nsion of the ma rkets for goods a n d services. (True/Fa lse)
5. Fiat money i nclu des a l l notes and cheq ues which the people in a cou ntry a re lega l ly
bou nd to accept as a med i u m of excha nge. (True/Fa lse)
6. S u pply of money incl udes stock of money held by the government. (True/Fa lse)
7. Com m e rcial ba n ks add to the s u p p ly of money t h rough demand deposits. (True/Fa lse)
8. O n ly net demand deposits a re ta ken as a pa rt of money s u p ply. (True/Fa lse)
Answers
1. True 2. True 3 . Fa lse 4. True 5 . Fa lse 6. Fa lse 7. True 8. True
D. Matc h i n g the Correct State ments
Column I Column I I
(a) F u l l bodied money (i) Money va l u e > Co m m od ity va l u e of money
(b) Term deposits ( i i ) Chequeable de posits
(c) Barter system of excha nge ( i i i ) Goods a re excha nged fo r money
(d) G ross demand de posits (iv) Does not include i nte r-banking claims
(e) High powe red money (v) Base money i n the economy
Answer
(e) H igh powered money - (v) Base money in the economy
Money 143
items in Column I:
Column I Column I I
(a) Govern ment o f a cou ntry ( i ) Lega l tenders
( b) Supply of money ( i i ) Cheques
(c) RBI ( i i i ) Supplier of mo ney
(d) F i d u ciary money (iv) Principal supplier of money
(e) Notes a n d coins (v) A stock concept
Answers
low
(a) - (i i i) , ( b) - (v), (c) -( iv) , (d ) - (i i) , (e) - (i )
E . 'Very Short Answe r' Objective Type Questions

1. What is barter system of excha nge?
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Ans. Barter system of excha nge is a system in which goods a re exchanged for goods. Money as a med i u m
o f excha nge does not exist.
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2. Define C-C economy.
Ans. C-C economy refers to that economy i n which com m od ities a re excha nged for com mod ities or i n
which goods a re excha nged for goods.
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3 . What d o you mean by double coi ncidence of wa nts?
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Ans. Dou ble coi ncidence of wants mea ns that goods in possession of two different i n d ivid u a l s a re needed
by each other at the same ti m e .
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4. What is meant b y money?
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Ans. Money ca n be defi ned as somet h i n g that is ge nera l ly accepted as a med i u m of excha nge a n d acts as
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a measu re and a store of va l u e .

5 . What is fiat money?
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Ans. Fiat money refers to money backed with order (a uthority) of the government.
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6. What is fiduciary money?

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Ans. Fiduciary money is the money backed with m utual trust between the payer a n d the payee.
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7. Define fu l l bodied money.

Ans. F u l l bodied money refers to money i n terms of coi n s whose com m od ity va l u e is e q u a l to the money
nd
va l u e as a n d when these a re issued .

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8. What is cred it money?

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Ans. Credit money is the money of which money va l u e (face va lue) is more than com mod ity va l u e ( i ntri nsic
va l u e ) .
9. What is ba n k money?
Ans. Ba n k money is the money created by the com m e rcial ba n ks in the form of demand deposits, ove r
a n d above cash de posits of the peop l e with the ba n ks.
10. Define h igh powered money.
Ans. H igh powered money refers to moneta ry base or base money i n the cou ntry. It incl udes:
(i) cu rre ncy held by the people, (ii) va u lt cash of the com mercial ban ks, a n d ( i i i ) cash reserves of the
com m e rcial ba n ks with the R B I .
11. Define money supply.
Ans. Money supply refers to the tota l qua ntity or stock of money ava i l a ble i n the economy at a point of ti me.

12. Write the com ponents of money s u p p ly.
Ans. (i) Cu rre ncy with the people,
( i i ) Demand de posits with commercia l ba n ks, a n d
( i i i ) Other deposits.
13. Who a re the s u p p l iers of money in India?
Ans. (i) The government of the cou ntry,
( i i ) The centra l b a n k of the cou ntry, a n d
( i i i ) T h e com m e rcial ba n ks.
1 4 . Defi n e d e m a n d deposits.
Ans. Demand deposits of com m e rcial b a n ks a re those deposits which ca n be withd rawn from the ba n k on
demand or by writing a cheque a ny ti me.
15. Defi n e term d eposits.
Ans. Term d eposits a re those deposits which ca n n ot be wit h d rawn from the ba n k as a n d when needed or
by writi ng a cheq ue a ny ti me. These de posits i nvolve a lock- i n period .
2. Rea so n - based Questions (Co m p re h e n s i o n of the S u bject - m atter)
Read the fo l l owi n g state m e nts ca refu l l y. Write Tru e or Fa lse with a rea so n .
1 . Dou b l e coi n cidence o f wa nts i s a n essenti al req u i rement o f excha nge.
Ans. Fa lse. Though it is an essenti a l req u i rement for the ba rter economy, in a money economy, excha nge
ca n ta ke place without d o u b l e coi ncidence of wa nts.
2 . Face va l u e of money is a l ways greater than its i ntrinsic va l u e .
A n s . Fa lse. In case coi n s a re made of gol d a n d si lver, i ntrinsic va l u e of money may over ti me exceed its face
va l u e .
3 . Stock o f money with t h e money iss u i ng a uthorities is a n i m po rtant compon ent o f money s u p ply.
Ans. Fa lse. Sup ply of money d oes n ot i n c l u d e the stock of it with the money iss u i ng authorities.
4. Fiat money is the same as fiduciary money.
Ans. Fa lse. Fiat money is the money backed with o rder of the government whereas fiduciary m oney is the
money backed with the m utual trust between the payer a n d the payee.
5 . Money supply includes demand deposits of the people with the com mercia l ba n ks.
Ans. True. Dema n d deposits of the peop l e with the commercia l ba n ks is a component of money s u p ply.
Beca use, these deposits a re converted i n cash j u st by writing a cheq ue.
6. Dou b l e coi n cidence o f wa nts is a typica l featu re o f moneta ry system o f excha nge.
Ans. Fa lse. Dou b l e coincidence of wants is a typica l featu re of barte r system of excha nge.
7 . Money has sepa rated the acts of sale and p u rchase.
Ans. True. With the i ntrod uction of money, a n i n d ivid u a l ca n buy or sel l a t h i ng without sel l i ng or buying
a nyt h i ng in retu r n .
8. There is no med i u m o f excha nge in the b a rter system .
A n s . Fa lse. U nder ba rter system, goods themselves a re the med i u m of excha nge for goods. Of cou rse,
there is no common med i u m of excha nge l i ke money.
9. There is no common u nit of va l u e i n barter system .
Ans. True. There i s a lack of com m o n u n it o f excha nge i n barter syste m . Evol ution o f money offered a
com m o n u n it of va l u e .
Money 145
10. Money may be used as a commod ity.
Ans. True. It ha ppens when i ntrinsic va l u e (co m m od ity va lue) of money exceeds its face va l u e (money
va l u e ) .
1 1 . Credit money i s the money received as a credit from the ba n ks.
Ans. Fa lse. Credit money is money whose money va l u e is more than its com mod ity va l u e .
1 2 . Moneta ry system o f excha nge facil itates m u c h greater excha nge than the b a rter system .
A n s . True. Beca use moneta ry system ( u n l i ke ba rter syste m ) d oes n ot req u i re d o u b l e coincidence o f wa nts.
13. M 1 measure of money supply i nc l udes only notes and coin s held by the people.
Ans. Fa lse.
M 1 = N otes a n d coi n s held by the people + Demand Deposits + Other Deposits.
low
14. M o n ey su pply in the economy refers to only the fiat money issued by the R B I .
A n s . Fa lse. Money s u p p ly i n the economy i nc l u des both fi a t money ( backed b y authority o f the R B I ) a s
wel l as fi d u c i a ry money ( backed b y mutual trust betwee n the payer a n d the payee).
15. Com mercia l banks play no rol e i n the stock of money supply i n the economy.
Ans. Fa lse. Com m e rcial ba n ks contribute to the stock of money s u p p ly i n the economy by way of cred it
ee
creation.
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Fr
1 6 . Cash reserves with the ba n ks a re a n i m po rta nt com ponent o f money supp ly.
Ans. Fa lse. Cash reserves with the b a n ks a re not a com ponent of money s u p p ly. Beca use cash reserves of
the s u p p l i e rs of money is not treated as a part of money s u p p ly.
or
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1. What is meant by an ideal su pply of money?
k
Yo
Ans. Ideal money su pply is that a m o u nt of money s u p p ly which keeps the tota l p u rchasing powe r in a
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state of balance with the s u p p ly of goods a n d services i n the economy, so that the economy does n ot
s l i p i nto i nflationary or deflationary situations.
B
2 . Commod ity va l u e of money has never been greater than the face va l u e (or money va l u e) . Is it true?
re
Ans. N o, the given statement is fa lse. I n good old days when coi n s were made of gol d a n d si lver, commod ity
va l u e of money ( referring to the va l u e of meta l conta i ned in the coi ns) wou l d someti mes exceed the
ou
ad
face va l u e of coins which is why coi n s we re someti mes melted a n d sold as a meta l .
3 . I s i t true that high powered money refers t o cash reserves o f t h e com mercial banks with t h e centra l
Y
bank?
Ans. N o, it is i n correct. H igh powe red money refers to ( i ) cu rrency with p u b l ic, ( i i ) va u lt cash of the
nd
Re
com m e rcial ban ks, a n d (iii) cash reserves of the com m e rcial ba n ks with the R B I .
4. Money becomes a com mod ity when i ntrinsic va l u e o f money exceeds its face va lue. Defend o r
Fi
refute.
Ans. Yes, the above statem e nt is correct. Beca u se when i ntrinsic va l u e exceeds face va l u e of money (as
it often h a p pened i n case of gol d and si lver coi ns), money is used as a com m od ity ( i m plying meta l
content of money is sold as a com m od ity) .
5 . A curb on high powered money wi l l lead to a curb on the creation of cred it by the com me rcial banks
i n the economy. Do you agree?
Ans. Yes, the given state ment is correct. This is beca use h igh powe red money i nc l u des cu rrency with the
p u b l i c as wel l as cash reserves of the commercia l ba n ks with the R B I . It serves as a moneta ry base for
the creation of credit i n the economy. A c u rb o n high powered m oney wi l l defi n itely lead to a curb
on the creation of credit by the commerci a l b a n ks.

4. Ana lysis & Eva l uation
1. Expl a i n how i ntroduction of money has led to the expa nsion of ma rkets.
Ans. Following observations may be noted in this rega rd :
( i ) I ntrod u ction of money has led to the expansion of markets t h rough the expa nsion of excha nge .
Beca use, ba rter syste m of excha nge req u i res 'do u b l e coi ncide nce of wa nts' w h i l e the moneta ry
syste m d oes not.
( i i ) Money has led to the emergence of fi n a ncial market and fi n a n c i a l i ntermed ia ries ( b a n ks
a n d other fi n a ncial i n stitutions). Ava i l a b i l ity of fu nds, both for pu rpose of con s u m ption a n d
i nvestme nt, has su bsta nti a l ly i ncreased . Conseq ue ntly, markets have expa nded .
( i i i ) I ntrod u ction of money has boosted the mobil ity of ca pita l across d iffere nt pa rts of the worl d .
T h i s has l e d t o the expa nsion o f g l o b a l ma rkets t h rough F D I (foreign d i rect i nvestment).
2 . Do you agree with the view that the excess of money su pply hinders the process of economic
growt h ? G ive reasons.
Ans. Yes, it is correct to say that the excess of m oney su pply h i nd e rs the process of economic growt h . The
fol lowi ng reasons exp l a i n this point of view:
(i) Excess of money s u p ply is a situation when p u rchasing power (also ca l led l i q u i d ity) with
the people is more than the existi ng ma rket va l u e of the goods and services ava i l a b l e i n the
economy. Conseq uently, pressu re of demand mou nts up on the ava i l a ble s u p p ly of goods a n d
services. Th is l e a d s t o a rise i n the genera l price leve l .
( i i ) If excess supply o f money conti n ues t o persist, t h e situation o f rising price leve l a lso conti n ues
to persist. This is ca l led a situation of i nflation-a situation of 'price s p i ra l'.
( i i i ) Persistent i nflati on leads to a rise in the rate of i nte rest. I m plying that the cost of i nvestment
tends to rise.
( iv) H igh cost of i nvestment leads to a cut i n the vol u m e of i nvestment.
(v) When i nvestment decli nes, the GDP growth a lso decli nes.
Th us, excess s u p p ly of money tends to h i nd e r the p rocess of economic growt h . It l owe rs the growth
rate of rea l G D P.
1. State the mea n ing a n d com po ne nts of mo ney s u p p l y. [CBSE Delhi 201 7]
[ Page 137, 138]
2 . Demand de posits i n c l u d e (choose the correct a lternative ) :
(a) saving accou nt de posits a n d fixed deposits
(b) saving accou nt de posits and cu rrent acco u nt deposits
(c) cu rrent acco u nt deposits and fixed deposits
(d) a l l types of deposits [CBSE {Al} 201 7]
[(b)]
3 . Exp l a i n "d ifficu lty i n storing wea lth" p roblem faced i n the barte r system of excha nge.
[ Page 135, 136] [CBSE (Al} 201 7]
4. Defi ne money. List its com ponents. [CBSE {F) 201 7]
[ Page 134
Com pone nts of money a re : ( i ) notes, ( i i ) coi n s, ( i i i ) b a n k's cheq ues a n d d rafts, ( iv) e-money.]
Money 147
5 . State the two components of M 1 meas u re of money s u p p ly. [CBSE 2018]
Or
State a ny two com ponents o f M 1 measu re o f money s u p ply. [CBSE 2019 {58/1/1)]
[ Page 138]
6. Defi ne "de m a n d deposits". [CBSE 2019 {58/4/1)]
[ Page 139]
6. N C E RT Questions (With H i nts to A n swers)
1. What is a barter syste m ? What a re its d rawbacks?

[ H i nt : Ba rter system is a system where goods a re excha nged for goods.
low
Drawbacks:
(i) It req u i res d o u b l e coi ncidence of wa nts.
( i i ) It lacks com mo n u n it of excha nge .
( i i i ) It lacks conve n i e nt means of storage of va l u e . ]
ee
2 . H ow does money overcome the shortco m i ngs o f a ba rter system ?
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[ H i nt: U se of money ove rcomes the d rawbacks of ba rter system of excha nge i n the fol lowi ng m a n ner:
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( i ) Use of money as a med i u m of excha nge has overcome the d ifficu lty of dou ble coincidence of
wants. Accord i ngly, excha nge has tended to expa n d .
( i i ) Money facil itates storage o f va l u e just i n terms o f p a p e r clai ms, avo i d i ng the storage o f goods
or
u nd e r barter syste m .
sf
u
( i i i ) Money acts as a sta n d a rd u n i t o f va l u e which is a bsent.
( iv) Money acts as an instru ment of defe rred payments. N o such i n stru ment is ava i la b l e in the barte r
k
Yo
system of excha nge.]
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3 . What a re the a lternative defi n itions of money s u p ply in I n d i a ?
B
[ H i n t: M 2 , M 3 , a n d M 4 (see Abil ity Zone for deta i ls).]

4. What is 'fiat money' ?
re
[ H i nt : F iat money refers to money backed with ord e r (authority) of the government.]
5 . What is high powe red money?
ou
ad
[ H i nt: H igh powered money means cash (coins a n d n otes) with the people a n d cash rese rves of the
Y
com m e rcial ba n ks.]
7. M isce l l a neous Q uestions a n d Reference to the Text for Answers

nd
Re
Fi
A. Questions of 3 & 4 m a r ks each

1. Exp l a i n the evo l u tion of money. [Page 1 33, 134]
2. Defi ne barter system of excha nge. State a ny two shortco m i ngs of barter system of excha nge.
[Page 134-136]
3. Exp l a i n a ny one problem faced in the barter syste m . H ow has money solved this problem?
[Page 1 35, 136]
4. G ive mea n i ng of money. State its d i fferent forms. [Page 1 34, 136, 1 3 7]
5 . Exp l a i n the i m porta nt forms of money. [Page 136, 137]
6. What is mea nt by money s u p p ly? State M 1 measu re of money s u p p ly. [Page 1 3 7, 138]

B . Questions of 6 ma rks each
1. State the l i m itations (d rawbacks) of ba rter syste m of excha nge. H ow a re these l i m itations removed
with the i ntrod uction of money? [Page 1 35, 136]
2 . "Money is what money d oes." Exp l a i n . [Page 1 33, 134]
3. Defi ne money s u p p ly. State a n d exp l a i n the d iffe rent com ponents of money s u p ply. [Page 1 3 7, 138]
4. H ow does RBI classify the s u p p ly of money? [Page 1 3 7, 138]
DOs and DON'Ts

1. You must u ndersta nd that barter system of exchange is a characteristic of backward economies or
prim itive economies. Moneta ry system of exchange is a cha racteristic of modern economies. G rowth
of an economy (from an underdeveloped economy to a developed economy) is deeply related to the
growth of monetary system of exchange.
2. Storage of money should not be m i sunderstood as 'idle cash' with the people. People hold money
(i) to meet thei r routine transactions, (ii) to cope with thei r emergent needs i n the near futu re, and ( i i i)
for pu rpose of i nvestment (buyi ng shares a n d bonds).
3. I n I ndia, RBI issues all paper notes, but not the one rupee note. Also, it does not issue coins. Al l coins and
one rupee notes are issued by M i n i stry of Finance, Government of India, under the Indian Coi nage Act.
However, circulation of the entire cu rrency (including notes and coins) is conducted only by the R B I .
....__. • M 2 , M 3 , M 4 Measures of Money Supply

M 2 Measurement
M 2 is a boarder concept of money sup ply compared to M 1 . Bes i des a l l the
components of M 1 , it also i ncludes savi ngs of the people with the post offices.
Thus,
M 2 = M 1 + Deposits with Post Office Saving Bank Account
M 3 Measurement
M 3 is also a broader concept of money supply compared to M 1 . Bes ides a l l the
components of M 1 , it also i ncl udes (net) time depos its (or fixed deposits/term
deposits) of the people with the commerc i a l ba n ks. Th us,
M 3 = M 1 + Net Time Deposits with the Commercial Banks
M 4 Measurement
M 4 con cept of money supply is sti l l b roader-it is broader than even M 3 .
Bes i des a l l the components of M 3 , it a l so i ncludes tota l depos its with the post
offi ces (other than in the form of N ational Saving Certificate) .
Th us,
M 4 = M 3 + Total Deposits with Post Offices
I
(other than i n the form of National Sav i n g Certificate)
Aggregate Monetary Resources of the Country
If money supply in the country is measured using M 3 measure, it is called 'aggregate
monetary resources' of the country.
Money 149
• 'Narrow Money' and 'Broad Money' Concepts of Money Supply
The d i stinction between na rrow money and broad money is someti mes d rawn
with reference to the measure u sed for esti mati ng tota l money supply in the
cou ntry. If M 1 or M 2 measures a re used, then it is known as 'na rrow money'
con cept of money supply. If M 3 or M 4 measures are used, then it is known as
'broad money' concept of money supp ly.
• Ind ian Monetary System
A moneta ry system refers to the form of money which circulates i n the economy
by way of order/authority of the govern ment. I n d i a is using pa per cu rrency.
low
Accord i ng ly, I ndian monetary system is descri bed as a Paper Currency Sta ndard .
Pa per cu rrency does not excl ude the use of meta l coi n s . Both meta l coins and
paper notes are cred it mo ney i n I n d i a . The o n ly difference is that w h i l e coi ns
a re of s m a l l denom i nation, pa per notes are of l a rge denominati on.
Note Carefully
ee
-Coins in I nd i a a re l i m ited leg a l ten der.
rF
Fr
- Paper notes i n I nd i a a re u n l i m ited legal tender.
It means that coi ns can be used to settle payments only of l i m ited va l ue; pa per
or
notes can be used to settle payments of u n l i m ited va l ue.
sf
u
• What Governs N ote Issuing i n I n d i a?
Note issuing i n I n d ia is governed by M i n i m u m Reserve System . The entire
k
Yo
cu rrency issued has the backi ng of m i n i m u m gold reserves. Two poi nts m ust
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be carefu lly u n derstood in this context:
B
(i) Gold reserves a re j u st the m i n i m u m reserves (� 1 1 5 crore) . These are not

proportionate to the cu rrency i n c i rc u l ation.
re
(i i) Money with the people is entirely 'credit money'. It can not be converted
i nto b u l l ion-si lver or gold by the i ssu i n g authority. G o l d reserves a re j u st a
ou
ad
backi ng, not the stock to convert pa per notes i nto gold .
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• The Concept of Liquidity

Li q u i d ity of an asset refers to its converti b i l ity i nto money/cas h . Faster an
nd
Re
asset can be converted i nto cash, more liquid it is. Obviously, money itself is
the most liquid asset.
Fi
Cheq ueable depos its/d emand depos its are highly l i q u i d assets . Accord i n g ly,
we can state that M 1 inclu des only those components of money supply which
a re most l i q u i d .
Term depos its or ti me depos its/fixed depos its a re not chequea b l e deposits.
These can not be withdrawn by issuing a cheque. These depos its are, therefore,
l ess l i q u i d than the dema nd depos its .
Accord i n g ly, M 3 and M 4 measures of money supply include such components
of money supply which are less l i q u i d .
Ill

•
•
•
Money Creation by the Commercial Banks
The Central Bank: Meaning and Functions
Control of Money Supply by the Central Bank (RBI in India)
,,
I. MONEY CREATION BYTHE COMMERCIAL BANKS
In the previous chapter, we noted that the commercial banks are an
important source of money supply in the economy. Unlike the central
bank, the commercial banks do not have the authority of issuing
currency: they cannot issue notes or coins. Yet, they are the suppliers
of money as they create money by way of demand deposits. In the
present chapter, we discuss the process of money creation by the
commercial banks: how exactly the commercial banks create money?
Process of Money Creation by the Commercial Banks
Following observations explain the process of money creation by the
commercial banks:
(i) Banks receive cash deposits from the people. These are called
'primary deposits'.
(ii) Banks lend money many times more than their cash reserves.
(iii) Money is lent by the commercial banks not in the form of cash,
but in the form of 'credit entry' in the accounts of the borrowers.
These credit entries are known as secondary deposits.
(iv) The borrowers can issue cheques against 'credit' (loans) in their
accounts. The cheques circulate in the economy as money.
(v) Primary deposits + Secondary deposits
= Demand deposits held by the people in the commercial banks
151
(vi) Total demand deposits with the banks are many times more than
the cash reserves of the commercial banks. This is because the
commercial banks know (by way of their historical experience)
that all the depositors would not show up in the banks to
withdraw all their deposits by way of cash.
(vii) If experience shows that withdrawals are generally around 10 per
cent of demand deposits, the banks need to keep only 10 per
cent of deposits as cash reserves.
(viii) All demand deposits (held by the people) serve as money supply
in the economy, just like cash held by the people.
low
(ix) Demand deposits serving as money supply is called bank money.
This is money created by the banks. Because this is circulating in
the system not in the form of cash, but in the form of cheques
issued by the banks to the holders of demand deposits.
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Illustration
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Let us illustrate the process of credit creation with the help of an example.
For the sake of simplicity, we assume that:
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(i) There is a 'single banking system' in the economy and initially,
the bank receives deposits of� 1,000.
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(ii) CRR = 10% and it does not change. This reflects cash reserves of
k
the commercial banks as a percentage of their demand deposits.
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Table 1 shows how the system would work for the creation of money:
B
Table 1. Creation of Money in a Single Banking System

re
Rounds Deposits Loans Cash Reserves (�)

(�) (� ) (CRR = 10%)
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1st Round 1,000 900 100

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2nd Round 900 810 90

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3rd Round 810 729 81

(and so on till all excess reserves are exhausted)
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Total 10,000 9,000 1,000

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• In the first round, bank receives deposits of� 1,000.

• The cash reserves to tackle the liability of� 1,000 is equal to� 100
(because cash reserve ratio is = 10% of total deposits). Implying
that the banks have excess reserves = � 1,000 - � 100 = � 900
which they can use for the purpose of lending.
• When these excess reserves are loaned out, deposits of the banks
are raised by� 900. The banks need to hold cash reserves as 10%
of� 900 or� 90. Now, excess reserves of the bank is� 900 -� 90 =
� 810 which can be loaned. This process continues till total demand
deposits are� 10,000 and cash reserves are� 1,000.

Thus, if cash reserve ratio is equal to 10%, initial deposits of� 1,000
allows the bank to create demand deposits up to� 10,000. So that,
Demand Deposits = Cash Reserves
C�R x
1
= X t 1, 000
1O%
= 10 X � 1,000 = � 10,000
Summing up, we can say that money creation by the commercial
banks depends on two principal factors, as under:
(i) Cash Balances with Commercial Banks which they can use as
cushion money (emergency fund) for the creation of credit.
Higher these cash balances, greater the money creation (or credit
creation) capacity of the commercial banks, and
(ii) CRR: Higher the CRR, lower the capacity to create money.
Besides the CRR (cash which the commercial banks ought to keep),
the banks may hold excess reserves, as 'vault cash'. Higher the vault
cash, lower would be the capacity to create money.
Primary and Secondary Deposits
Primary deposits are cash deposits with the commercial banks by the people. These
F@CUS
ZON
are a part of total demand deposits of the banks. E
Secondary deposits are those deposits which arise on account of loans by the banks
to the people. T hese are also a part of total demand deposits of the banks.
Important to note it is, that while primary deposits indicate savings of the depositors
with the banks, secondary deposits indicate borrowings of the depositors from the banks.
Secondary deposits are also called Derivative Deposits.
Total Demand Deposits of the Commercial Banks
= Primary Deposits of the Commercial Banks + Secondary Deposits of the
Commercial Banks.
CRR and Credit Multiplier

In India, CRR is determined not by the commercial banks themselves
but by the RBI (Reserve Bank of India). Therefore, it is also called LRR
(Legal Reserve Ratio).
Also, the commercial banks are required to keep the stipulated
(legally required) cash reserves not with themselves, but with the RBI
(of course, the banks can keep excess reserves as 'vault cash' with
themselves).
Once CRR is known (as fixed by the RBI), we can find out 'credit
multiplier', or the number of times the commercial banks can create
credit, per unit of their cash reserves with the RBI.
Banking 153
Credit multiplier is found in terms of the following equation:
1
k=
CRR
Here, k = Credit multiplier.
CRR = Cash reserve ratio.
Example: If CRR = 10%, then
w
1 = 100 =
k= 10
10%
It implies that if CRR = 10% then the commercial banks can credit
money 1O times of their cash reserves with the central bank. Thus:
low
if cash reserves are =�10,000, the commercial banks can create credit,
as per the following equation:
Credit Creation or Money Creation = � 10, 000
x 1�%
ee
= �10, 000
100
--:io =�1, 00, 000
rF X
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Note that this is the maximum amount of money (credit) that the
commercial banks can create given their cash reserves. This is because
or
CRR is legally determined by the RBI, and the commercial banks must
comply with it.
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F@CUS
k
Credit Multiplier
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Z N O E k
I
= CRR
B
Here, k = Credit multiplier, CRR = Cash reserve ratio.

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In India, CRR is fixed by the RBI.Accordingly, credit multiplier indicates the maximum amount
of money that the commercial banks can create; given their cash reserves with the RBI.
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ad
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2. THE CENTRAL BANK

The central bank is an apex bank that controls the entire banking
nd
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system of a country. It is the sole agency of note issuing and controls

the supply of money in the economy. It serves as a banker to the
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government and manages forex (foreign exchange) reserves of the

country. Reserve Bank of India (RBI) is the central bank of India.
Functions of the Central Bank

Principal functions of the central bank are as under:
(1) Bank of Issuing Notes: Central bank of a country has the exclusive
right (monopoly right) of issuing notes. This is called Currency
Authority function of the central bank. The notes issued by the
central bank are an unlimited legal tender.

(2) Banker to the Government: Central bank is a banker, agent, and
financial advisor to the government.
• As a banker to the government, it manages accounts of the
government.
• As an agent to the government, it buys and sells securities on
behalf of the government.
• As an advisor to the government, it frames policies to regulate
the money market.
(3) 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. Three observations
need to be noted in this context:
(i) The central bank accepts deposits from the commercial
banks, and offers them loan.
(ii) The central bank provides 'Clearing House' facility to the
commercial banks. It is a cheque clearing facility provided at
one centre to all the banks.
(iii) In its supervisory role, the central bank ensures that the
commercial banks show compliance to its directives,
particularly relating to CRR and SLR. The central bank
changes CRR, SLR as and when required. It ensures that
the commercial banks show compliance to these changes so
that the desired targets are achieved.
(4) Lender of the Last Resort: It means that if a commercial bank fails
to get financial accommodation from anywhere, it approaches
the central bank as a last resort. Central bank advances loan to
such a bank against approved securities. By offering loans to
the commercial banks in situations of emergency, the central
bank ensures: (i) that the banking system of the country does
not suffer any set-back, and (ii) that money market remains
stable.
(5) Custodian of Foreign Exchange: Central bank is the custodian
of nation's foreign exchange reserves. It also exercises 'managed
floating' to ensure stability of exchange rate in the international
money market. Managed floating refers to the sale and purchase
of foreign exchange with a view to achieving stability of exchange
rate for the domestic currency.
(6) Clearing House Function: Central bank performs the function
of a clearing house. Let us take an example to understand this
function. Supposing, Bank A receives a cheque of� 10,000 drawn
Banking 155
on Bank B, and Bank B receives a cheque of� 15,000 drawn on
Bank A. Both, Banks A and B have their accounts with the central
bank. The cheques of both the banks are cleared through their
accounts with the central bank. This is how the central bank acts
as a clearing house. It avoids transfer of cash between the banks
and reduces requirement of cash.
(7) Control of Credit: The principal function of the central bank is to
control the supply of credit in the economy. 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
low
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. Section 3 of the
chapter gives a detailed description of how the central bank
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controls supply of money in the economy.
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Performing all these functions, the central bank focuses on growth
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with stability. (Growth refers to a sustained rise in GDP. Stability refers
to the elimination of inflationary and deflationary situations in the
or
economy.)
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The Central Bank and A Commercial Bank-The Difference
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The Central Bank A Commercial Bank
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_ _ _ _ _ - _ _ _ _ _ _ - _ _ _ _ _ - - - --1
- _ _ _ _ - _ _ _ _ _ - _ _ _ _ _+-_(_ _A _ c_om
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(z Th e centr bank is the apex bank mercial bank is that fi nancial
E the bank of all banks in the country.
i)
institution which accepts deposits
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All commercial banks function under from the general public and offers
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the control of the central bank. loans to the people for purpose of
It accepts deposits from the consumption and investment.
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commercial banks and advances

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loans to them. But, it does not deal

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with the general public.

(ii) Th e central bank regulates the (ii) A commercial bank only contributes
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supply of money, besides being the to the supply of money by way of

principal source of money supply in credit creation.
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the economy.
(iii) Th e central bank is a custodian (iii) A commercial bank is not a custodian
of forex reserves of the country. of forex reserves of the country.
It conducts 'managed floating' However, it deals in the sale and
to regulate exchange rate of the purchase of foreign exchange for
domestic currency. purpose of profit.
(iv) Th e central bank is a note issuing (iv) A commercial bank is not a note
authority. It is a currency authority issuing authority. It is not a currency
of the country. authority.
(v) Th e central bank focuses on growth (v) A commercial bank focuses on profit
and stability of the economy. maximisation.

t>TS
Q. What is the significance of centralised cash reserves with central bank?
Ans. Two observations need to be noted in this context:
(i) Centralised cash reserves enable the RBI to offer financial help to the commercial banks during
emergencies. It is called 'financial accommodation' by the RBI. Banks get financial accommodation
(or financial help) in times of emergency.
(ii) Centralised cash reserves enable the RBI to exercise control over the commercial banks. Because
these reserves depend on CRR (fixed by RBI in India) and by varying the CRR, the RBI can increase
or decrease the credit creation capacity of the commercial banks. Accordingly, money supply in
the economy is regulated.
3. CONTROL OF MONEY SUPPLY (OR CREDIT

SUPPLY) BY THE CENTRAL BANK (RBI IN INDIA)
The central bank adopts various measures to control the supply of
money in the economy. Largely, these measures relate to credit supply
by the commercial banks. These are broadly classified as:
(A) Quantitative Instruments, and
(B) Qualitative Instruments.
Following is a brief description of these instruments. It may be noted
that these instruments are used to decrease the supply of money
when there is inflationary spiral in the economy and to increase the
supply of money when there is deflationary spiral in the economy.
(A) Quantitative Instruments of Credit Control

Quantitative instruments are those instruments of credit control
which focus on the overall supply of money in the economy. Supply of
money is lowered to tackle inflation, and it is raised to tackle deflation.
Following is a brief description of these instruments:
(1) Bank Rate: Bank rate refers to the rate of interest at which the
RBI lends money to the commercial banks. It relates to instant
(immediate) loan requirement of the commercial banks.
The increase (or decrease) in bank rate is often followed by
increase (or decrease) in the market rate of interest (the interest
rate charged by the commercial banks from the general public).
Accordingly, the cost of credit (also called the cost of capital)
changes in the market. When bank rate is increased, market
rate of interest is also increased. Accordingly, the cost of capital
increases. This lowers the demand for credit and therefore, the
supply of money tends to fall. Accordingly, inflation is corrected.
Banking 157
On the other hand, when bank rate is decreased, market rate
of interest is also decreased. Accordingly, the cost of capital
decreases. This increases demand for credit and therefore, supply
of money tends to rise. Accordingly, deflation is corrected.
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Rise in Bank Rate----. Rise in market rate of interest----. Rise in cost of capital----. Fall in demand
for credit----. Fall in the supply of money----. Inflation is controlled.
Fall in Bank Rate----. Fall in market rate of interest----. Fall in cost of capital----. Rise in demand
for credit----. Rise in the supply of money----. Deflation is controlled.
(2) Open Market Operations: Open market operations refer to the
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sale and purchase of securities in the open market by the RBI on
behalf of the government. By selling the securities (like, National
Saving Certificates-NSCs) in the open market, the RBI soaks
liquidity (cash) from the economy. And, by buying the securities,
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the RBI releases liquidity.
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When liquidity is soaked (as during inflation), cash reserves of
the commercial banks are squeezed. Implying a cut in their credit
creation capacity. On the other hand, when liquidity is released
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(as during recession/deflation), cash reserves of the banks tend to
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rise. Implying a rise in credit creation capacity of the commercial
banks.
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Thus, inflation is corrected by selling the securities and soaking
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liquidity, while deflation is corrected by buying the securities

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and releasing liquidity.

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Sale of Securities by the RBI ----. Soaks liquidity and leads to a fall in cash reserves of the
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commercial banks ----. Fall in credit creation capacity of the commercial banks ----. Fall in money
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supply----. Inflation is controlled.

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Purchase of Securities by the RBI----. Releases liquidity and leads to a rise in cash reserves of the
commercial banks----. Rise in credit creation capacity of the commercial banks----. Rise in money
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supply----. Deflation is controlled.

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Two Types of Open Market Operations

There are two types of open market operations (i) outright, and (ii) repo
Outright open market operations are permanent in nature. These are as discussed above. The other
type is known as repo open market operations. In such type of operations, there is a promise of
repurchase and resale of securities (unlike in the first type).
(3) Repo Rate: The rate at which the RBI (central bank) offers short
period loans to the commercial banks by buying the government
securities in the open market is called 'Repo Rate'. In fact, it is
a Repurchase Rate. A repurchase agreement is signed by both

the parties stating that the securities will be repurchased by the
commercial banks on a given date at a predetermined price.
In other words, the RBI issues a loan cheque to the commercial
banks by buying from them the government securities. But, it
carries the agreement of repurchase of securities by the commercial
banks at the predetermined date and at a predetermined price.
During inflation, the cost of capital is increased by increasing the
repo rate. This lowers the demand for credit and accordingly, the
supply of money in the economy, as desired. On the other hand,
during deflation, the cost of capital is reduced by reducing the
repo rate. This increases the demand for credit and accordingly,
the supply of money in the economy, as desired.
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Rise in Repo Rate --.. Rise in cost of capital --.. Fall in demand for credit --.. Fall in supply of
money by the commercial banks --.. Inflation is controlled.
Fall in Repo Rate --.. Fall in cost of capital --.. Rise in demand for credit --.. Rise in supply of
money by the commercial banks --.. Deflation is controlled.
(4) Reverse Repo Rate: The rate at which the RBI (central bank)
accepts deposits from the commercial banks (through government
securities) is called 'Reverse Repo Rate'. It is also called Reverse
Repurchase Rate. In this case, a reverse repurchase agreement
is signed by both the parties stating that the securities will be
repurchased on a given date at a predetermined price. Reverse
repo rate allows the commercial banks to generate interest
income.
When reverse repo rate is lowered, banks are discouraged to
park their surplus funds with the RBI. Instead, the banks may use
these funds as (RR-funds with the RBI. This leads to a rise in credit
supply (money supply) by the commercial banks. Accordingly,
supply of money is enhanced in the economy, as desired to
control deflation. On the other hand, a rise in reverse repo rate
may induce the commercial banks to park more funds with the
RBI to generate interest income. This lowers their capacity to
offer (RR-funds to the RBI for the creation of credit. Accordingly,
supply of money is reduced in the economy, as desired to control
inflation.
Fall in Reverse Repo Rate --.. Less funds are parked by the commercial banks with the RBI to
generate interest income --.. More funds are used as CRR-funds with the RBI, for the creation of
credit --.. Supply of money increases --.. Deflation is controlled.
Rise in Reverse Repo Rate --.. More funds are parked by the commercial banks with the RBI to
generate interest income --.. Less funds are used as CRR-funds with the RBI, for the creation of
credit --.. Supply of money decreases --.. Inflation is controlled.
Banking 159
(5) Cash Reserve Ratio (CRR) : It refers to the minimum percentage
of a bank's total deposits required to be kept with the RBI. It is
fixed by the RBI and is varied from time to time to regulate the
supply of money in the economy.
When the supply of money is to be increased, CRR is lowered, and
when the supply of money is to be reduced, CRR is raised.
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Rise in CRR ---. Rise in cash reserves for a given amount of demand deposits ---. Fall in money
supply of the commercial banks ---. Inflation is controlled.
Fall in CRR ---. Fall in cash reserves for a given amount of demand deposits ---. Rise in money
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supply of the commercial banks ---. Deflation is controlled.
(6) Statutory Liquidity Ratio (SLR): Every bank is required to

maintain a fixed percentage of its assets in the form of liquid
assets, called SLR. The liquid assets include: (i) cash, (ii) gold,
and (iii) unencumbered approved securities. The rate of SLR
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(like that of CRR) is fixed by the RBI and is varied from time to
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time. To decrease the supply of money (as during inflation), the
central bank increases SLR. Accordingly, funds available for CRR
deposits (for the creation of credit) are reduced. Conversely, SLR
or
is reduced to increase the supply of money (as during deflation)
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in the economy. Accordingly, funds available for (RR-deposits
(for the creation of credit) are increased.
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Rise in SLR ---. Rise in liquid assets to be held by the commercial banks with themselves ---. Fall
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in the availability of funds for CRR-deposits with the RBI ---. Fall in money supply of the commercial
banks ---. Inflation is controlled.
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Fall in SLR ---. Fall in liquid assets to be held by the commercial banks with themselves ---. Rise in
the availability of funds for CRR-deposits with the RBI ---. Rise in money supply of the commercial
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banks ---. Deflation is controlled.

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(B) Qualitative Instru ments of Credit Control

Qualitative instruments are those instruments of credit control which
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focus on select sectors of the economy. These instruments are used

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to increase or decrease the supply of money to select sectors of the

economy. (These are those sectors which are the principal source of
instability in the economy.) Broadly, the qualitative instruments are
placed in three categories, as under:
(1) Margin Requirement : 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. Suppose, a
person mortgages his house worth � 1 crore with the bank for a
loan of� 80 lakh. The margin requirement in this case would be
� 20 lakh. The margin requirement is raised when the supply of

money needs to be red uced . The margi n req u i rement is lowered
when the su pply of money is to be i ncreased . Often the margi n
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req u i rement is kept high fo r specu l ative (trad ing) activities .
Rise in Margin Requirement ---+ Fall in demand for credit ---+ Fall in supply of credit by the
commercial banks ---+ Fall in money supply ---+ Inflation is controlled.
Fall in Margin Requirement ---+ Rise in demand for credit ---+ Rise in supply of credit by the
commercial banks ---+ Rise in money supply ---+ Deflation is controlled.
(2 ) Rationing of Credit: Rationing of credit refers to fixation of credit

quotas for d ifferent business activities. Rationing of credit is
introduced when the supply of credit is to be checked particularly
for speculative activities in the economy. The RBI fixes credit quota
for d ifferent business activities. The commercial banks cannot
exceed the quota limits while granting loans. This restricts the
supply of money in the economy, and inflation is controlled . On the
other hand , rationing of credit (if already in practice) is withdrawn
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to increase the supply of money. This controls deflation.
Introduction of Credit Rationing ---+ Decreases the supply of credit by the commercial banks
---+ Decreases the supply of money ---+ Inflation is controlled.
Withdrawal of Credit Rationing ---+ Increases the supply of credit by the commercial banks
---+ Increases the supply of money ---+ Deflation is controlled.
(3 ) Moral Suasion : It is l i ke rendering an advice to the commerci al

banks by the RBI to follow its d i rectives . The ban ks are advised
to restrict loans d u ri n g inflation , and be li be ral in lend i ng d u ri ng
deflatio n . 'persuasion' and
'pressu re'. The RBI
Check the followi ng flow chart for a summary statement o f the tries to persuade the
quantitative as wel l as qual itative instru me nts of cred it contro l : com merc i al ba nks to
follow its d i rectives, but
if persuation does not
Instruments of Credit Control work, it uses the req u i red
pressu re as an a pex
b ank of the cou ntry.
If p ressu re also does
Qualitative not work, the RBI can
'o a Instruments
>- >- use d i rect action which
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Vl t:; Ba nk Rate i ncl udes derecog nition
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§:i o
c Margin
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0... u of the concerned bank.
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.tc § Repo Rate Req u i rement As a n i nstrument of
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.._ Q) ..s::.. .._ -0 monetary policy, 'mora l
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Reverse Repo Rate Rationing suasion' works both as a
- of Cred it q u a ntitative i nstrument
..., 0�
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u QJ ro QJ c
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Cash Reserve Ratio as wel l as a q u a l itative
=
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Moral Suasion i nstru ment. However,
Cl... v, _c 2 :� Statutory Liq uid ity Ratio often it is classified as a
o .g ;_ 1,; 13 q u a l itative i n strument.
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I-'- 0:: -� � Open Ma rket Operations
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Banking 161
t>TS
Q. What is selective credit control?
Ans. It refers to discri m inatory policy of the central ba nk relating to select sectors of the economy. Flow of
credit to certain sectors (priority sectors) may be encou raged with a view to stim u lating production i n
these sectors. This is a positive application o f selective credit controls. On t h e other hand, t h e centra l
b a n k may decide t o restrict t h e availability o f cred it t o certai n (non-priority) sectors. Generally,
d u ri ng periods of i nflation, availability of credit for speculative activities ( l i ke storage of food grains)
is d iscou raged. This is a n egative a pplication of the selective credit controls.
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Power Poi nts & Revision Window ------------
Money Creation by the Commercial Banks: Com m e rc i a l b a n ks contri bute to moneysupply by creating cred it.
They d o it by adva ncing loans ( i n terms of demand d eposits)
m a ny ti m es more t h a n their cash reserves. They d o it o n the
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basis of their h istorica l experience that the d epositholders
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l i a b i l ity towa rds the depositholders ca n be ma naged by kee ping
o n ly a s m a l l percentage of d eposits as cash rese rves.
or
Credit M u ltiplier = � . It shows the n u m b e r of ti m es the com m e rc i a l ba n ks ca n create c redit per u n it
C R
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of thei r cash rese rves with t h e RBI. In I n d ia, C R R i s fixed by t h e R B I .
The Central Bank i s a n a pex b a n k o f t h e e nti re b a n ki ng system of a cou ntry. R B I i s t h e centra l ba n k o f I n d i a .
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� Functions: ( i ) Ba n k o f iss u i ng n otes, ( i i ) Ba n ke r t o t h e gover n m e nt, ( i i i ) Ba n ke rs' ba n k a n d s u p e rvisory role,
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(iv) Le n d e r of t h e l a st resort, (v) Custod i a n of foreign exc h a nge, (vi) C l e a ri ng house fu nction, (vi i ) Control
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of c red it.
Control of Money Supply by the Central Bank
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Monetary Pol icy is t h e p o l i cy to co ntro l t h e supply of credit/ m o n ey in t h e eco n omy. It a i ms at correcting

t h e situations of i nflati o n a n d d efl ation i n t h e eco n o my. I n stru m e nts of m o n eta ry pol icy
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a re b roa d l y classified a s : ( i ) Qua ntitative i nstru m e nts, a n d ( i i ) Qua l itative i nstru ments.
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These a re a lso ca lled 'i nstru m e nts of cre d it contro l'.

Quantitative Instruments of Monetary Policy:
nd
( i ) Th ree p o l i cy rates: ( a ) Ba n k rate, ( b ) Repo rate, a n d (c) Reve rse re po rate.

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( i i ) Two pol icy ratios: (a) C R R, a n d (b) S L R .

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( i i i ) Open m a rket operations.

Qua litative Instruments of Monetary Policy:
( i ) M a rgi n req u i re m e nt,
( i i ) Rati o n i ng of cred it, a n d
( i i i ) M o ra l s u a s i o n .

rEX E RC I S Ej
1 . Obj ective Type Questions (Remem bering & U ndersta n d i n g based Questions)
A. M u lt i p l e Choice Questions
1. In the context of com mercial ba n k, which one of the following statements is correct?
(a) N ote-iss u i n g authority of the cou ntry
( b ) Creates cred it on the basis of cash rese rves
(c) Accepts deposits of the genera l p u b l i c
( d ) Both ( b ) a n d ( c )
2 . Commerci a l ba n ks create money b y way of:
(a) ti me de posits (b) d e m a n d deposits
(c) trea s u ry b i l l s ( d ) b i l l o f excha nge
3 . Which of the fol l owing is not concerned with ban king orga n isation?
(a) Ba n k rate ( b ) Fisca l deficit
(c) Cred it creation ( d ) Cash rese rve ratio
4. Credit ca rds issued by the ba n ks :
(a) enco u rage cons u m e r s pe n d i n g ( b ) i ncrease aggregate demand i n the economy
5 . The m a i n aim of the commercial ba n ks is:
(a) socia l welfa re ( b ) to earn profits
(c) to p rovide services to the people ( d ) none of these
6. Maxi m u m credit that the com mercia l ba n ks ca n lega lly create depends on their:
(a) gol d reserves ( b ) cash rese rves with the R B I
(c) statutory l i q u i d ity ratio ( d ) term deposits
7. Term deposits a re those :
(a) against which no cheq ue ca n be issued ( b ) aga i n st which n o i nterest is paid to the de positors
(c) which a re a part of M 1 supply of money ( d ) none of these
8. The percentage of demand deposits which the com mercia l banks a re lega l ly req u i red to m a i nta i n
as t h e i r liquid assets is ca lled:
(a) C R R ( b ) re po rate
(c) SLR ( d ) reverse repo rate
9. SLR req u i res the com mercia l ba n ks to build their liquid assets by way of:
(a) reserves of cash (b) reserves of gold
(c) reserves of u nencu mbered secu rities ( d ) a l l of these
10. Centra l ba n k is a n a pex bank of the cou ntry that:
(a) controls the enti re ba nking system of the cou ntry
( b ) issues cu rrency
(c) acts as a ba n ker to the government
( d ) a l l of these
Banking 163
1 1 . I n I n d ia, the centra l ba n k is:
(a) Federa l Rese rve System ( b ) Federa l System
(c) Reserve Ba n k of I n d i a (d) both (a) and ( b )
1 2 . Maxi m u m credit that t h e commercia l ba n ks ca n lega lly create is i n d icated by:
1 1 1
(a) ( b ) __ X
SLR CRR Cash reserves with the R B I
(c) ! x Tota l deposits (d) ! x Cash reserves with the R B I
c R c R
13. Credit control mea ns:
(a) contraction of credit o n ly
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(b) extension of credit o n ly
(c) extension a n d contraction of money s u p ply
(d) none of these
14. Which of the following is not the i nstru ment of credit control?
(a) CRR ( b ) SLR
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(c) Bank rate ( d ) M a n aged fl oati ng
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15. Which of the fol l owing does not come under q u a ntitative methods of moneta ry pol icy?
(a) Open market operations ( b ) Cash rese rve ratio
or
(c) M o ra l suasion ( d ) Repo rate
16. Open market operations as an i nstru ment of credit control a re performed by:
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(a) the centra l b a n k of the cou ntry ( b ) the commercia l b a n k of the cou ntry
(c) both (a) a n d ( b ) ( d ) n o n e o f these
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17. With a n increase i n m a rgin req u i rement, ava i l a b i l ity of cred it i n the economy:
(a) increases (b) decreases
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(c) u ncha nged (d) none of these

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18. If i nflation is to be com bated, the R B I :

(a) ra ises SLR a n d lowers CRR ( b ) l owers SLR a n d ra ises CRR
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(c) ra ises both CRR as wel l as SLR ( d ) none of these

19. If recession is to be com bated :
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(a) ba n k rate needs to be lowered

(b) CRR needs to be l owered
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(c) both (a) and ( b )

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(d) repo rate needs t o be l owered a n d CRR needs t o be ra ised

20. Reverse repo rate :
(a) ge nerates i nterest i ncome (b) is increased to curb inflation
(c) is n ot a pol icy rate ( d ) both (a) a n d ( b )
Answers
1. (d) 2. (b) 3. (b) 4. (c) 5. (b) 6. ( b ) 7. (a) 8. (c) 9 . (d) 10. ( d )
1 1 . (c) 12. ( d ) 13. ( c ) 14. (d) 15. (c) 16. (a) 17. ( b ) 18. (c) 19. (c) 20. ( d )
1 64 Introductory Macroeconomics
B. Fill i n the Bla n ks
Choose appropriate word and fil l in the blank:
1. Com m e rcial ba n ks contribute to the s u p ply of money by way of
( loans i n cash/loans i n d e m a n d de posits)
2. deposits a rise o n acco u nt of loans by the b a n ks to the people.
( Pri m a ry/Secon d a ry)
3. In case, a commercial b a n k fa i l s to get fi n a ncial acco m m odation from a nywhere, it a p p roaches the
_______ as a last resort. (cooperative b a n k/centra l bank)
4. _______ relates to i n sta nt ( i m mediate) loa n req u i rement of the commercia l b a n ks .
( B a n k rate/Repo rate)
5. Demand Deposits = Pri m a ry deposits + ( Ba n k de posits/Secon d a ry de posits)
6. By sel l i ng the secu rities i n the open ma rket, the RBI _______ l i q u i d ity (cash) from/i nto
the economy. (soa ks/releases)
7. Rati o n i ng of credit is the method to control money s u p p ly i n the economy.
(q ua ntitative/q ua I itative)
8. As an advisor to the gove rnment, centra l b a n k fra mes pol icies to reg u l ate the
(ca pita l market/money ma rket)
9. Centra l ba n k con d u cts to regulate excha nge rate of the domestic cu rrency.
( m a n aged floati ng/d i rty floati ng)
10. Liq u id assets of the commercial b a n ks which they a re req u i red to m a i nta i n as a m i n i m u m percentage
of their tota l deposits refer to (cash rese rve ratio/statutory l i q u i d ity ratio)
Answers
1. loans in demand deposits 2. Secondary 3. centra l ba n k 4. Ba n k rate
5. Secondary deposits 6. soa ks 7. q u a l itative 8. money ma rket
9. managed floating 10. statutory liquidity ratio
C. True or Fa lse
State whether the fol lowing statements are True or False:
1. I n I n d ia, LRR is determi ned by the com m e rcial ba n ks themse lves . (Tru e/Fa lse)
2. B a n ks lend money m a ny ti mes more than their cash reserves w i t h the R B I . (Tru e/Fa lse)
3. H igher the CRR, h igher is the ca pacity t o create money. (True/Fa lse)
4. The centra l b a n k focuses on growth a n d sta b i l ity of the economy. (Tru e/Fa l s e )
5. Open ma rket operations a re con d u cted by the R B I to reg u l ate the s u pply of money. (Tru e/Fa lse )
6. When the s u p p ly o f money is t o be increased, CRR is ra ised . (True/Fa lse)
7. Credit creation is the principal fu nction of the centra l ba n k. (Tru e/Fa lse)
8. M a rgin req u i rement is a q u a ntitative method of credit contro l . (True/Fa lse)
9 . T h e n otes issued b y the centra l b a n k a re a n u n l i m ited lega l tender. (Tru e/Fa lse)
10. With rati o n i ng of credit, s u p p ly of money is red uced . (True/Fa l s e )
Answers
1 . Fa lse 2 . True 3 . Fa lse 4. True 5 . True 6. Fa lse 7 . False 8. Fa lse 9. True 10. True
Banking 165
D. M a tc h i n g the Correct Statements
Column I Column I I
(a) SLR (i) Fixed by the commercia l ba n ks
(b) Primary deposits ( i i ) Derivative de posits
(c) Commerc i a l bank (iii) Advisor to the gove rnment
(d) Central b a n k ( iv) P rovides 'Clearing House' facil ity
(e) Secondary de posits (v) Not a part of total demand deposits of the b a n ks
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Answer
( d ) Centra l ba n k -( iv) Provides 'Clearing House' facility
items in Column I:
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Column I
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(a) D e m a n d deposits 1
(i)
CRR
(b) Central b a n k
or
( i i ) Fixed b y the R BI
(c) Money m u lti p l ie r ( i i i ) Re purchase rate
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(d) Repo rate ( iv) x Cash Rese rves
CRR
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(e) CRR (v) An apex ba n k of the cou ntry
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Answers
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( a ) - (iv), ( b ) -( v ), ( c ) - ( i ), ( d ) - ( iii ), ( e ) - ( ii )
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E . 'Very S h o rt Answer' Objective Type Questions

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1. Defi ne credit m u ltiplier.

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Ans. Credit m u lti plier is the reci p roca l of CRR (cash reserve rati o ) .
Cred it M u lt i p l i e r =
C�R
nd
Re
2. Defi ne pri m a ry deposits.

Ans. Pri m a ry de posits a re cash deposits with the com m e rcial ba n ks by the people. These a re a part of
Fi
demand deposits of the b a n ks.

3 . What a re secondary deposits?
Ans. Seco n d a ry deposits a re those deposits which a rise on acco u nt of loans by the b a n ks to the people.
These a re reflected as a part of d e m a n d de posits of the b a n ks. These a re a lso ca l led derivative
deposits.
4. What is a centra l ba n k?
Ans. A centra l b a n k is a n a pex i n stitution of a cou ntry that controls a n d reg u lates the moneta ry a n d
fi nancial system o f the cou ntry.
5. Defi ne CRR.
Ans. CRR (cash reserve ratio) refers to the lega l ly req u i red cash reserves of the com m e rcia l b a n ks with the
centra l bank as a perce ntage of thei r tota l deposits.

6. What is SLR?
Ans. SLR (statutory l i q u i d ity ratio) refe rs to l i q u i d assets of the commercia l b a n ks which they a re req u i red
to m a i nta i n as a m i n i m u m percentage of their tota l deposits .
7. Defi ne ba n k rate .
Ans. The b a n k rate is the rate at which the centra l ba n k of the cou ntry offers loans to the commercia l
b a n ks by d iscou nti ng the secu rities. It is a lso ca lled d isco u nt rate : the rate at which secu rities a re
d iscou nted for pu rpose of loans. It d oes n ot i nvolve a ny col late ral, a n d it d oes not a l l ow rep u rchase
of secu rities.
8. What is re po rate?
Ans. Repo rate is the rate of i nterest at which commerci a l b a n ks ca n ra ise short-te rm loans from the
centra l b a n k .
9 . What is reve rse re po rate?
Ans. Reverse re po rate is the rate of i nterest at which com m e rcial b a n ks ca n park their surplus fu nds with
the centra l ba n k, for short period of ti me.
10. What do you mean by open market operations?
Ans. Open ma rket operations refer to the sale and p u rchase of government secu rities in the open ma rket
by the centra l b a n k of the cou ntry.
1 1 . Defi ne m a rgin req u i rement.
Ans. M a rgin req u i rement refers to the d ifference between market va l u e of the secu rity offe red for loans
a n d the a m o u nt of loans offe red by the com m e rcial ba n ks .
12. Defi ne mora l suasio n .
A n s . Mora l suasion refers to persuasion as wel l as pressu re exercised by the centra l b a n k on the commercia l
b a n ks to be restricted a n d selective i n l e n d i n g d u ri ng i nflation, a n d to be l i be ra l i n l e n d i n g d u ring
deflati o n .
2 . Reason- based Questions (Com prehension o f the S u bject-matter)
Read t h e fol lowi ng statem ents ca refu l l y. Write Tru e or Fa lse with a reason .
1. H igher CRR i m p l ies higher capacity to create cred it.
Ans. Fa lse. H igher CRR i m plies lower ca pacity of the com m e rcial ba n ks to create credit. Beca use, cred it
m u lti p l i e r is the reci p roca l of CRR.
2. By purchasing govern ment secu rities i n the open ma rket, the centra l ba n k i ntends to release more
money s u p p l y i n the market.
Ans. True. Ce ntra l ba n k buys government secu rities with a view to increase the money s u p ply. P u rchase
of secu rities by the centra l bank leaves more money with the people. It a lso increases l i q u i d ity of the
com m e rcial ba n ks to create more credit (in te rms of demand d eposits ) .
3 . M a rgin requ i re ment is ra ised b y t h e centra l ba n k with a view t o i ncreasing money supply.
Ans. Fa lse. To increase money s u p ply, the centra l b a n k l owe rs the m a rgi n req u i rement so that people a re
i n d u ced to ra ise loans a n d the b a n ks a re a b l e to create more cred it by way of loans.
4. During periods of depression, com mercia l ba n ks a re a dvised to follow dear money policy.
Ans. Fa lse. To c u rb depression, s u p p ly of money needs to be i ncrease d . Accord i ngly, commerci a l b a n ks
a re advised to p u rsue cheap money policy.
5 . The centra l ba n k is a lender of last resort.
Ans. True. A centra l ba n k adva n ces loan to a commercia l b a n k when the latter fa i l s to get fi n a ncia l
accommodation from a nywhere aga i n st a p p roved secu rities.
Banking 167
6. The centra l ba n k is a ba n ker to the government.
Ans. True. As a ba n ker to the government, centra l ba n k keeps the accou nts of a l l government b a n ks a n d
ma nages government treasu ries.
7. The com mercia l ba n k has the currency a uthority.
Ans. Fa lse. The centra l ba n k is the sole issu i ng a uthority i n the cou ntry. It has the exclusive right of note
iss u i ng.
8. I n I n d ia, CRR a n d SLR a re fixed by the com mercia l ba n ks themselves.
Ans. Fa lse. I n I n d ia, CRR a n d SLR a re fixed by the R B I .
9. Dem a n d deposits a re e q u a l t o cash deposits with t h e commercial banks.
Ans. Fa lse. Cash de posits a re o n ly primary deposits with the com m e rcial b a n ks. Deposits created by way
low
of loans a re seco n d a ry deposits.
Demand De posits = Pri m a ry de posits + Seco n d a ry deposits
10. Secondary deposits of a com mercial bank a re always less than its pri m a ry deposits.
Ans. False. Secondary deposits are many ti mes more than the primary deposits of a commercial bank. Because,
primary deposits are cash deposits. A com mercial ban k can park its cash with RBI as 'cash reserves'. It ca n
ee
lega l ly create secondary deposits (by way of loans) many times more than their cash reserves.
rF
11. When CRR is ra ised, credit creation by the com mercial ba n ks is not necessarily red uced .
Fr
Ans. True. Beca use commercia l b a n ks may have some excess reserves .
12. CRR and SLR work opposite to each other.
or
Ans. Fa lse. CRR a n d SLR a re com p l e menta ry to each other. A rise i n these ratios controls the creation of
credit, a n d vice versa.
sf
u
13. Ma rket rate of i nterest tends to be positively related to the ba n k rate.
Ans. True. I ncrease o r decrease i n b a n k rate is often fol l owed by increase or decrease i n the ma rket rate
k
Yo
of i nterest.
oo
14. Repo rate is the rate of i nterest charged by the ba n k on com mod ity loans.
B
Ans. Fa lse. Repo rate is that rate at which centra l bank offers short-term loans to com m e rcial ba n ks .
re
15. H igher repo rate i m p l ies h i g h e r credit creation ca pacity o f t h e ba n ks.

Ans. Fa lse. H igher repo rate i m p l ies l ower cred it creation ca pacity of the ba n ks . Beca use, b a n ks a re n ot
ou
i n d u ced to borrow l i q u i d ity (cash ) from the RBI for e n l a rging their cred it-ma rket.
ad
16. The com mercial ba n ks design a l l i nstru ments of moneta ry policy and the centra l bank controls them.
Y
Ans. Fa lse. Centra l bank designs all i n stru ments of moneta ry pol icy a n d a lso controls the m .
1 7 . The com mercia l ba n ks a re t h e controller o f money supply.
nd
Re
Ans. Fa lse. The centra l ba n k controls the money supply i n the economy. The com m e rcial b a n ks o n ly
contri bute to money s u p p ly by way of cred it creation.
Fi
18. The centra l ba n k issues cu rrency on the basis of CRR.

Ans. Fa lse. Centra l ba n k does not issue cu rrency on the basis of CRR. The ratio CRR i m pacts cred it creation
ca pacity of the com m e rcia l b a n ks.

1. If the com mercial ba n ks buy govern ment secu rities, their ca pacity to create credit is red uced . Do
you agree?
Ans. Yes, the given statem e nt is correct. By a l lowi ng or i n d ucing the commercial b a n ks to buy government
secu rities, the centra l b a n k soa ks cash ba l a n ces of the com m e rcial b a n ks which they cou l d use to
create credit. Accord i n gly, the credit creation capacity of the com m e rcial ba n ks is red uced .
2. Is it correct that when m a rgins a re ra ised, demand for loans is negatively i m pacted?
Ans. When m a rgi ns a re ra ised, the d iffe rence between the ma rket va l u e of the secu rity offered for loans
a n d va l u e of loans gra nted becomes high. It is now expensive for the people to ta ke loans from the
b a n ks. Therefore, demand for loans red uces i n the economy. Thus, the given i nformation is correct.
3. Is repo rate an i nstru ment of qualitative credit control?
Ans. N o, repo rate is a n i n stru ment of q u a ntitative cred it contro l . It i m p acts the ava i l a b i l ity of cred it across
a l l sectors of the economy.
4. If CRR is lowered, i nvestment demand m ust rise. Defend or refute.
Ans. Yes, the above statem e nt is correct. If CRR is l owered, cred it creation capacity of the com m e rcia l
b a n ks is e n h a nced . H igher ava i l a b i l ity of cred it a n d at l ower i nte rest rate m u st lead to a rise i n
i nvestment demand.
5 . H ow is qua ntitative credit control d ifferent from qual itative credit control?
Ans. Quantitative cred it control refe rs to overa l l cred it control i n the economy, affecti ng all sectors of
the economy eq u a l ly a n d without d iscri m i n atio n . Qua l itative cred it control refers to se lective cred it
control that focuses on a l l ocation of credit to d ifferent sectors of the economy. Flow of credit is
e ncou raged to the priority sectors, w h i l e it is d iscou raged to the non-p riority sectors .
6. Com mercia l ba n ks create credit o n ly on the advice o f the government. Is i t true?
Ans. N o, this is fa lse. Com m e rcial b a n ks do not create cred it only on the advice of the govern ment.
H oweve r, t h e i r capacity to c reate cre d i t d e p e n d s o n cred it p o l i cy of t h e centra l ba n k of the
co u nt ry.
7. Com mercia l ba n ks do not h ave the note issu ing a uthority, but they do contri bute to m oney supply
i n the economy. Com ment.
Ans. Yes, the give n statement is correct. The centra l b a n k is the sole a uthority of issu i n g n otes in the
cou ntry. H owever, by advancing loans t h rough credit creation, com m e rcial b a n ks contribute to
money s u p p ly in the economy.
8. What role does CRR play in the creation of credit by the com mercia l ba n ks?
Ans. CRR (cash reserve ratio) sets a l i m it u p to which commercia l b a n ks ca n lega l ly create cred it.
Exa m ple: If CRR = 4%, it i m p l ies that the com m e rcial b a n ks ca n create cred it ( by way of loans)
maxi m u m u p to 25 ti mes ( � = 25 ) of their cash reserves with the R B I .

4
9. "Rate cuts might not b e imminent"-Reserve Bank of India. [The Economic Times]
Why RBI is not ready to cut the rates? Write you r opinion.
Ans. H e re, rate cut refers to repo rate . The R B I believes that a cut i n repo rate is goi ng to fuel reta i l
i nflation which is a l ready h i g h . H ence, a c u t i n repo rate (which w i l l increase money supply i n the
economy) is not recom mended .
10. RBI lowers repo rate from 5.40% to 5. 15%. {4th October, 2019]
Ana lyse the economic va lue of this statement from the viewpoi nt of ( i ) the households,
( ii ) i nvestors, and ( iii ) the economy.
Ans. A cut i n repo rate (the rate at which commercial b a n ks ca n ra ise loans from R B I ) is expected to be
fol l owed by a cut in ma rket rate of i nterest (the rate at which the commerci a l ba n ks offe r loans to the
people). It is expected to i m pact the househol ds, i nvestors, a n d the economy as u nder:
( i ) I m pact on Households: A cut i n ma rket rate of i nterest (fo l l owed by a cut i n re po rate) is expected
to i n d uce borrowi ngs for the p u rchase of con s u m e r d u ra b l es, as wel l as houses a n d flats. Also,
the existi ng loans ( ra ised aga i n st floati ng i nterest rate) w i l l now attract l ower E M I . I m plying a
d i rect moneta ry benefit to the households.
Banking 1 69
( ii ) I m pact on the I nvestors : As a resu lt of a cut i n the market rate of i nterest, the cost of borrowi ngs
( i m plying the cost of ca pita l ) wi l l red uce. Accord i n gly, i nvestment is expected to i ncrease across
a l l a reas of prod uction activity.
( iii ) I m pact on the Economy: When d e m a n d for cons u m e r d u ra bles rises, aggregate d e m a n d is
expected to rise. Aggregate demand a lso te nds to rise when i nvestment expenditure rises.
Beca use both cons u m ption expe nditure and i nvestment expenditure a re sign ificant com ponents
of aggregate dema n d . Th us, the leve l of plan ned output is expected to rise a long with the leve l
of plan ned p u rchase i n the economy. Accord ingly, the eq u i l i b r i u m G D P level is expected to rise.
I m plying a rise i n the growth rate of G D P.
low
1 . H ow, i n you r opin ion, credit creation by the commerci a l ba n ks accelerates the pace of economic
growth? Write two obse rvations.
Ans. Fol l owing observations may be noted i n this rega rd :
O bservation-1: Cred it creation accelerates the process of growth by expa n d i ng the ava i l a b i l ity of
credit for pu rpose of i nvestment.
ee
rF
O bservation-2 : Credit creation contrib utes to the p rocess of growth by expa n d i ng size of the ma rket
Fr
(or aggregate d e m a n d ), as the ava i l a b i l ity of credit for the p u rchase of consu mer d u ra bles i ncreases.
2. H ow i m p rovement i n banking habits of the people pushes u p credit ava i l a b i l ity from the com mercial
or
ba n ks?
Ans. When ba n king h a b its of the people i m p rove, they sta rt hold i ng less money as cash-i n-ha n d . I nstead,
sf
u
more and more money is de posited with the commerci a l b a n ks. Accord i ngly, cash rese rves of the
com m e rcial b a n ks sta rt rising. H igher cash rese rves of the ba n ks enable them to deposit more fu nds
k
Yo
with the R B I as CRR-de posits. If CRR rem a i n s consta nt, h igher CRR-de posits with the R B I gives the
oo
com m e rcial ba n ks the lega l a uthority to create more credit by way of loans/credit. Accord i n gly,
ava i l a b i l ity of credit from the commerci a l b a n ks is i ncrease d .
B
3 . H ow ca n 'Ja n-Dhan Yojana' be used as a n i nstru ment t o i ncrease s u p p l y o f money b y t h e com mercial
re
ba n ks?
Ans. A la rge section of the popu lation i n I n d i a d o n ot have their b a n k accou nts. 'J an-Dhan Yojana' prom pts
ou
people to open their b a n k accou nts . When more a n d more accou nts a re opened then some of the
ad
cash balances with the people (or idle cash lyi ng with the people) is bou nd to reach the banking
Y
system as cash deposits or primary deposits. This increase e n a b les com mercia l b a n ks to increase
their cash reserves with the centra l ba n k. If �CR (add itional cash rese rves with the R B I ) = � 10,000
nd
Re
a n d if CRR = 4%, then the add itional d e m a n d deposits the b a n ks ca n create = � x �10, 000 =
4
Fi
� 2,50,000. This is how 'J an-Dhan Yojana' may be used as a n i n stru m e nt to increase s u p ply of money
by the commerci a l b a n ks.
4. Why has the Government in I n d ia fa iled to com bat inflation even when a series of moneta ry
measures a re available in the textbook of macroeconom ics?
Ans. Moneta ry meas u res of com bati ng/contro l l i n g i nflation focus l a rgely on moderating/lowering the
demand for goods a n d services by making the ava i l a b i l ity of cred it costlier a n d d ifficu lt. It does n ot
a d d ress s u p ply side of the pro b l e m .
W h i l e the fact o f the matte r is t h a t i n I nd i a i nflation has often b e e n triggered b y ( led by) the l ow
ma rket s u p p l ies. U n less s u p p l ies a re boosted (particu l a rly the s u p ply of fa rm output) we sha l l
conti n u e t o wrestle with i nflation without ta m i n g (correcti ng) it.

5 . Ana lyse the i m pact of demonetisation ( of 500 a n d 1,000 ru pee notes) on credit creation by the
com mercia l ba n ks i n the I n d i a n economy.
A n s . De m o n etisation h a s led to h u ge de pos its of cash i n t h e co m m erci a l ba n ks . P ri m a ry d e posits of
t h e ba n ks h ave risen s i g n ifica nt ly. T h i s e n a b les t h e m to kee p h i g h e r C R R-de posits with t h e R B I .
Acco rd i ng l y, c re d it creat i o n ca pacity o f t h e com m e rc i a l b a n ks i s expected t o rise.
5. C B S E Questions-Pa st 5 yea rs
1. Exp l a i n 'government's ba n k' fu n ctio n of centra l ba n k . [CBSE Delhi 2015; {F} 2015, 201 6]
Or
Exp l a i n "ba n ker t o t h e government" fu nction of t h e centra l bank. [CBSE Delhi 201 7]
[ Page 155]
2. Exp l a i n the 'ba n k of issue' fu nction of centra l ba n k. [CBSE Delhi 2015; {Al) 2015; {F} 201 6]
[ Page 154]
3 . Government of I nd i a has recently l a u nched 'J an-Dhan Yojana' a i med at eve ry household i n the
cou ntry to have at least one bank accou nt. Exp l a i n how d eposits made u nder the plan a re going to
affect national i n come of the cou ntry. [CBSE Delhi 2015]
[With the i ntrod uction of 'J an-Dhan Yojana' by the Government of I n d ia, m i l l ions of people have
opened their b a n k acco u nt. This has e n h a n ced pri m a ry deposits of the com m e rcial b a n ks. It is on the
basis of their pri m a ry deposits (cash deposits) that the b a n ks a re able to create seco n d a ry deposits.
It leads to expa nsion of credit in the fi n a ncial market. Accord i ngly, i nvestment te nds to rise. H igher
i nvestment leads to increase i n nati o n a l i ncome of the cou ntry.]
4. Exp l a i n the "ba n ke rs' b a n k" fu nction of the centra l bank. [CBSE (Al) 2015, 201 7; {F} 2015, 201 6]
[ Page 155]
5 . Cu rrency is issued by the centra l b a n k, yet we say that com m e rcial ba n ks create money. Exp l a i n . H ow
is this money creation by com mercial b a n ks l i kely to affect the nati o n a l i ncome? Exp l a i n .
[CBSE {A l) 2015]
Or
Why do w e say that commercia l ba n ks create money w h i l e w e a lso say that t h e centra l b a n k h a s the
sole right to issue cu rrency? Exp l a i n . What is the l i kely i m pact of money creation by the com m e rcia l
b a n ks o n national i ncome? [CBSE (F) 2015]
[ M oney s u p ply has two com ponents: cu rrency a n d demand de posits. Cu rrency is issued by the centra l
b a n k whereas demand deposits a re created b y t h e commercia l b a n ks. They create money i n the
form of demand deposit related to the loans offered by them. Demand deposits of the com m e rcia l
b a n ks a re m a ny ti mes more than their cas h reserves. This is based on the historica l expe rience of the
b a n ks that cash with d rawa l of fu nds is o n ly a s m a l l perce ntage of the tota l demand deposits.
The money created by the com m e rcial ba n ks in the form of demand deposits is m a i n ly used for
i nvestment or prod uction pu rposes. Any rise i n i nvestment leads to m a ny ti mes more increase i n the
nati o n a l i ncome of a n economy, via ., the m u lti plier effect.]
6. Exp l a i n how 'ba n k rate' is h e l pfu l i n contro l l i ng credit creation? [CBSE Delhi 201 6]
[ Page 157, 158]
7. Exp l a i n how open market operations a re h e l pfu l in contro l l i ng cred it creati o n . [CBSE Delhi 201 6]
[ Page 158]
8. Exp l a i n how 'margin req u i reme nts' a re h e l pfu l in contro l l i ng cred it creati o n . [CBSE Delhi 201 6]
[ Page 160, 161]
Banking 171
9. Exp l a i n the role of cash reserve ratio i n contro l l i n g cred it creati o n . [CBS£ (Al) 2016]
[ Page 160]
10. Exp l a i n how 'repo rate' ca n be h e l pfu l in contro l l i ng cred it creati o n . [CBSE (AJ) 2016)
[ Page 158, 159]
11. Exp l a i n the role of 'reverse repo rate' in contro l l i ng cred it creati o n . [CBS£ (Al) 2016]
Or
Exp l a i n t h e role o f 'rese rve re po rate' i n contro l l i n g money s u p p ly. [ CBS£" Delhi 201 7}
[ Page 159]
12. The ratio of tota l de posits that a com mercia l b a n k has to keep with Rese rve B a n k of I n d i a is ca l l ed :
(choose the correct a lternative) [CBS£" Delhi 201 7}
low
(a) Statutory l i q u i d ity ratio ( b ) Deposit ratio
(c) Cash reserve ratio ( d ) Lega l rese rve ratio
[(c)]
13. Exp l a i n the p rocess of credit creation by com m e rcial b a n ks . [CBSE (Al) 201 7}
Or
ee
Exp l a i n the money creation fu nction o f com m e rcial ba n ks . [CBSE (F) 201 7}
rF
Fr
[ Page 151-153]
14. Repo rate is the rate at which: [CBSE (F) 201 1]
(a) com m e rcial b a n ks p u rchase government secu rities from the centra l ba n k
or
( b ) com m e rcial b a n ks ca n ta ke loans from t h e centra l b a n k
sf
( c ) com m e rcial b a n ks ca n keep their deposits with t h e centra l b a n k
u
( d ) short-te rm l o a n s a re given b y com mercia l b a n ks
k
[(b)]
Yo
oo
15. Exp l a i n the "va ryi ng reserve req u i rements" method of credit control by the centra l ba n k .
[ Page 160] [CBSf (F) 2017]
B
[ N ote : Va rying reserve req u i rements is the same as va rying cash reserve ratio.]
re
16. Credit creation by com m e rcial b a n ks is determi ned by: (choose the correct a lternative) [CBSE 2018]
(a) Cash Rese rve Rati o (CRR) ( b ) Statutory Liq u i d ity Ratio (SLR)
ou
ad
(c) I n itia l deposits ( d ) A l l the a bove

[(d)]
Y
17. What is moneta ry pol icy? State a ny t h ree i n stru m e nts of moneta ry policy. [CBSE 2018]
[Moneta ry pol icy is the pol icy p u rsued by the centra l b a n k to regulate s u pply of money i n the
nd
Re
economy.
The three m a i n instru ments of moneta ry pol icy a re : ( i ) Repo Rate, ( i i ) Cash Reverse Ratio, and (iii) Open
Fi
M a rket Operations. Page 157-159]

18. E l a borate a ny two i n stru m e nts of credit control, as exercised by the Reserve B a n k of I n d i a .
[ Page 157-161] [CBSE 2019 (58/1/1)]
19. Defi ne credit m u lti p l i e r. What role d oes it play i n determ i n i ng the cred it creation power of the
b a n k i ng system ? Use a n u merica l i l l ustration to expla i n . [CBSE 2019 (58/1/1)]
[Credit m u lti p l i e r refers to the n u m ber of ti mes the com m e rcia l ba n ks ca n create credit per u n it of
cash reserves with the R B I . It reflects credit creation powe r of the ba n ki n g syste m in the cou ntry.
I m plying the power to i nfl uence the s u pply of money i n the economy.
I l l ustration :
1
k= [k: Credit m u lti p l ier; CRR: Cash reserve ratio]
CRR
Assu m i ng CRR = 2%
1
k = -- = 50
2%
I m plying that com m e rcial ba n ks ca n create credit 50 ti mes of their cash rese rves with the R B I .
I n case, CRR is ra ised t o 4%, i. e.,
1
k = - = 25
4%
I m plying that cred it creation power of the com m e rcial b a n ks is red uced to half. It wou l d lead to a
sign ificant cut i n money s u p ply i n the economy.]
20. Defi n e 'money m u lti p l ie r'. [CBSE 2019 (58/2/1))
[ Page 154]
21. Disti nguish between 'Qu a l itative a n d Qu a ntitative tools' of cred it control as may be used by a Centra l
Ba n k. [CBSE 2019 (58/2/1))
[ Page 157-161]
22. Discuss briefly the fol l owing fu nctions of a Centra l B a n k :
( i ) Ba n ker's ba n k .
( i i ) Lender o f last resort. [CBSE 2019 (58/2/2)]
[ Page 155]
23. Discuss briefly the "cred it control ler" fu nction of a Centra l Ba nk. [CBSE 2019 (58/2/3)]
[ Page 156-161]
24. Accord i n g to a re port forwa rded by the Reserve B a n k of I n d ia, there was a fa l l i n rate of i nflation as
measu red by Consu m e r Price I ndex (CPI) on yea r-on-year basis to 5% from 8% i n the p revious yea r.
Which of the fol lowi ng state ments rep rese nts the situation?
(a) C P I has fa l l e n ( b ) C P I has risen a t a rate l ower than the preceding yea r
(c) C P I is consta nt (d) None of the above
[(b)] [CBSE 2019 (58/3/1)]
25. Exp l a i n the p rocess of money creation by a com m e rcial b a n k using a hypothetica l n u merica l
exa m ple. [CBSE 2019 (58/3/1)]
Or
Discuss briefly the cred it creation process of the ba n king syste m, using a hypothetica l n u merica l
exa m ple. [CBS£ 2019 (58/4/3)]
[ Page 151-153]
26. State the role played by the centra l ba n k as the "lender of last resort". [CBSE 2019 (58/4/1)]
[ Page 155]
27. Exp l a i n, using a n u m erica l exa mple, how an increase in rese rve de posit ratio affects the cred it
creation powe r of the b a n k i ng system . [CBSE 2019 (58/4/1)]
[ Page 172, Q. 19]
28. Exp l a i n, using a n u m erica l exa m p l e, h ow a red u ction in rese rve deposit ratio, affects the cred it
creation powe r of the b a n k i ng system . [CBSE 2019 (58/4/2}]
k = � [k: Cred it m u lti p l ier; C R R : Cash rese rve ratio]
C R
Assu m i ng CRR = 4%
1
Accord i n gly, k = - = 25
4%
I m plying that commerci a l b a n ks ( b a n king system in the cou ntry) ca n create credit u pto 25 ti mes of
their cash rese rves with the R B I .
Banking 173
In case, CRR is cut to 2%,
1
k = - = 50
2%
I m plying that cred it creation power of the com m e rcial b a n ks is d o u b l e d . It wou ld lead to a sign ifica nt
rise in the s u p p ly of money in the economy.]
29. If lega l reserve ratio is 20%, the va l u e of money m u lti p l i e r wou l d be _______
(Choose the correct a lternative) [ CB5E 2019 (58/5/1)]
(a) 2 (b) 3
(c) 5 (d) 4
[(c)]
30. What a re p r i m a ry de posits? [CBSE 2019 (58/5/1)]
low
[ Page 153]
31. Exp l a i n the fol l owing fu nctions of the Centra l Ba n k :
( i ) Ba n ker's ba n k .
( i i ) Authority o f cu rrency issue. [CB5E 2019 (58/5/1)]
ee
[ Page 154, 155]
32.
rF
Exp l a i n the fol l owing fu nctions of the Centra l Ba n k :
Fr
( i ) Lender o f last resort.
( i i ) Ba n ker to the Government. [CB5E 2019 (58/5/2)]
or
[ Page 155]
sf
u
33. (a) Exp l a i n how u s i ng "Ba n k Rate" the Centra l Ba n k ca n reg u l ate money s u p ply i n a n economy.
( b ) What is meant by 'Repo Rate' ? [CBSE 2019 (58/5/3}]
k
Yo
[ Page 157, 158]
oo
6. NCERT Questions {With Hints to Answers)

B
1. What a re the instru ments of moneta ry pol icy of R B I ?

re
[Hint: I n stru m e nts o f moneta ry pol icy o f R B I a re broad ly classified as:

ou
(a) Qua ntitative I n struments: ( i ) Ba n k Rate, ( i i ) Repo Rate, ( i i i ) Reverse Repo Rate, ( iv) CRR
ad
(Cash Rese rve Ratio), (v) SLR (Statutory Liq u i d ity Ratio), a n d (vi) Open Ma rket Operations.
Y
(b) Qua l itative I nstru ments: ( i ) M a rgin req u i rement, (ii) Rationing of cred it, (iii) Mora l suasion .]
2. Do you consider a com mercial b a n k 'creator of money' i n the economy?
nd
Re
[Hint: Yes, com m e rcial b a n ks a re an i m porta nt sou rce of creating credit in the economy. They create
cred it in the form of d e m a n d deposits rel ated to the loans offe red by the m . Demand deposits of the
Fi
com m e rcial b a n ks a re m a ny ti mes more than their cash rese rves. If cas h rese rves a re (say) � 1,000
a n d if d e m a n d deposits a re (say) � 10,000, then the com mercial b a n ks a re creati n g credit te n ti mes
of their cas h reserves. Accord i n gly, on the basis of cash reserves of � 1,000, the com mercia l b a n ks
a re contributi n g � 10,000 to the s u p ply of money.]
3 . What role of R B I is known as 'lender of last resort'?
[Hint: As a lender of last resort, the centra l ba n k sta nds as a guara ntor to the com m e rcial b a n ks
d u ri n g fi n a ncia l emergencies. A com mercia l b a n k may lose confide nce of the depositors prom pti ng
them to withd raw their deposits en mass. Si nce cash reserves of the com m e rcial b a n k a re only a
fraction of its d e m a n d de posits, its reserves may ru n out, p u s h i ng the b a n k i nto fi nancial crises. It is
the centra l bank d u ri n g such ti mes that sta nds by the com m e rcial bank as a guara ntor and saves it
from i nsolve ncy.]

1. State the main fu nctions of a centra l ba n k .
Or
State a ny t h ree m a i n fu nctions o f a centra l b a n k . Describe a ny o n e o f t h e m . [Page 154-156]
2. H ow is the centra l b a n k d ifferent from com m e rcial ba n k? [Page 156]
3. Exp l a i n a ny one of the fol l owing fu nctions of a centra l b a n k :
( i ) Cu rrency a uthority, a n d
( i i ) Lender o f last resort. [Page 154, 155]
4. Exp l a i n the 'ba n kers b a n k' fu nction of the centra l bank. [ Page 155]
5. Exp l a i n 'ba n ker to the government' fu nction of the centra l bank. [Page 155]
6. H ow d oes a centra l ba n k perform the fu nction of contro l l e r of cred it? [Page 156]
7. State a ny t h ree methods by which a centra l ba n k tries to control the q u a ntity of cred it.
[Page 1 5 7-1 61 ]
8. What is repo rate? H ow d oes it control the s u p p ly of cred it i n the economy? [Page 158, 159]
9. H ow d oes a centra l ba n k control the ava i l a b i l ity of credit by open ma rket operations?
Or
What a re open ma rket operations? H ow d o these work as a method of credit control? [Page 158]
B. Questions of 6 ma r ks each
1. Defi n e a centra l bank. What a re the fu nctions of centra l b a n k? [Page 154-156]
2. "Co m m ercial ba n ks create money i n the econ omy." Com m e nt. [Page 151-153]
3. H ow d oes the centra l b a n k of a cou ntry control the su pply of money in an economy? [Page 157-1 61 )
4. State the basic differe nce between q u a ntitative a n d q u a l itative instru ments of credit contro l . G ive
s u ita ble exa m ples. [Page 1 5 7-1 61 ]
DOs and DON'Ts

1. It needs to be noted with emphasis that w h i l e the commercial banks a re a source of money supply i n
t h e economy, they DO N OT have t h e authority o f issuing notes or coi n s . They a re a source o f money
supply only as creators of cred it or bank money.
2. Both C R R and SLR a re lega lly determined by the R B I . B ut, both a re independently determ i ned, as these
a re differently esti mated. N ever miss the point that w h i l e CRR has a d i rect beari ng on cred it creation by
the commercial banks (as it sets the l i m it up to which the commercial banks can legally create cred it),
SLR i mpacts cred it creation only i n d i rectly by i ncreasing or decreasing the amount of l iq u i d assets of
the commercial banks (Check text for deta i ls) .
Banking 175
.,...__. • Success of Repo Rate as an I nstrument of Credit Control
Success of repo rate pol icy as an i n stru ment of credit control depen ds on the
fol low i n g factors:
(i) Degree of Dependence of the Commercial Banks upon the Central Bank
for Loans: I f commercial banks have the i r own surp l u s fu nds which they
can uti l ise d u ri n g periods of h i g h credit needs, their dependence on the
centra l bank is red uced .
(ii) Degree of Sensitivity of Bank's Demand for Funds from the Central Bank:
Depen ding on busi ness cond itions, commercial banks may not be very
low
sen sitive to s m a l l vari ations in repo rate. I n such situations, repo rate
po l i cy may not be a big success.
(iii) Structure of Interest Rates in the Money Market: I f non-ba n ki n g fi n a n c i a l
i n stitutions i n t h e ma rket do not va ry thei r i nterest rates i n accordance
with what the centra l bank expects from the commercial banks, the repo
ee
rate po l i cy may not succeed .
rF
Fr
(iv) Overall Supply of Funds in the Market: Repo rate pol i cy may not be a
success if non-ba nking sou rces of fu nds are more popu l a r than the
banking sources.
or
• Success of Open Market Operations as an I nstrument of Credit Control
sf
u
Success of open market operations as an instrument of cred it control depends
on the fol lowing factors
k
Yo
(i) Existence of Securities Market: There m ust be a wel l org a n i sed and wel l
oo
fu ncti o n i n g ma rket for the sale and p u rchase of secu rities. I n the absence
B
of it, open ma rket operati ons wou l d be l ittle s i g n ifi ca nce as an i n stru ment
of monetary policy.
re
(ii) Excess Reserves with the Banks: If commercial banks have healthy
excess reserves as 'Vau lt Cash' they need not buy secu rities. This is the
ou
ad
standard practice i n developed cou ntries l i ke USA. Accord i n g ly, open

ma rket operations fa i l to be a successfu l i n stru ment of credit contro l .
Y
• Difference between Bank Rate and Repo Rate

nd
Re
- Bank Rate Re o Rate -

(i) Bank rate rel ates to the loans offered by (i) Repo rate rel ates to the loans offered by
Fi
the R B I to the com merc i a l banks without the R B I to the commercial b a n ks N OT

any collatera l (secu rity for p u rpose of w ithout collatera l. The securities are
loans) . pledged as a secu rity for the loa n s .
(ii) Ba nk rate does not a l low any fac i l ity of (i i) Repo rate a l lows rep u rchase of securities .
repurchase of secu rities . The b a n k rate is The holder of securities can repurchase
s i m p l y the Rate of D i scount. them at a later date. Therefore, repo rate
is a l so called Repurchase Rate.
(ii i) Bank rate relates to borrowings by the (ii i) Repo rate rel ates to short-term borrowings
com merc i a l b a n ks to cope with the i r by the commercial banks.
i mmed iate cas h-cru n c h .
[ N ote: Ban k rate i s often h igher than the re po rate as it ( ba n k rate) re l ates to i n stant
loan req u i rem ent of the co m m ercial ban ks. ]
Ill
•
•
•
Concept of AD (Aggregate Demand)
Components of AD (Aggregate Demand)
,,
•
Concept of AS (Aggregate Supply)
• ]
Con umptio Function with reference to Propensity to Consume
� �
•
Saving Function and Propensity to Save
Relationship between Propensity to Consume and Propensity to Save
I. CONCEPT OF AD (AGGREGATE DEMAND)

Following observations need to be noted to understand the concept
of AD in macroeconomics:
(i) AD does not refer to the demand for any particular good (or
service) in the markets. It refers to demand for all goods and
services in the economy.
(ii) AD is often measured for the period of an accounting year. So, it
is a flow concept.
(iii) AD can be measured (a) with reference to general price level in
the economy, or (b) with reference to the level of income of the
people. If AD is related to the general price level, we shall find
negative relationship between price level and AD. So that, AD
curve slopes downward. On the other hand, if AD is related to
the level of income, we shall find positive relationship between
income and AD. So that, AD curve slopes upward.
(iv) At the +2 level, we study AD only in relation to the level of
income. So that, AD rises as the level of income rises in the
economy.
177
(v) AD is measured not as the sum total of physical quantities of
goods demanded in the economy. In fact, it is not possible to do
so. AD is always measured in terms of total expenditure on the
goods and services.
(vi) AD is always expressed as what people wish to spend or what
people plan to spend at different levels of income. Never interpret
AD as what people actually spend on the purchase of goods and
services in the economy.
With these observations in mind, we may define AD as under:
low
F@CUS AD is the sum total of expenditure that the people plan to incur on the purchase of
goods and services produced in the economy (during the period of an accounting year)
ZONE corresponding to their different levels of income.
ee
Behaviour of AD: AD Schedule
rF
Fr
Since AD is measured in terms of aggregate expenditure (on the
purchase of goods and services) in the economy, behaviour of AD
AD is never zero even
or
when Y (income)= 0. is studied in terms of the behaviour of aggregate expenditure at
Because: Some
different levels of Y (income). Thus, behaviour of AD means how
sf
u
expenditure is always
essential for survival. This aggregate expenditure (AE) responds to different levels of Y in the
is incurred even when
k
economy. This is expressed by way of a schedule, known as AD
Yo
income is zero. This is
oo
done either by using schedule or AE schedule. Table 1 is an example of this schedule.
the past saving or by
B
borrowing. Table 1. AD Schedule showing relationship between AD and Y

AD
re
(= AE or Planned Expenditure)
V
ou
0 30
ad
20 35
Y
40 40
60 45
nd
Re
80 50
Fi
100 55
120 60
Table 1 offers following observations:

(i) There is always some minimum level of expenditure in the
economy even when Y = 0. Thus, AD = 30 when Y = 0. The
reason is simple: you must incur some expenditure to buy goods
for your survival, even when your income (Y) is absolutely zero.
You may do it through borrowing, called negative saving.
(ii) AD increases as Y increases. Thus, AD is positively related to Y.

(iii) After a certain level of Y is reached, AD lags behind Y. Thus,
when Y = 60, AD = 45. Likewise, when Y = 80, AD = 50. This
happens because, at higher levels of Y, people start saving a part
of their income.
AD Curve
Fig. 1 shows AD curve. It is a diagrammatic presentation of AD
schedule.
y AD in relation to Y (income)
y
-�
QJ
� 60 C + I (= AD or AE)
QJ
01 40
<t 30
20
<t 10 �--,�------------!
0 �---..----..-----.-----.-----r----x
m � w oo 100 1m
Y (lncome)/GDP
• 45 line indicates the level ofY, as shown on the X-axis.
°
• AD= Y at point E, when Y = 40.

• Prior to it, AD> Y This is because of the impact of minimum
level of AD.
• Beyond it, AD< Y. This is because at higher levels ofY,
people start saving a part of their income.
• Minimum level of AD= 30.
This indicates expenditure independent of the level of
income in the economy.
AD starts from 30 on the Y-axis. It suggests minimum level of

expenditure, or expenditure which is independent of the level of Y in
the economy. E is the point where AD = Y. Prior to it, AD > Y. This
is because of the impact of minimum level of AD. Beyond point E,
AD < Y. This is because at higher levels of income, people tend to save
a part of their income. Generally, AD increases as Y increases.
AD schedule is a table showing AD (or aggregate expenditure) corresponding to different levels of

income (Y) in the economy AD is positively related to Y However, there is always some minimum
level of AD even when Y = 0 At higher levels of Y, AD lags behind Y Because, people start saving a
part of their income.
AD curve is a diagrammatic presentation of AD schedule, showing AD corresponding to different
levels of Y in the economy It tends to slope upward, showing positive relationship between
AD and Y
Aggregate Demand, Aggregate Supply and Related Concepts 179

2. COMPONENTS OF AD (AGGREGATE DEMAND)
Components of AD (or aggregate expenditure) are discussed with
reference to (1) closed economy, and (2) open economy. A detailed
discussion is as under:
(I) Components of AD in a Closed Economy

A closed economy may be: (i) two sector closed economy, or (ii) three
sector closed economy.
A two sector closed economy includes: (i) household sector, and
low
(ii) producer sector. Specifically, there is no government sector in this
economy. Households purchase goods for purpose of consumption.
Accordingly, their expenditure is called consumption expenditure (C).
Producers, on the other hand, purchase goods for purpose of
ee
investment. Accordingly, their expenditure is called investment
rF
expenditure (I). Thus, in a two sector closed economy, AD has two
Fr
components as these:
AD C + I
or
t t sf t
u
Aggregate Household Producers This is equal to
J
Demand Consumption Investment Private Investment
k
[ Expenditure, as there
Yo
Expenditure Expenditure .
oo
1s no government sector
B
A three sector closed economy includes: (i) household sector,

re
(ii) producer sector, and (iii) government sector. The government makes
'collective consumption expenditure'. It refers to public consumption
ou
ad
expenditure or consumption expenditure on behalf of the society

Y
as a whole. (Example: Government expenditure on the purchase

of food and clothes for the defence forces.) Also, the government
nd
makes investment expenditure, such as expenditure on roads and

Re
bridges. The total government expenditure (including government

Fi
consumption expenditure and government investment expenditure)

is indicated by G. So that, in a three sector closed economy, there are
three components of AD, as these:
AD C + I + G
t
Aggregate
t
Household
t
Private
t
Government
Demand Consumption Investment Expenditure
Expenditure Expenditure (including both
consumption as well as
investment expenditure)

(2) Components of AD in an Open Economy
An open economy includes four sectors: (i) household sector,
(ii) producer sector, (iii) government sector, and (iv) rest of the world
sector.
Rest of the world sector generates demand for our goods and services
in terms of our exports. Thus, exports add to AD in the domestic
economy. But, we also make imports from rest of the world. Imports (M)
are opposite to exports (X). While exports increase AD in the domestic
economy, imports decrease it. Accordingly, we find the value of
net exports (X - M). It is this value which contributes to AD in the
domestic economy. Accordingly, we have four components of AD in
an open economy, as these:
AD C + I + G + (X - M)
t t t t t
Aggregate Household Private Government Net
Demand Consumption Investment Expenditure Exports
Expenditure Expenditure (including government
consumption expenditure
and government
investment expenditure)
AD = C +I+ G + (X - M)
3. CONCEPT OF AS (AGGREGATE SUPPLY)
Concept of AS
AS (aggregate supply) refers to aggregate production as planned by
the producers during an accounting year. It implies the flow of goods
and services in the economy during an accounting year. We know,
production of goods and services implies 'value addition', and value
addition implies 'income generation'. Our knowledge of national
income accounting tells us that 'value added' and 'income generated'
are identical to each other. Accordingly, AS implies flow of income (Y)
in the economy during an accounting year. AS and Y, therefore, can
be treated as identical to each other.
I
AS refers to flow of goods and services as planned by the producers during an accounting year. It is
identical with the flow of income (Y) during an accounting year AS and Y, therefore, may be treated
as identical to each other.

It needs emphasis that in the context of macroeconomic equilibrium,
AS refers only to 'planned production' or 'desired production' during an
accounting year. It does not refer to actual output. Desired production
is what the producers desire to produce or plan to produce during an
accounting year.
AS Schedule
AS schedule is a table showing the behaviour of AS, corresponding to
different levels of Y. Table 2 is an example.
low
Table 2. AS Schedule (� in crore)
Y (Income) AS (Aggregate Supply)
0 0
20 20
ee
40 40
rF
Fr
60 60
80 80
100 100
or
120 120
sf
u
Table 2 shows perfect identity between AS and Y. This is explained in
k
terms of the following observations:
Yo
oo
(i) Identity between Y and AS shows that the producers in the
economy are ready to supply (or sell) all that they wish to produce.
B
(ii) Why do the producers wish to sell/supply all that they wish to
re
produce?
ou
This is because, there is excess capacity in the economy. Accordingly,

ad
whenever there is a rise in demand, the producers respond to it

Y
That in macroeconomic
by Keynes, price has

model, as propounded by planning an equal rise in supply (so that their excess capacity is
utilised). Note that a proportionate increase in AS (corresponding
nd
Re
no role to play as a
determinant of AS. to any increase in AD) leads to a constant price level in the
Because: Owing to economy. So that price has no role to play as a determinant of AS.
Fi
excess capacity in the

economy, there is a (iii) Why should we presume that there is excess capacity in the
proportionate rise in AS economy?
as and when there is any
rise in AD which leads to This, in fact, is the basic assumption of macroeconomic model as
a constant price level in
the economy.
propounded by Keynes.
Keynes made this basic assumption because he was dealing with
the economies facing severe unemployment in the wake of Great
Depression of 1930's. Such economies must have excess capacity
or unutilised capacity (because of the lack of demand).
Thus, we can identify AS with Y.

Fig. 2 is a diagrammatic presentation of AS schedule.
y
Y=AS
120
>-
8:: 100
::::,
en
� 80
� 60
40
20
Y (lncome)/GDP
20 40 60 80 100 120
AS line happens to be a 45 ° line. This is because of the fact

that AS on the Y-axis is identical with Yon the X-axis.
The above diagram shows that AS and Y are equal to each other.
Therefore, AS is indicated by a 45 ° line from the origin.
It must be noted that this behaviour of AS (as 45 ° line from the
origin) is true only with respect to such economies where there is
excess capacity, and AS can proportionately rise whenever there is
any rise in AD.
4. CONSUMPTION FUNCTION
Household consumption expenditure (C) is an important component
of aggregate demand in the economy. It is directly related to the
level of income (Y). Higher Y leads to higher C, and vice versa.
The functional relationship (or the algebraic relationship) between
C and Y is called Consumption Function. It reveals the behaviour
of household consumption expenditure with respect to the level of
Studying the behaviour of C with respect to Y, the economists have
identified the following points as of central significance:
(i) There is always some minimum level of C, even when Y = 0.
This is called autonomous consumption. This leads to negative
saving (-S).
(ii) Consumption is positively related to income: rise in Y causes a
rise in C, and vice versa.
(iii) The entire increase in Y during a particular period is not
converted into C. A part of it is saved as well. So that the rate at
which C increases often lags behind the rate at which Y increases.

Accounting for these observations, the behaviour of C with respect to Y
is specified as in Table 3.
Table 3. Consumption Function: A Tabular Presentation
Y (�) C(�)
0 20
so 60
100 100
150 140
low
Table 3 offers a simple tabular presentation of consumption function.
It reveals that:
(i) 20 is the minimum level of consumption. This is the level of C
even when Y = 0.
(ii) C rises in response to a rise in Y. So that C is positively related to Y.
ee
(iii) The rate at which C increases is lower than the rate at which
rF
Fr
Y increases. Thus, while Y increases each time by 50, C increases
by 40 only. (The difference between Y and C indicates saving
or
out of income.)
sf
u
Diagrammatic Presentation
Diagrammatically, when the data related to consumption and income
k
Yo
are plotted on a graph paper, we get consumption function as in Fig. 3.
oo
B
Consumption Function: A Diagrammatic Presentation

y
re
160 DATA-SET
ou
ad
c 140 ............................................... . C y C
Break-even Point 0 20
·g_
Y
120 so 60
�B
100 ................................. ············-··! 100 100
nd
150 140
Re
80
!::::!,
u 60
···:
Fi
40
20
............... . ·
O��-s�o---,-00---,
s�o-----x
Y (lncome)/GDP
Observations:
• C-line starts from 20 indicating that C; 20, when Y; 0.
(This is the minimum level of consumption.)
• Initially (-line is above the Y-line. But eventually it is below
the Y-line. It indicates that the rate at which C increases is
lower than the rate at which Y increases.
• C-line crosses Y-line at point B. It is called 'break-even point'.
Here, total consumption is equal to total income.

In Fig. 3, consumption is measured on Y-axis, and income on X-axis.
A line making an angle of 45 ° and shooting from the origin is drawn
as a line of reference. It indicates the equality between consumption
and income.
C-line represents consumption function, indicating the behaviour of
C with respect to Y. Now, note the following observations carefully:
(i) C-line starts from 20 (on Y-axis). It is the minimum level of
consumption (value of C when Y = 0).
(ii) C-line is positively sloped, moving upward from left to right. It
indicates that C is positively related to Y: higher Y leads to higher C.
(iii) Though initially C-line is above the Y-line (45 ° line), eventually
it remains below the Y-line. Implying that the rate at which
C increases is lower than the rate at which Y increases.
Slope of C-l ine (Cons u m ption Function):

Margi nal Propensity to Consume
Slope of C-line (indicating consumption function) needs some
elaboration. It refers to the rate at which C increases in response to
a given increase in Y. It indicates the proportion of additional income
that goes to consumption. This is measured as the ratio between
�C (increase in C) and �Y (increase in Y). This is known as marginal
propensity to consume (M PC). Fig. 4 shows the estimation of MPC
as the slope of C-line.
Slope of C-line and Estimation of MPC

y
C
1 60
I : : : : : : : : : : : -: : : ::f
Slope of C-line
I',( 40 o.s
= M = so =
e 40
� 80
U 60
40
20
O
L.- ---,.
s o___1 � ___s�---- x
00 1 o
Y ( l n come)/G DP
The figure shows that when:

Y increases from 1 00 to 1 50,
C increases from 1 00 to 1 40.

So that, LlC = 40 and LlY = 50.
. LlC = 40 =
MPC (the slope of C-hne) = 0.8
LlY 50
It shows that out of every additional rupee of income, 80% is spent
as consumption expenditure.
APC and M PC are Different Concepts

Important It needs to be noted that APC (Average Propensity to Consume) and
Both APC and M PC MPC (Marginal Propensity to Consume) are different concepts, even
indicate the ratio between
when both indicate the ratio between consumption and income. The
low
consumption and income.
But, these are different difference is as under:
C
ratios. Wh ile APC = Y' APC is the ratio between total consumption and total income, while
the ratio between total MPC is the ratio between additional consumption and additional
consumption and total
�c income.
income, M PC = --;;;;-, the
ee
Thus:
ratio between
rF
Fr
change in consumption APC = .f_
(add itional consumption) y
and change in income LlC
(add itional income). MPC =
or
LlY
= =
sf
In Fig. 4, when Y 150 and C 140, then:
u
140 =
APC = 0. 933
k
150
Yo
oo
In Fig. 4 again, when LlY = 50 and LlC = 40, then;
B
40 =
MPC = 0. 8
50
re
Briefly, APC shows consumption per unit of total income, whereas

MPC shows consumption per unit of additional income.
ou
ad
Slope of (-function is indicated by MPC, N OT by APC.

Y
Slope of a Straight Line (-function (as in Fig. 4) is Constant,

nd
so that M PC is Constant
Re
We know that a straight line has a constant slope. So that a straight

Fi
line (-function as in Fig. 4 indicates constant slope of (-function.

Implying that MPC (as indicated by the slope of C-line or C function)
must be constant corresponding to all levels of income. Such a
(-function is called linear consumption function. It suggests that every
time there is a rise in Y, a constant proportion of it is converted into C.
In Fig. 4, consumption function is linear and MPC = 0.8, it suggests
that every time there is a rise in income, 80% of it is converted into
consumption.

Algebraic Presentation of (-function
Algebraically, consumption function is expressed as in the following
equation:
C = C + bY
C in this equation refers to the minimum level of consumption. It is
!� .
the value of consumption when Y = 0. The parameter 'b' refers to the rate
at which C increases in response to an increase in Y. It is = It is
the slope of (-function, also called 'marginal propensity to consume'.
Fig. 4 shows that C = 20 and MPC = 0. 8. Using these values, we can
write our consumption function equation as under:
C = 20 + 0. 8Y
This equation enables us to estimate the values of C corresponding to
different values of Y. Using values of Y as 50, 100 and 150 respectively
(as in Table 3), we can estimate the corresponding values of C, as
under:
C = 20 + 0. 8Y (as given)
C when Y = 0, = 20 + 0. 8 (0) = 20
C when Y = 50, = 20 + 0. 8 (50) = 20 + 40 = 60
C when Y = 100, = 20 + 0. 8 (100) = 20 + 80 = 100
C when Y = 150, = 20 + 0. 8 (150) = 20 + 120 = 140
We find that the estimated values of consumption are exactly the
same as in Table 3. Thus, we can find the values of C once we know
the values of C, b and Y.
f>TS
Q. 1. Find C, when C = 200, MPC = 0.5 and Y = 1,000.
Ans. We know that,
C = C + M PC(Y)
Substituting the va lues, we get:
C = 200 + 0.5 ( 1,000)
= 200 + 500 = 700.
Q. 2. Would consu m ption fu nction be linear in case MPC is constant? G ive reason in su pport of you r
answer.
Ans. Yes. Consu m ption function wou ld be linear i n case MPC is consta nt. Reason : Consta nt M PC im plies
that C-line is a stra ight line ( beca use M PC is the slope of C-line). A straight line C-line means that the
consumption function is l i near.
Aggregate Demand, Aggregate Supply and Related Concepts 1 87

5 . SAVING FUNCTION
Income is either consumed or saved, so that Y = C + S. We have
already discussed how C behaves with respect to Y (consumption
function). We now discuss how S behaves with respect to Y (saving
function). The functional relationship between S and Y is called saving
function.
Once (-function is specified, 5-function can easily be derived from it.
Because C and S are the only two components of income and because
both C and S are determined by Y. Let us get back to the tabular
low
presentation of (-function and see how 5-function can be derived
from it.
(-function (as in Table 3)
V C
(�) (�)
ee
rF
0 20
Fr
so 60
100 100
or
150 140
sf
u
Table 4. S-f unction (d erived from (-f unction as stated above)
k
Yo
V
oo
(�)
v-c
'----' = s
..........
i i
B
0 0 - 20 = -20
re
so 50 - 60 = -10
ou
ad
100 100 - 100 = 0

Y
150 150 - 140 = + 10

-
The 5-function as specified in Table 4 reveals that:
nd
Re
(i) S = -20 when Y = 0. This is because C = 20 when Y = 0. We

Fi
know that C + S = Y. So that, if C = 20 and Y = 0, then S must

be = -20.
(ii) S increases as Y increases. Implying that S is positively related to Y.
(iii) S remains lower than Y. It is never greater than Y. Because, S is
only a part of Y.
Diagrammatic Presentation
Fig. 5 shows diagram matic presentation of 5-function. It is drawn
using the data-set of Table 4.

DATA-SET
y Saving Function
1 20
1 00
y s
0 -20
Ol 80
so -10
60 1 00 0
1 50 +1 0
V) 40
20
-10
-20
Y (l ncome)/G D P
Y'
Observations:
• 5-line starts from -20. This is because when Y = 0 and
C = 20, then S must be eq ual to -20.
• 5-line crosses X-axis when Y = 1 00. It is here that S = 0,
because Y = C = 1 00. It is called 'break-even' point.
Because 'S' is no longer negative. I m plying t h at
borrowing is not needed to meet the minimum C.
• 5-line is positively sloped, indicating that S is positively
related to Y H ig her Y leads to hig her S.
In Fig. 5 , saving is measured on Y-axis, and income on X-axis. 5-line

represents saving function, indicating the behaviour of S with respect
to Y. It offers the following observations:
(i) 5-line starts from -20 (on Y-axis). It indicates the value of S when
Y = 0 . [ Note that S = -20, because C = 20 when Y = O].
(ii) 5-line is positively sloped, moving upward from left to right.
It indicates that S is positively related to Y: higher Y causes
higher S.
(iii) 5-line crosses the X-axis when Y = 1 00 . It indicates that S = O
when Y = 1 00 . (Here, consumption must be equal to income.)
So that, S = O when Y = 1 00, S is negative when Y < 1 00, S is
positive when Y > 1 00 .
Slope of S-l i n e (Savi ng Function):

Marginal Propensity to Save
Slope of 5-line (indicating saving function) refers to the rate at
which S increases in response to a given increase in Y. It indicates the
proportion of additional income that goes to saving. It is measured as
the ratio between LlS (additional saving) and LlY (additional income).
This is called marginal propensity to save (MPS). Fig. 6 shows the
estimation of MPS as the slope of 5-line or 5-function.

y Slope of S-line or Estimation of MPS
1 20
1 00
80
60 Slope of 5-l ine

40 =� _!_Q_ 0 2
/',.Y = so =
20
10
-10
-20
low
Y (l ncome)/GDP
Y'
Fig. 6 show that when:

Y increases from 100 to 150,
ee
S increases from O to 10.
rF
So that, �s 10 and �Y = 50.
Fr
=
MPS (the slope of S-hne)

. 10 =
= �s
0.2 =
or
�Y 50
It shows that out of every additional rupee of income, 20% is saved.
sf
u
[This exactly matches with our (-function which shows that out
k
of every additional rupee of income, 80% is spent as consumption
Yo
oo
expenditure. ]
B
APS and M PS are Different Concepts

re
APS (Average Propensity to Save) and MPS (Marginal Propensity

to Save) are different concepts, even when both indicate the ratio
ou
ad
between saving and income.

Y
APS is the ratio between total saving and total income, while MPS is
the ratio between additional saving and additional income.
nd
Re
Thus:
Fi
APS = i_
y
S
MPS = �
� y
In Fig. 6, when Y 150 and S = 10, then:
=
10 =
APS = 0.067
150
In Fig. 6 again, when �S = 10 and �Y = 50, then:
10 =
MPS = 0.2
50
Briefly, APS shows saving per unit of total income, whereas MPS
shows saving per unit of additional income.
Slope of $-function is indicated by MPS, N OT by APS.
Slope of a Straight Line S-function {as in Fig. 6) is Constant,

so that M PS is Constant
A straight line has a constant slope. So that, a straight line S-function
(as in Fig. 6) indicates that it has a constant slope. Implying that MPS
(as indicated by the slope of S-line or S-function) must be constant
corresponding to all levels of income. Such an S-function is called
linear saving function. It suggests that every time there is a rise in Y, a
constant proportion of it is converted into S. In Fig. 6, saving function
is linear and MPS = 0 . 2 , it suggests that every time there is a rise in
income, 20% of it is saved.
Algebraic Presentation of S-function

Algebraically, S-function is specified as under:
S = -C + (1 - b)Y
-C indicates the value of S when Y = 0. [C indicates the value of C
when Y = 0 . Accordingly, -C indicates the value of S when Y = O . ]
So that, when C = 2 0 , - C = - 2 0 (which is the value of S when Y = 0).
1 - b = MPS. It indicates the rate at which 'S' changes in response to a
change in 'Y'. Why is MPS = 1 - b (where b = MP()? This is because
MPC + MPS = 1 (see the next section for details).
Thus, if (-function is known, then the equation for S-function can be
derived from (-function, as under:
C = 2 0 + 0 . 8Y (this is (-function)
S -20 + ( 1 - 0 . 8)Y (this is $-function as
=
derived from (-function)

Or, S = -20 + 0 . 2Y
This is the value of S when Y = 0

and corresponds to the va lue of
_j L This is the va lue of M PS when
the va l u e of M PC = 0.8
C (= 20) when Y = 0

Derivation of S-function from (-function:
Diagrammatic Illustration
Fig. 7 shows derivation of $-function from (-function.
(A) (-function
Derivation of S-function from (- function
DATA-SET
1 60 y C
0 20
c 1 40 so 60
low
g_ 1 20 1 00
1 50
1 00
1 40
� 1 00 -1+--� C = Y
[Break-even I MPC = 0.8 I
s 80
Point]
u 60
40
ee
20
rF
Fr
i
X
0 so 1 50
i Y (l ncome)/GDP
l QO
or
(B) S-function
1 60
sf
u
DATA-SET
1 40
y S (= Y - C)
1 20
k
Yo
0 -20 (= 0 - 20)
'
oo
.S 1 00 ' so -1 0 (= 50 - 60)
!:0- 80 1 00 0 (= 1 00 - 1 00)
B
V)
60 1 50 + 1 0 (= 1 50 - 1 40)
re
40 : S=O
i [Brea k-even Point] s MPS = 1 - MPC
20
-----------------------lL---- = 1 - 0.8
ou
ad
10
X = 0.2
-1 0
Y
-20
Y (l ncome)/GDP
Y'
nd
Re
Observations:
• S-fu nction starts from - 2 0 because (-fu nction starts from
+20. It indicates that when Y = O an d C = 20, then S must
Fi
be eq ual to -20.
• S = 0 when Y = 1 00. Th is is because C = Y when Y = 1 00.
• S-fu nction is a l i nea r fu nction. Beca use S-J ine is a stra i g h t
l i ne, movi ng u pwa rd from left t o rig ht.
We need to focus on three points:

(i) S-line starts from the point which indicates the value of S. And
the value of S is equal to the value of C, but with a negative
sign. Thus in Fig. 7 (8), S-line starts from - 2 0 because (-line
starts from +20.

(ii) 5-line crosses the X-axis when C = Y, so that S = 0. Thus in Fig. 7(8),
S-line crosses X-axis when C = Y = 100, and therefore, S = 0.
(iii) The slope of S-line is equal to '1 - slope of C-line'. Thus in
Fig. 7(A) and 7(8), while the slope of C-line = 0. 8 that of S-line
= 1 - 0. 8 = 0.2. ( N ote that: MPS = 1 - MPC.)
t>TS
Q. 1 . How would you specify the saving function, given the consu m ption fu nctio n as u nder?
C = bY
Ans. S = ( 1 - b)Y.
[Note: I n the (-fu nction, there is n o consta nt term l i ke C. Accordi ngly, there is no consta nt term
l i ke -C i n the savi ng fu ncti o n . Such a (-fu ncti o n (or S-fu nction) i n d i cates that C = 0 (or S = O)
when Y = 0.)
Q. 2. What value will you assign to the slope of S-function when the slope of (-function is given as = 0.6?
An s. Slope of (-fu nction = M PC
Slope of S-function = M PS
We know, M PC + M PS = 1
Thus, slope of S-function = 1 - M PC
= 1 - 0.6 = 0.4.
Q. 3. Find S when C = 200, M PS = 0.4 and Y = 1,000.
Ans. We know that, S = -C + M PS( Y)
We a lso know that, savi ng is negative to the extent consu m ption is positive when Y = 0. So that
-c = -200
Substituti n g the given values, we get:
S = -200 + 0.4 ( 1,000)
= -200 + 400
= 200.
6. RELATIONSH I P BETWEEN PRO PENSI TY TO

CONSUME AND PROPENSI TY TO SAVE
Propensity to consume refers to the ratio between consumption (C)
and income (Y). It has two aspects, as noted earlier:
C �C
APC = y, and MPC =
M
Average propensity M arg inal propensity
to consume to consume
Propensity to save refers to the ratio between saving (S) and income (Y).
Its two aspects are:
s
APS = y, and MPS = �
S
� y
Average propensity M arg inal propensity
to save to save

Relationship between propensity to consume and propensity to save
is as expressed as in the following equations:
(i) APC + APS = 1.
(ii) MPC + MPS = 1.
These equations are explained (and proved) as under:
(i) APC + APS = 1 , always. Because if (say) � of total income is
!
spent, then the other half ( � ) of total income must be saved.
Or, if ! of total income is spent, then of total income must
low
be saved. Simply because, Y = C + 5.
Algebraically, it can be proved as under:
We know that,
C S
APC = Y' and APS = y
ee
rF
Fr
We also know that, Y = C+S
So that,
or
APC + APS = f_ + 2-
y y
sf
u
= C + S = _y_ = 1
y y
k
Yo
Hence, APC + APS = 1, always.
oo
(ii) MPC + MPS = 1 , always. This is because, if (say) � of additional

B
! !
income is spent, then the other half ( � ) of additional income
re
must be saved. Or, if of additional income is spent, then of

ou
ad
additional income must be saved. Simply because, fl.Y = ll.C + 8.5.

Y
Algebraically, it can be proved as under:

nd
We know that,
Re
ll.C 8.5
MPC = , and MPS =
Fi
/l.Y /l.Y
We also know that, ll.C + 8.5 = fl.Y
So that,
ll.C ll. S
MPC + MPS = +
/l.Y /l.Y
ll.C + 8.5 = /l.Y =
= 1
/l.Y /l.Y
Hence, MPC + MPS = 1, always.
t>TS
Q. 1. If personal d is posable i ncome is � 1,000 crore and consumption expenditure is � 750 crore, fi n d out
average p ropensity to save.
Ans. S = Y - C = � 1,000 crore - � 750 crore = � 250 crore
APS =y
s
250
1, 000
= 0.25
Q. 2. Can APS ever be negative? If yes, give a n exa m ple .
Ans. Yes. APS can be negative i n situations when S is negative (or when C > Y) .
Example: Y = 50, C = 60, S = -10
APS =y
s
-10
50
= --0. 2 .
Q. 3. A P C and M PC are two parameters. The val u e o f wh ich para m eter ca n be greater tha n one, a n d when?
Ans. Val u e of APC can be greater tha n one. It ha ppens when the level of i ncome is low a n d C > Y. Val u e of
M PC ca nnot be greater than one. M PC is the ratio betwee n additional consu mption and additional
i ncome ( !� ) . Si nce additiona l consum ption (�C) is only a pa rt of additional i ncome (�Y), !� can n ot
be greater than one.
Q. 4. Can M PS or MPC ever be n egative? Give reasons i n support of your answer.
Ans. N o . N e ither M PS nor M P C ca n ever be negative. Beca use: M PS is the ratio betwee n add itional
savi ng (�S) a n d a d d itional i ncome (�Y) . Li kewise, M PC is the ratio between a d d itional cons u m ption
(�C) and additional i ncome (�Y). The ratio !� refers to slope of S-function wh ich is a lways positive
(because of positive relationsh i p between S and Y).
Likewise, the ratio !� refers to slope of (-fu nction which is always positive ( because of positive
relationsh i p between C a n d Y) .

Power Poi nts & Revision Wi ndow ------------
Aggregate Demand (AD) is the s u m tota l of d e m a n d fo r a l l good s a n d services i n the economy d u ri n g
t h e period of a n accou nti ng yea r. It is measu red i n terms of tota l ( p l a n n e d )
j
expe n d it u re o n the goods a n d services i n the eco nomy d u ri n g a n acco u n ti n g
yea r.
Components:
AD = C + I + G + (X - M )
= P l a n ned expen d it u re o n the d o mestica lly prod uced goods a n d services d u ri n g a n acco u n ti n g
yea r.
Aggregate Supply (AS) refers to the prod uction of goods a n d services i n the economy as plan ned by the
low
prod ucers d u ri ng a n acco u nting yea r.
It is i d entica l with G D P i n the economy where : ( i ) prices a re consta nt, a n d ( i i ) s u p ply
responds proportionately to i ncrease in d e m a n d , owi ng to excess ca pacity. B e i n g
i d e ntica l w i t h G D P, it is i n d icated b y a 45 ° l i ne .
Consumption Function o cctio c a l ce latio osh l p coos , m ption a n d I ncom e . It I s specifi e d a s
ee
�:;:,i
::::::
rF
Fr
]
Slope of C-line (consumption function) is t h e rate at w h i c h C (co n s u m pti o n ) i ncreases i n respo nse t o a
given i n c rease i n Y ( i n co m e ) . It i s measu red as t h e ratio betwe e n a d d iti o n a l co n s u m ption a n d a d d itio n a l
or
i ncom e .
£1(
sf
u
Slope of (-fu n ction = M PC = L'1
Y
Saving Function is t h e fu n cti o n a l re lationsh i p betwee n savi ng a n d i nco m e . It is usu a l ly specifi e d as u nd e r :
l
k
Yo
S = -C + ( l - b)Y
oo
Slope of S-line (saving function) i s measu red as the rati o betwee n a d d iti o n a l saving a n d a d d itio n a l
B
i n co m e .
!
re
!1S
Slope of S-fu n ction = M PS = L'1
Y
Average Propensity to Consume i s the ratio betw e n t t I consu m ption a n d tota l i nco m e .
ou
ad
:pc : �
Y
Average Propensity t o Save i s the ratio betwee n tota l s:ving a n d tota l i nco m e .
l
nd
Re
APS = -
y
Fi
Relationship between Propensity to Consume and Propensity to Save

! APC + APS = 1
& a l ways
MPC + M PS = 1
rEX E RC I S Ej
1 . Objective Type Questions (Remem bering & U ndersta n d i n g based Q uestions)
A. M u lt i p l e Choice Q uestions

1. AD refers to:
(a) demand for a l l goods a n d services produ ced i n the economy d u ring a period of one yea r
( b ) tota l u n p l a n ned expe n d iture on t h e goods a n d services i n t h e economy d u ring a n acco u nti ng
yea r
(c) sum total of i nvestment expenditu re and saving i n the economy d u ri ng a n accounting yea r
( d ) a l l o f these
2. In an open economy, aggregate demand is esti mated as:
(a) Private cons u m ption expe n d itu re
( b ) Private cons u m ption expe n d itu re + G overnment expend itu re
(c) Private i nvestment expend itu re + Private cons u m ption expend itu re + Government expe n d itu re
( d ) Private consum ption expe n d itu re + Private i nvestment expen d itu re + Government expend itu re
+ N et exports
3. Cons u m ption fu nction is a fu nctional relationsh i p between :
( a ) i n come a n d savi ng (b) price and consu m ption
(c) cons u m ption a n d i ncome (d) consu m ption and savi ng
4. Average p ropensity to consu m e is eq ual to:
Y t:,.y
(a) (b)
C t!i.C
C t!i.C
(c) (d )
Y t:,.y
5. M a rginal p ropensity to consu me is eq u a l to:
t:,.y y
(a) - (b)
t!i.C C
t!i.C C
(c) - (d)
t:,.y y
6. M PC being eq u a l to 0.5, what wi l l be �C, if i ncome increases by � 100?
(a) � 60 ( b ) � 50
(c) � 40 (d) � 70
7. If C = 450 a n d Y = 1,000, the average p ropensity to consume wi l l be:
(a) 750 (b) 0.75
(c) 450 ( d ) 0.45
8. When S cha nges from -30 to -20, then �S is eq ual to:
(a) -10 ( b) +10
(c) -20 (d) -30

9. Savin g fu nction is the fu nctional relationsh i p between :
( a ) i n come a n d consu m ption ( b ) price a n d saving
(c) saving a n d i ncome (d) consu m ption and savi ng
10. In the consu m ption fu nction, C = C + bY, the term C refers to:
(a) va l u e of C when Y = 0 ( b ) va l u e of C when Y = C
(c) va l u e of C when Y cha nges ( d ) va l u e of C when Y is consta nt
11. Average p ropensity to save is eq u a l to:
(a) :; (b) ;
dS S
low
(c) (d) y
dY
12. If M PS is 0.6, what will be AS when i ncome i ncreases by � 50?
(a) � 30 (b) � 20
(c) � 25 ( d ) � 35
13. If M PC is 40 per cent, M PS wi l l be:
ee
(a) 70 per cent (b) 60 per cent
rF
Fr
(c) 50 per cent (d) 40 per cent
14. If cons u m ption fu nction is C = bY, what will be the savi n g fu nction?
(a) S = -C + bY ( b ) S = ( 1 - b)Y
or
(c) S = -C +(1 - b)Y (d) S = -bY
sf
u
15. Which of the fol lowi ng is correct?
(a) M PC + M PS = 1 ( b ) 1 - M PC = M PS
k
Yo
(c) 1 - M PS = M PC ( d ) A l l of these
oo
16. If M PC = 0.4 a n d AV = � 1,000, what will be AS?

B
(a) � 400 ( b ) � 500

(c) � 600 ( d ) � 250
re
17. The slope of S-li n e is i n d icated by:

(a) M PC ( b ) M PS
ou
ad
(c) 1 - M PC ( d ) both ( b ) a n d (c)

Y
18. When C = 100 + 0.SY a n d Y = 1,200, a utonomous consum ption wi l l be:

(a) 100 (b) 1,000
nd
Re
(c) 500 ( d ) 600

19. When C = 300 + 0.8Y a n d Y = 500, savi ng at zero i n come level w i l l be:
Fi
(a) 300 (b) -300

(c) 1, 100 ( d ) 800
20. Brea k-even poi nt occurs whe n :
(a) Y = S (b) S = 0
(c) Y = C ( d ) both ( b ) a n d (c)
Answers
1. (a) 2. (d ) 3. (c) 4. (c) 5 . (c) 6. ( b) 7. (d ) 8. ( b) 9. (c) 10. (a)
11. (d ) 12. (a) 13. ( b) 14. ( b) 15. (d ) 16. (c) 17. (d ) 18. (a) 19. ( b) 20. (d )

1. I n the context of macroeconomic eq u i l i bri u m, AD a lways refers to
(ex-a nte AD/ex-post AD)
2. AD is a l ways exp ressed as what peo ple at d ifferent levels of i ncome.
(wish to spend/actua l ly spend)
3 . A two sector closed economy i nc l u des household sector and sector.
( p roducer/government)
4. i m p l ies plan ned output i n the economy d u ring a n acco u nting yea r. (AD/AS)
5. Slope of C-l i n e i n d icates the proportion of that goes to consum pti o n .
( i n co m e/a d d iti o n a l i n come)
6. I n a two sector cl osed economy, if consum ption is eq u a l to i n come, average propensity to save wi l l
be (zero/one)
7. A stra ight line C-l i n e means that the co nsu m ption fu nction is ( l i nea r/non- l i nea r)
8. When S-l i n e crosses the X-axis, it i n d icates that S is (zero/negative)
9. shows savi ng per u n it of additional i n come. (APS/M PS)
10. Consta nt term i n the consu m ption fu nction refers to consu m pti o n .
( a utonomous/i n d u ced )
Answers
1. ex-a nte AD 2. wish to spend 3 . producer 4. AS 5. a d d itional i ncome
6. zero 7. l i nea r 8. zero 9. M PS 10. a utonomous
C. True or Fa lse
State whether the following statements a re True or False:
1. Aggregate d e m a n d is negatively rel ated to i ncome. (Tru e/Fa lse)
2. Col lective consum ption expe n d it u re refers to consu m ption expend itu re
on beha lf of the society as a whole. (Tru e/Fa lse)
3 . AD is measu red with reference t o the level o f i ncome o f the peo ple. (Tru e/Fa lse )
4. In Keynesia n model, price has a major role to p l ay as a determ i n a nt of AS. (True/Fa lse)
5 . I n co m e is either cons u m ed or i nvested . (Tru e/Fa lse)
6 . APC is t h e ratio between tota l consum ption a n d tota l i ncome. (True/Fa lse )
7. Slope of S-fu nction is i n d icated by APS. (Tru e/Fa lse)
8. If M PS is 45%, then M PC wi l l be 55%. (Tru e/Fa lse)
9. I n savi ng fu nction -50 + O.SY, the va l u e of autonomous cons u m ption wi l l be -50. (Tru e/Fa lse)
10. I n a two sector closed economy, if i n come is zero, APC wi l l a lso zero. (True/Fa lse )
Answers
1. Fa lse 2. True 3. True 4. Fa lse 5 . Fa lse 6. True 7. False 8. True 9. Fa lse 10. Fa lse

Column I Column II
(a) Aggregate demand (i) A flow concept
(b) I m ports ( i i ) Decreases AD in the dom esti c econ omy
(c) APC ( i i i ) Slope of C-l i n e
(d) Aggregate s u p p l y ( i v ) Actual p rod uction
(e) APS (v) Ca n be greate r than one
low
Answer
(b) l m ports - (ii) Decreases AD in the domestic economy
items in Column I:
Column I Column II
ee
(a) AD cu rve ( i ) I ncome - Con s u m ption
rF
Fr
(b) Savi ng M
(ii) M
(c) Net exports ( i i i ) Saving is ze ro
or
( d) M PC ( iv) Diagra m matic presentation of AD schedule
sf
u
(e) Y = C (v) Exports - I m ports
k
Yo
oo
Answers
(a) - ( iv), ( b) -(i), (c) - (v), (d) - ( ii), (e) - ( i i i )
B
re
E . 'Very S h o rt Answe r' Objective Type Questions

ou
ad
1. What is aggregate dema n d ?

Ans. Aggregate d e m a n d is the tota l d e m a n d for goods a n d services i n a n economy, measu red i n terms of
Y
tota l expend itu re.

2. N a m e the p ri nci pal com ponents of aggregate d e m a n d i n a n open economy.
nd
Re
Ans. The principal com ponents of aggregate d e m a n d a re : ( i ) Private consu m ption expend itu re, ( i i ) Private
i nvestment expend itu re, ( i i i ) Government expend itu re, a n d ( iv) Net exports.
Fi
AD = C + I + G + (X - M )
3 . Define aggregate d e m a n d sched ule.
Ans. Aggregate demand sched u l e is a ta ble showing AD (or aggregate expend itu re) correspo n d i ng to
d ifferent levels of i ncome in the economy.
4. Define aggregate d e m a n d curve.
Ans. Aggregate d e m a n d (AD) cu rve is d iagra m matic presentation of AD sched u l e, showing AD
corresponding to d ifferent levels of Y ( i ncome) in the econo my.
5. What is consu m ption fu nction?
Ans. Cons u m ption fu nction refers to the fu nctional relationship between cons u m ption (C) a n d income (Y) .
C = C + bY

6. What is mea nt by a utonomous cons u m ption?
Ans. Autonomous consu m ption refers to m i n i m u m level of consum ption, even when i ncom e is zero.
7 . W h a t is a l i nea r consum ption fu nction?
Ans. Linea r consu m ption fu nction is a stra ight line consu m ption fu nction i n which M PC rem a i n s consta nt.
8. What is brea k-even poi nt?
Ans. The point where tota l consum ption is eq u a l to the tota l i ncom e or the poi nt where tota l saving is
eq u a l to zero is ca l led brea k-even point.
9 . Defi ne propensity to consu me.
Ans. Propensity to consume refers to the proportion of i ncom e used as consu m ption expend itu re. It is
m easu red as the ratio between C and Y.
10. What is average propensity to consu me?
Ans. Average propensity to cons u m e is the ratio of aggregate cons u m ption expend itu re to aggregate
i ncome.
APC = �
y
1 1 . Defi ne m a rgi n a l propensity to consu me.
Ans. M a rgi n a l propensity to consu m e is the ratio of cha nge in cons u m ption to cha nge in i n come.
C
M PC = l:!.
l:!. Y
12. W h a t is mea nt b y savi ng fu nction?
Ans. Saving fu n ction refers to the fu ncti o n a l relations h i p between savi ng (S) a n d i ncom e (Y) .
S = -C + ( 1 - b)Y
13. Defi ne propensity to save.
Ans. Propensity to save refers to the proportion of i ncom e which is kept as savi ng. It is measu red as the
ratio between S a n d Y.
14. What is average propensity to save?
Ans. Average p ropensity to save is the ratio of aggregate savi ng to aggregate i ncome.
APS = �
y
15. Defi ne m a rgi n a l propensity to save.
Ans. M a rgi n a l propensity to save is the ratio of cha nge i n savi ng to cha nge i n i ncom e .
S
M PS = l:!.
l:!.Y
16. Why ca n not the va lue of m a rgi n a l propensity to consume be greater than one?
Ans. It is beca use cha nge in consu m ption ca n n ot be greater tha n cha nge in income.
17. W h a t is t h e relations h i p between m a rgi n a l propensity to save a n d m a rgi n a l propensity to consu me?
Ans. Aggregate of m a rgi n a l p ropensity to save a n d m a rgi n a l p ropensity to cons u m e is eq u a l to one o r
M PS + M PC = 1.
18. W h a t is t h e va lue o f m a rgi n a l propensity t o consu me when m a rgi n a l propensity t o save is zero?
Ans. Va l u e of m a rg i n a l p ropensity to consume is 1 when m a rgi n a l propensity to save is zero.
19. The d isposa ble income is � 1,000 crore a n d level o f consu m ption is � 800 crore. Ca lculate average
propensity to consume.
. to co nsume = 800
A ns. Average p ropensity O 8.
l, 000 = .

20. If average propensity to save is 0.6, how much wi l l be average p ropensity to consume?
Ans. Average p ropensity to co nsume w i l l be 0.4, as APC + APS = 1.
21. If average propensity to consume is 0. 7, how m uch wi l l be average p ropensity to save?
Ans. Average p ropensity to save wi l l be 0.3, si nce APC + APS = 1.
22. How m uch is the m a rgi n a l propensity to consu me in an economy in which m a rgin a l propensity to
save is 0.2?
Ans. M a rg i n a l propensity to consu m e wou l d be 0.8, si nce M PC + M PS = 1.
23. How m uch is the m a rgi n a l p ropensity to save i n a n economy i n which the m a rgi n a l propensity to
consume is 0.75?
Ans. M a rg i n a l propensity to save wou l d be 0.25, since M PC + M PS = 1.
low
2. Reason - based Questions (Com prehension of the S u bject - matte r)
Read t h e fol l owi ng statements ca refu l l y. Write Tru e or Fa lse with a reaso n .
1 . M PC i s the ratio between desired consu m ption a n d income, not the actual consu m ption a n d income.
Ans. True. M PC reflects what peo p l e wish to consume at d ifferent l evels of i ncome.
ee
rF
2 . C is positively related to Y, but C is not zero when Y is zero.
Fr
Ans. True. C is positively related to Y, but C is not zero when Y is zero. Beca use, there is a l ways some
m i n i m u m level of C i rrespective of level of Y.
or
3 . C ca n exceed Y, but S ca n n ot.
Ans. True. Beca use there is a lways some m i n i m u m l evel of C even when the l evel of Y is zero .
sf
u
4. AD does not incl ude exports.
Ans. Fa lse. AD incl udes exports. Beca use exports refer to demand fo r the domestica l ly prod u ced goods i n
k
Yo
rest o f the worl d .
oo
5 . Consum ption never exceeds i n come.
B
Ans. Fa lse. Co nsu m ption ca n be greater t h a n i ncome. There is a l ways some m i n i m u m level of consu m ption
even when i ncome is zero .
re
6. Savi ng ca n never b e negative.

Ans. Fa lse. Savi ng ca n be negative when consu m ption is greater than i ncom e . N egative savi ng a m o u nts to
ou
ad
borrowing.
Y
7 . Brea k-even point is struck when S = 0.

Ans. True. B rea k-even point is struck when S = 0. At brea k-even poi nt, C = Y.
nd
Re
8. Average p ropensity to consume ca n never be greater than one.

Ans. Fa lse. Average p ropensity to cons u m e ca n be greater t h a n one when consu m ption is greater t h a n
Fi
i ncome.
9 . A P C a n d M PC a re never eq u a l .
A n s . Fa lse. APC a n d M PC ca n be eq u a l . When APC is consta nt, APC w i l l be eq u a l to M PC.
10. APC + APS = 1.
Ans. True. We know that,
Y=C+S
Y C - S
- = - + [Divi d i ng both sides by Y]
y y y
C S
1 = -+-
y y
=> APC + APS = 1

11. M PC + M PS > 1.
Ans. Fa lse. M PC + M PS = 1, it ca n neve r be greater than o r less than 1.
12. The rate at which C increases a lways tends to be lower than the rate at which Y increases.
Ans. Tru e . The rate at which consu m ption (C) i ncreases is often less than the rate at which i ncom e (Y)
i ncreases. This is in accord a nce with the Psychologica l Law of Consum pti o n .
13. T h e rate a t which S increases a lways tends t o be greater than the rate a t which Y i ncreases.
Ans. Fa lse. Beca use a ny increase in Y is s p l it i nto two parts : ( i ) i n crease in C, a n d ( i i ) increase in S.
Acco rd i n g ly, t h e rate at w h i c h S i n c reases ( o r C i n c reases) m u st be l owe r t h a n t h e rate at w h i c h
Y i ncreases.
14. The va lue of m a rginal p ropensity to save is a lways positive.
Ans. Tru e . M a rgi n a l propensity to save is the ratio between additional savi ng a n d a d d iti o n a l i ncom e which
is always positive beca use of positive rel ations h i p between saving a n d i ncom e .
1 5 . Average p ropensity t o save is never negative.
Ans. Fa lse. Ave rage propensity to save ca n be negative . It is negative in situations when savi ng is negative
or when consu m ption is greate r than i ncom e .
1 6 . Va lue o f average p ropensity t o save is a lways greater t h a n zero.
Ans. Fa lse. The va l u e of average propensity to save (APS) ca n be less than zero. It h a p pens when
consu m ption is greate r than i ncom e or when APC > 1 .
1 7 . N egative va lue o f average propensity t o save always i m p l ies negative va l u e o f m a rginal propensity
to save.
Ans. No, it is not true. The va l u e of ave rage propensity to save is negative when consum ption is greate r
than i ncom e but this d oes not mea n that m a rg i n a l p ropensity to save ( M PS) wi l l a lso be negative . I n
fact M PS i s never negative . Beca use i t i s the ratio between AS a n d AV a n d AS ca n neve r b e negative,
as a component of AV.
18. APC + M PC = 1.
Ans. Fa lse. Because, whereas APC is the ratio betwee n tota l consum ption and tota l i n come, M PC is the
ratio between additional consu m ption a n d additional i ncom e .
1 9 . Average p ropensity t o save is a lways less t h a n 1.
Ans. Tru e . The va l u e of ave rage p ropensity to save (APS) is a lways l ess t h a n 1 . Beca use a part of i ncom e (Y)
m u st be consumed (C ca n not be ze ro ) . I m plying that o n ly a part of Y is save d . Conseq ue ntly, APS
m u st a l ways be l ess t h a n 1.

1. Do you agree that M PS ca nnot be negative, but APS ca n be?
Ans. G iven the fact that there is a positive rel ationsh i p between savi ng and i ncome, an i ncrease in i ncome
m u st cause a n increase i n savi ng. I m plying that M PS m u st a l ways be positive. H oweve r, APS ca n be
negative when at a ve ry low leve l of i ncom e consu m ption is greater t h a n i ncom e so that savi ng is
negative .
2. The s u m tota l of APC a n d APS is a lways eq ual to one, even when APC > 1. Is it true?
Ans. Yes. APC + APS = 1, eve n when APC > 1 . Beca use consu m ption and savi ng a re the o n ly two com ponents
of i nco me.
Aggregate Demond, Aggregate Supply and Related Concepts 203

3 . Do you t h i n k h igher the level of Y, h igher should be the level of a utonomous con su m ption i n
C-fu nction?
Ans. Th is is not correct beca use autonomous consum ption is not re l ated to the l evel of Y.
4. Increase i n M PC i m p l ies increase i n the slope of C-fu nction. Com ment.
Ans. The given statem e nt is correct. Beca use M PC sh ows the rate at which consu m ption i ncreases i n
response t o increase i n i nco me. O r, M PC is the slope o f C-fu nctio n .
5 . I f APC is consta nt, C a n d Y should a lso be consta nt. Defend or refute.
Ans. Consta nt APC o n ly i m plies that the ratio � is consta nt. H e n ce, the a bove state ment is i ncorrect.
6. What is aggregate dema n d ? How it is d ifferent from market dema n d ?

A n s . Aggregate demand refers to demand for a l l goods and services in the economy. It is measured i n terms of
low
total expenditure on goods and services prod uced in the economy d u ring an accounting yea r. Whereas
ma rket demand is the sum tota l of demand for one commod ity by a l l the buyers in the ma rket.
M a r ket d e m a n d is a micro concept w h i l e aggregate d e m a n d is a macro co ncept.
7 . Com plete the fol l owing ta ble:
Income Saving M arginal Propensity Average Propensity
ee
to Consu me to Consume
rF
Fr
-10
0 -20 - -
50 - -
or
100 0 - -
150 30 - -
sf
u
200 60 - -
Income Saving Consumption M arginal Propensity Average Propensity

k
I
Yo
Ans.
(Y) (S) (C) = v - s to Consu me to Consume
oo
Ile C
(M PC) = (APC) = -
B
M y
re
0 -20 20 - -
-10
ou
40 60
ad
50 60 - = 0. 8
50 so = 1 . 2
Y
100 0 100 40 100

- = 0.8 =l
50 100
nd
20 120
Re
150 30 120 - = 0.4 = 0·8

50 150
Fi
20 140
200 60 140 - = 0.4 = 0 ·7
50 200
� -
-
8. Com plete the fol l owing ta ble:
M arginal Propensity Average Propensity

-
Income Consumption
to Save to Consume
0 15 - -
50 50 - -
100 85 - -
150 120 - -

Ans. Saving M arginal
Income Consumption Change in I Average Propensity
(V) (C) (S) = Y - C Saving Propensity to Save to Consume
(L'.S) S C
(MPS) = � (APC) = -
V
0 15 -15
�y
- - -
50 50 0 15 15
50 = o . 3 �=1
50
100 85 15 15 15 85
50 = o . 3 100
= 0.85
15 120
150 120 30 15 = 0·8
50 = o.3 150
9 . Com p l ete the fol l owing ta ble:
Marginal Propensity to Average Propensity
Income I Consume
Saving
to Consume
0 -30
100 0.75
- -
- -
200 0.75
300 0.75
- -
- -
Ans. Income Marginal Propensity Saving Consumption Average Propensity

(V) to Consume (S) = Y - C (C) to Consume
(MPC) C
(APC) = -
V
0 - -30 30 -
105
100 0 . 75 -5 105 = 1.05
100
200 0.75 20 180 180

= 0 ·9
200
255
300 0.75 45 255 = 0.85
300
[ H i nt : C = C + M PC (Y); w h e re, C = 30 at Y = 0 and M PC = 0 . 7 5 . ]
10. G iven below is the con s u m ption fu nction i n a n economy:
C = 100 + 0.SY
Ans. G iven co n su m pti o n fu ncti o n is,

With the help of a n u merica l exa mple show that in this economy as income increases APC will decrease.
C = 100 + 0.5Y
When Y = 0, C = 100
N ow ass u m e Y 1 = 1,500 a n d Y 2 = 2,000
W h e n Y = Y 1 = 1,500
C = 100 + 0.5 { 1,500)
= 100 + 750 = 850
APC = �
850
= 0.57
1, 500
=

When Y = Y 2 = 2,000
C = 100 + 0.5 (2,000)
= 100 + 1,000
= 1, 100
C 1, 100
APC =
y = 2 OOO = 0.55
I
We fi n d that as i ncome i n the economy inc reases, APC w i l l decrease.

11. Fi n d a utonomous consu m ption and tota l consu m ption when savi n g fu nction is S = -100 + 0.SY a n d
Y = 1,500.
Ans. G iven,
low
S = -100 + O.SY
Autonomous consu m ption = C = - (-) 100 = 100
C = C + M PC (Y)
= 100 + ( 1 - 0.5) 1,500 [ M PC = 1 - M PS and M PS = 0.5]
ee
= 100 + 0.5 ( 1,500)
rF
= 100 + 750
Fr
= 850
Autonomous consu m ption = 100.
or
Tota l co nsu m ption = 850.
sf
u
12. Fi n d consu m ption and savi n g when C = 100, M PC = 0.5 and Y= 2,000. Is there greater i ncrease i n
i ncome as com pa red to consu m ption when i ncome changes to 2,500?
k
Ans. We know that,
Yo
oo
C = C + M PC (Y)
When Y = 2,000, C = 100 + 0.5 (2,000)
B
= 100 + 1,000
re
= 1, 100
We a lso know that,
ou
ad
Y =C+S
Y
O r, S = Y-C
= 2,000 - 1, 100
nd
= 900
Re
Consu m ption = 1, 100

Fi
Savi ng = 900
When Y = 2,500
C = 100 + 0.5 (2,500)
= 100 + 1,250
= 1,350
Cha nge in C = 1,350 - 1, 100 = 250
Cha nge i n Y = 2,500 - 2,000 = 500
Yes, the i ncrease i n i n come is greater than the increase in consu m ption when Y i ncreases from 2,000
to 2,500.

13. At what rate consu m ption is increasing i n the y
economy when M PS = 0.5, and a utonomous 1 00
consu m ption is zero? Draw a d iagra m .

§ 75
Ans. M PC + M PS = 1 ·g_ C = O.SY
� 5 0 +----------,.,,r
M PC = l - M PS
3 C=O
= 1 - 0.5 2 5 +---,,r
MPC = 0.5
= 0.5 """'----+---�>-----+X
50 1 00
M PC (0.5) indicates the rate at which consu m ption Y (l ncome)/G D P
i ncreases i n response to i ncrease i n i ncome. Note:
At every level ofY, C = OSY or C =
2 Y. Th us,
when Y = 50, C = 25; when Y = 1 00, C = 50.
According ly, � (= 05) is constant, as
indicated by a straight line (-function.
14. Find change in savings when 2/3 rd of i n come is always spent as consu m ption expenditure a n d
cu rrent i n come is 50% more than t h e i n iti a l i n co me of � 50,000.
Ans. Cu rrent i ncome = 50% of � 50,000 + � 50,000
= � 25,000 + � 50,000
= � 75,000
I n itial i ncome = � 50,000
Cha nge in i ncom e (11Y) = � 75,000 - � 50,000
= � 25,000
2
M PC =
3
M PS = l - M PC
2 1
= l- =
3 3
We know, M PS = M
tl.Y
1 tl.S
=> 3 25, 000
25, 000
=> 11S =
3
= � 8,333.33
Alternative M ethod :
Y =C+S
Consu m ption expend itu re = ; of i ncom e
1
Savi. ngs .
3 o f i ncome
=
I n iti a l savi ngs = ! x � 50, 000 = � 16,666.67
Cu rrent savings = ! x � 75, 000

= � 25,000
Cha nge in savi ngs = � 25,000 - � 16,666.67
= � 8,333.33
Aggregate Demand, Aggregate Supply a n d Related Concepts 207

15. Com plete the fol lowing ta ble:
Income Average Propensity Saving Marginal Propensity
(�) to Consume (�) to Consume
0 - -80 -
100 1.6 - -
200 1 - -
300 0.8 - -
Income Average Propensity Consumption Saving Marginal Propensity to

Ans.
(Y) to Consume (C)
I (S) = Y - C Consume ( M PC) =
�c
(APC) �Y
low
(�) (�) (�)
0 - 80 -80 -
100 1.6 160 -60 80

= 0·8
100
ee
200 1 200 0 40
= 0.4
rF 100
Fr
300 0.8 240 60 40
= 0.4
100
[H i nt: APC = � C = APC x Y]
or
=}
16. The exports fa/1 15% to 1 718.07 er. in first 6 months of FY 15.
sf [Business Standard]
u
H ow will this affect aggregate dem a n d i n the economy?
k
Yo
Ans. Fa l l i n exports wou l d be reflected as a fa l l i n aggregate d e m a n d . Because, exports a re a component
oo
of aggregate d e m a n d .
B
1 7 . D o you t h i n k increase i n M PS should b e beneficia l t o the growth o f G D P i n I nd i a ?

A n s . I ncrease i n M PS i m pl ies that people sta rt savi ng more when their i ncome rises. This is good for the GDP
re
growth, provided people put their savi ngs i n the ba n ks and the ba n ks a re a b l e to convert savi ngs i nto
i nvestment ( by way of loans to the i nvestors). However, in cou ntries l i ke I nd i a where ba nking habits of
ou
ad
the people a re yet not grown, savings may rem a i n as idle cash balances with the people. I m plying that
add itional i ncome of the people is not converted i nto add itional demand. This m ay ca use deficiency of
Y
AD. Deficient AD may lead to economic slowdown (state of recession in the economy).
nd
Re
4. Ana lysis & Eva l u ation

1. Why shou ld rising M PS be a ca use of worry when it is a sign of rising GDP i n the economy?
Fi
Ans. Rising M PS i m p l ies fa l l i n g M PC, as M PS + M PC = 1. It i n d i cates that lesser a n d l esser proportion of the
add itional i n come goes to consum ption expend itu re . I m plying a gra d u a l s h r i n kage of AD (aggregate
d e m a n d ) in re lation to Y ( i ncome). In such a situation, the economy m ight s l i p i nto a state of recession
or economic slowdow n .
2. I n I nd i a propensity t o consu me is fai rly h i g h . W h y is it that t h e m a n ufact u ri n g sector i n I n d i a shows
a low rate of growth beca use of low d e m a n d ?
A n s . H igh propensity t o consu me i n I n d i a is primari ly beca use o f l o w i ncome o f the people. When i ncome
is low, the b u l k of it is used as expe nd itu re on food and a l l ied ite ms. H avi ng spent the b u l k of t h e i r
i ncom e on food (and re l ated items), the p e o p l e have l i m ited capacity t o buy man ufact u red goods.
Th us, d e m a n d fo r m a n ufact u red goods re m a i n s low. Which is why, m a n ufacturing sector shows a
low rate of growt h .

(With A n swers or Reference to the Text for Answers)
1. What i s 'aggregate s u p p ly' in macroeconom ics? [CBSE Delhi 2015]

Or
Defi n e aggregate s u p p ly. [CBSE 2018]
[Page 181]
2. What is 'aggregate demand' i n macroeconomics? [CBSE {Al) 2015]
[Page 178]
3 . N a m e a ny two components of 'aggregate dema nd'. [CBSE {F) 2015]
[Page 180, 181]
4. Disti nguish between m a rgi n a l propensity to consu me a n d average p ropensity to consu me. G ive a
n u merica l exa m p l e . [CBSE Delhi 201 6]
Or
Disti nguish between ave rage propensity t o consu me a n d m a rgi n a l propensity t o consu me using a
n u merica l exa m p l e . [CBSE {F) 201 6]
[Page 186]
5 . G iven consum ption cu rve, de rive savi ng cu rve a n d state the ste ps ta ke n in the process of de rivati o n .
Use diagra m . [CBSE Delhi 201 6]
Or
G iven a consum ption cu rve, outl i n e t h e steps req u i red t o b e ta ke n i n d e rivi ng a saving cu rve from it.
Use diagra m . [CBSE (Al) 201 7]
[Page 192, 193]
6. What is aggregate d e m a n d ? State its components. [CBSE {Al) 201 6]
[Page 178, 180, 181]
7. G iven savi ng cu rve, d erive consum ption cu rve a n d state the ste ps i n doing so. Use d iagra m .
[Page 212] [CBSE {Al) 201 6]
8. Defi n e m a rgi n a l p ropensity to con s u m e . [CBSE {Al) 201 7]
[Page 186]
9. Defi n e m a rgi n a l p ropensity to save . [CBSE {Al} 201 7]
[Page 190]
10. Su ppose i n a hypothetica l economy, the i ncome rises from � 5,000 crore to � 6,000 crore. As a resu lt, the
cons u m ption expend itu re rises from � 4,000 cro re to � 4,600 crore . M a rg i n a l p ropensity to consu me
i n such a case wou l d be . (Choose the correct a lternative) [CBSE 2019 (58/1/1)]
(a) 0.8 (b) 0.4
(c) 0.2 ( d ) 0.6
[(d)]
11. State a n d d iscuss the components of aggregate demand i n a two sector economy.
[Page 180] [CBSE 2019 (58/1/1)]
12. State the m e a n i n g of a utonomous con s u m ption. [CBSE 2019 (58/2/1)]
[Page 183]

13. If m a rgi n a l propensity to save is 20% a n d is consta nt at a l l leve ls of i ncome a n d the autonomous
cons u m ption is � 100 crore, construct consu m ption fu nction of the given hypoth etica l economy.
[Page 443] [CBS£ 2019 (58/3/1)]
14. If m a rg i n a l p ropensity to save is 10% a n d is consta nt at a l l levels of i n come, a n d the autonomous
[Page 443, 444] [CBSE 2019 (58/3/2}]
15. If m a rgi n a l propensity to consu me is 80% a n d is consta nt at a l l leve ls of i n come, a n d the autonomous
[Page 444] [CBSE 2019 (58/3/3) ]
16. State the fol lowi ng statem e nt as true or fa lse. G ive va l i d reasons.
low
I n a two-sector economy, if consu m ption is equal to i n come, average propensity to save wi l l be
zero. [CBSE 2019 (58/3/1)]
[True. We know that, Y = C + S
When C = Y, S wi l l be zero. Thus, APS = � = � = 0 ]
ee
I n a two-sector economy, if i n come is zero, consu m ption wi l l a lso be zero. [CBSE 2019 (58/3/2}]
rF
Fr
[ Fa lse. If i n come is ze ro, consu m ption wi l l not be zero. Because, there is a lways some m i n i m u m
l evel o f consu m ption (autonomous co nsu m ptio n ) i n t h e economy eve n w h e n i ncome l eve l is zero. A
m i n i m u m consu m ption is a l ways req u i red fo r s u rviva l, no matter what the leve l of i n come is.]
or
sf
I n a two-sector economy, if i n come is zero, average p ropensity to consu me wi l l a lso zero.
u
[ CBSE 2019 (58/3/3))
k
[ Fa lse. If i n come is zero, ave rage propensity to consu me w i l l not be zero. Because, there is always some
Yo
oo
m i n i m u m l evel of consu m ption (a uton omous consu m ption) i n the economy eve n when i ncome leve l
is zero. Th us, APC ( = � ) = � ( a ny positive va l u e) wi l l not be zero. Rather it wou l d te nd towa rds
B
infin ity.]
re
19. Which of the two, average propensity to consu m e or ave rage propensity to save, ca n be negative a n d
why?
ou
[CBSE 2019 (58/4/1))

ad
[Page 195]
Y
20. The consu m ption fu nction of an economy is: C = 40 + 0.8V ( a m o u nt i n � crore). Dete r m i n e that leve l
of i n come where ave rage propensity to consu m e will be one. [CBS£ 2019 (58/4/1)]
nd
[Page 444]
Re
Fi
6. NCERT Questions (With Hints to Answers)

1. What is margi n a l propensity to consume? H ow is it rel ated to m a rg i n a l p ropensity to save?
[Hint: M a rg i n a l p ropensity to consu me is the ratio of cha nge in consu m ption to cha nge in i nco me.
tic
M PC =
tiv
M a rgi n a l propensity to save is the ratio of cha nge i n savi ng to cha nge i n i ncom e .
tis
M PS =
tiv
M PC + M PS = 1
M PS = 1 - M Pc.]


1. Defi n e aggregate dema n d . State its components. [Page 1 78, 180, 181 ]
2. Exp l a i n the concept of consu m ption fu ncti o n . [Page 1 83-1 85]
3. Exp l a i n the concept o f savi ng fu ncti o n . [Page 1 88, 189]
4. Disti nguish between ave rage p ropensity to consu m e a n d m a rgi n a l propensity to consu me. The va l u e
o f w h i c h o f these two ca n be greate r t h a n one a n d when? [Page 1 86, 195]
5. Disti nguish between ave rage propensity to save a n d m a rgi n a l p ropensity to save . The va l u e of which
of these two ca n be negative a n d when? [Page 1 90, 195]
6. What is the re l ationship between average propensity to consu m e a n d average propensity to save?
Ca n the va l u e of APS be negative? If yes, when? [Page 1 94, 195]
7. Exp l a i n the re l ationsh i p between m a rgi n a l p ropensity to consu m e a n d m a rg i n a l p ropensity to save.
[Page 1 94]
8. Write an equation for a stra ight l i n e u pwa rd risi ng cons u m ption fu nction, sta rti ng fro m the Y-axis.
Also, d raw the d iagra m . [Page 1 83-187]
B . Questions of 6 m a r ks each
1. Exp l a i n the concept of AD using a suita b l e sched u l e a n d diagra m . [Page 1 77-1 79]
2. What is co nsu m ption fu nction? I l l ustrate its behavi o u r using a s u ita b l e d iagra m .
Or
Exp l a i n 'consu m ption fu nction' with t h e h e l p o f a d iagra m . [Page 1 83-1 85]
3. What is mea nt by propensity to consume? Exp l a i n its differe nt aspects. [Page 1 93, 194]
4. What is mea nt by savi ng fu nction? Exp l a i n it with the h e l p of a d iagra m .
Or
Exp l a i n 'savi ng fu nction' with t h e h e l p o f a d iagra m . [Page 1 88, 189]
5. D raw a d iagra m showi ng stra ight l i n e consu m ption fu ncti on. From it, how wou l d you de rive a savi ng
fu nction? Exp l a i n d iagra m m atica l ly, ta king some hypothetica l figu res. [Page 1 92, 193]
6. G iven a stra ight l i n e savi ng cu rve, d raw the consu m ption curve . Exp l a i n the process of its de rivati o n .
Also show (i) t h e income level where C = Y, and (ii) t h e i ncome level where S is negative. [Page 212]
DOs and DON'Ts

1. Remember that S can never be greater that Y. Beca use, S is only a part of Y. So that Y (= APS)
can never be g reater than 1 . However, S can be negative. I m p lying that APS can be less than
zero (or it can be negative) .
2. Remember that M PS is the s lope of S-fu nction, or S-l i ne. Beca use S-l ine has a pos itive
slope, M PS can never be n eg ative. Log ical ly: M PS is the ratio between additional saving
a n d add itional income. Addition a l saving out of add ition al income can n ever be negative.
Therefore, M PS can never be negative.
L i kewi se, M PC i s the slope of C-fu nction, or C-l i ne. Beca use C-l i ne has a positive slope, M P C
c a n never b e negative.

• Derivation of C-fu nction (C-cu rve) from S-function (S-cu rve) :
Diagram matic I l l u stration
We know,
C = C + bY
S = -C + (1 - b)Y
Fi g . 9 i l l ustrates the derivatio n of C-fu nction (C-cu rve) from S-fu n ction (S-cu rve) .
[Al S-function y
s
low
·5
V)
0
I
I
I
I
I
I Brea k-even point
ee
I
(-) p I
rF Y'
I
Fr
I
[Bl (-function y I
I
I
I C
c0 Y=
I
C I
or
·g_ P*
�I
sf
u
u p
k
Yo
oo
B
o��----�L-------x
re
Y (lncome)/GDP
C-fu nction [Fi g 9(B)] i s derived from S-fu nction [Fi g . 9 (A)], ta k i n g the fol l ow i n g
ou
ad
steps :
Y
Step l : - C i n d i cates negative savi n g w h e n Y = 0 . Thi s is equal t o (-) O P

Correspon d i n g t o it C wou l d be eq u a l t o O P (consu mption when Y = 0) .
nd
Re
Thus, P becomes the sta rt i n g poi nt of C-fu n ction (when Y = 0) .

Step 2: W h e n S = 0 [at p o i n t L i n F i g . 9 (A)] , C = O P* [at p o i n t Q i n F i g . 9 ( B)] .
Fi
T h i s corresponds to i ncome l evel O L i n both the fi g u res.

Thus, between O to O L level of Y, C > Y.
Step 3: Sta rt i n g from P a n d pass i n g thro u g h point Q, we stretch the C-fu nction
as a stra i g ht l i ne. The l i n e shows constant slope (= b) . This corres pon d s to the
constant slope of S-function = (1 - b) .
Note that: b + (1 - b) = 1
t t
Slope of S l ope of
C-l i n e S-l i n e
Ill
{ / .,CHAPTER: 8
///�
. h'l/
EQUILIBRIUM
OUTPUT
•
•
•
Concept ofShortRun
Concept ofEquilibrium Output (GDP)
Determination ofEquilibrium Output (GDP):
AS-AD Approach and S-l Approach
,,
• Shift in Equilibrium: Impact ofAdditional Investment (M)
• Investment Multiplier and its Mechanism
I. CONCEPT OF SHORT RUN

In macroeconomics (and according to Keynes), short run is defined
as a period of time during which 'technology' plays no role in the
determination of output in the economy. It is assumed to remain
constant. Output is determined exclusively by the level of employment
in the economy. Higher level of employment leads to higher level of
output, and vice versa.
Technology remaining constant, there is one-to-one relationship
between output and employment. Thus, if employment is doubled,
output will also be doubled. In other words, the level of employment
in the economy measures the level of output (GDP) in the economy.
Accordingly, output cannot increase once there is full employment in
the economy.
I
In the context of Keynesian Economics, there is one-to-one relationship between output and
employment, as technology is assumed to be constant. Accordingly, output (GDP) cannot increase
once there is full employment in the economy
213
2. CONCEPT OF EQUILIBRIUM OUTPUT (GDP)
Why is there an Equilibrium output (also called equilibrium GDP or equilibrium
equilibrium in the income) refers to that level of output in the economy where:
economy when AS = AD?
AS = AD
Because in such a
situation, intended [Aggregate Supply = Aggregate Demand]
production in the
economy is equal to We have already learnt in the previous chapter that:
intended purchase in the
economy The producers AS refers to the desired level of output in the economy. It is the
do not suffer: (i) the level of GDP that the producers wish to produce (or plan to produce)
burden of unwanted
low
supplies (or unsold during an accounting year (also called ex-ante AS).
stocks), or (ii) the loss of
unfulfilled demand (due to AD, on the other hand, refers to the level of GDP that the buyers
lack of stocks). When wish to buy during an accounting year (also called ex-ante AD). The
AS= AD, actual stocks with
the producers = desired equilibrium GDP means that level of GDP where what the producers
stocks with the producers. wish to produce (or plan to produce) is exactly equal to what the
ee
rF
buyers wish to buy (or plan to buy) during an accounting year. So
Fr
that, there is no excess production (or unwanted stocks with the
producers). Or, there is no shortage of output in relation to its
or
demand.
sf
u
Equality between AS and AD implies the equality between Y and AD.
Because Y = AS.
k
Yo
oo
Thus, we can write that the equilibrium is struck when:
AS=AD
B
or
re
Y=AD
[Here, Y denotes income, and Y = AS, as already discussed in the
ou
ad
previous chapter.]
Y
Equilibrium GDP
nd
Equilibrium GDP implies a situation, when:

Re
AS = AD or Y = AD
Fi
In such a state,
Actual stocks of the producers = Required (or Desired) stocks of the producers
In case AS > AD (or Y > AD),
Actual stocks > Required stocks
The producers suffer losses because of excessive stocks or unsold stock of goods.
In case AS < AD (or Y < AD),
Actual stocks < Required stocks
The producers suffer losses on account of unfulfilled demand in the economy.

Alternative Approach: Equilibrium is struck when S = I
Now, we know that in a simple two sector economy (producer sector
and household sector), the equilibrium is struck when:
Y = AD
Since, Y = C + S, and
AD = C + I (as discussed in the previous chapter)
The equilibrium equation can be written like this:
�=�
il il
Y AD
Or that, equilibrium is struck when:
S = I (as C is common on both sides of the
equation)
You Must Note it

In the context of equilibrium GDP, we should focus only on ex-ante saving and ex-ante investment.
Equilibrium is struck when:
ex-ante saving (S) = ex-ante investment (I)
Ex-ante Saving: It refers to 'desired saving' or planned saving during the period of one year. These
are the savings which people intend to make in the economy during the period of one year.
Ex-ante Investment: It refers to 'desired investment' or planned investment during the period of one
year. This is the investment expenditure which is intended to be made in the economy during the
period of one year. It does not include unplanned investment.
(Unplanned investment is like unsold stock of goods which is treated as inventory investment. But
this is 'undesired inventory'.)
Related concepts are: ex-post saving and ex-post investment.
Ex-post Saving: It refers to 'actual saving' in the economy during the period of one year. This aspect
of saving is considered in the context of 'National Income Accounting'
Ex-post Investment: It refers to 'actual investment' in the economy during the period of one year.
Like actual saving, this aspect of investment is considered in the context of 'National Income
Accounting'. It includes both planned as well as unplanned investment.
[Note: Equilibrium GDP is struck only when Desired or Planned Saving = Desired or Planned
Investment. Equilibrium GDP has nothing to do with actual saving and actual investment.]
3. DETERMINATION OF EQUILIBRIUM OUTPUT (GDP)

OR EQUILIBRIUM INCOME
We have two approaches to study the determination of equilibrium
output (GDP) or equilibrium income:
(i) AS = AD approach, and
(ii) S = I approach.
In what follows, we discuss how equilibrium is determined using each
of these approaches:
Short Run Equilibrium Output 215

(i) AS = AD Approach and Equilibrium GDP
or Equilibrium Income
According to this approach, equilibrium GDP or equilibrium income
is achieved when AS = AD. We have already discussed the concepts
of AS and AD in the previous chapter. Only a brief description is
repeated as required in the context of equilibrium GDP.
AS
AS refers to planned output in the economy. As described in the
low
previous chapter, it is indicated by a 45 ° line from the origin. The
45 ° line indicates that AS and GDP are identical to each other. AS is
not related to price, as we are considering an economy where price
remains constant. It is an economy with excess capacity where AS
responds proportionately to AD and price remains unaffected.
ee
Thus, AS-function is drawn as in Fig 1.
rF
Fr
AS-function
y
or
DATA-SET
AS (orY) AS
sf
u
That Keynes related Y/GDP
his discussion on '> 0 0
o_
equilibrium GDP to a Q_ 30 30
k
::J
so so
Yo
situation when there is en
� so
oo
a severe depression in <U
the economy. In such a 0)
�
B
situation, there is a lack

of AD, and production
°'
0)
30
::;.
re
capacity remains en
<{
unutilised. The economy
would emerge out of
��-�-----------x
ou
ad
the state of depression

only when AD rises. AS 30 so
Y
would automatically Y (lncome)/GDP

respond to AD because
there is excess capacity
nd
Re
(unutilised capacity).
Thus, Keynes considers The figure shows that Y ( or GDP) and AS are identical to each other.
AD as the principal Thus, when Y = 30, AS is also = 30. Likewise, when Y = 50, AS is
Fi
determinant of
equilibrium GDP (as AS is also = 50. And so on.
perfectly elastic owing to
excess capacity).
AD
AD refers to desired expenditure (or planned expenditure) in the
economy during an accounting year. It has two components: desired
consumption expenditure and desired investment expenditure. Desired
investment expenditure is assumed to be autonomous, so that it is not
related to the level of income in the economy.

Desired consumption expenditure is related to the level of income:
there is a positive relationship between consumption (C) and income (Y);
C rises as income rises. However, there is always some minimum level
of C, independent of Y. Thus, C may be 30 when Y = 0. (This is just
an assumption that C = 30 when Y = 0.)
Based on this description, I-function, (-function and combined
C and I function are drawn as in Fig. 2, Fig. 3 and Fig. 4 respectively.
The combined C and I function is called AD-function.
I-function
y
w
.�
"'CJ
C
QJ
Q_
X
w
.....,
C
QJ
Autonomous I = 20
C at all levels of income
-20------------1
'-
0 ----------+X
Y (lncome)/GDP
• All investment is treated as autonomous investment.
I is not related to Y So that, I is drawn as a horizontal
straight line.
C-function
y
y
DATA-SET
'6100 y C
C
QJ 0 30
$- 80 20 40
w
C 40 50
.g 60 60 60
Q_
80 70
::::, 40 100 80
c:0 30
\:d, 20
u
--...�-.--.----r------- X
40 60 80
Y (lncome)/GDP
• OK is autonomous consumption(= 30.)
• C rises as Y rises.
• (-function is a straight line, implying that it is a linear
function.

C and I Functions Combined (AD-function)
y
DATA-SET
y C I C+l(=AD)
0 30 20 50
20 40 20 60
40 50 20 70
1 ----------------------------
....., 00
C 60 60 20 80
o(l 80 70 20 90
� 80 100 80 20 100
['.I! 120 90 20 110
'6 60 140 100 20 120
low
C 50
� 40 Autonomous C = 30
w 30 Autonomous I = 20
20----
, ---------I
Autonomous Expenditure
-� - � - � - - -----x = 30 + 20 = 50
o-- 04 60 80 100
ee
Y (lncome)/GDP
rF
Fr
• C and I functions are combined to get AD-function.
• Constant value of I(= 20) is added to different values
of C to get C + I.
• Example: I= 20, C = 30 so that C +I= 50. This is
or
when Y = 0.
Likewise, when Y = 100, then C= 80, I= 20 and
sf
u
C + I= 100. k
Yo
Equilibrium GDP or Equilibrium Income: Tabular Presentation
oo
Table 1 illustrates the equilibrium level of GDP in terms of the equality

B
between aggregate demand and aggregate supply.

re
Table 1. Equilibrium GDP in terms of Equality between

Aggregate Supply and Aggregate Demand
ou
ad
Income (GDP) C I C+ I(= AD)

Y
Y (t crore) (t crore) (t crore) (t crore)

0 30 20 50
nd
Re
20 40 20 60
40 50 20 70
Fi
60 60 20 80
80 70 20 90
100 80 20 100
120 90 20 110
- 140 100 -
20 120 -
Equilibrium is struck when planned output (AS)= planned expenditure (AD)

= � 100 crore. It need not necessarily correspond to full employment.

Equilibrium GDP or Equilibrium Income: Graphic Presentation
Fig. 5 illustrates the equilibrium level of GDP or equilibrium level of
Equil ibrium GDP/Income: AS = AD or Y = C + I
y
Y = AS
AD (C+I)
1 00 ----------------------------
DATA-SET
: I
'' 0 30 20
y C C + l (=AD)
0 80
so
' 20 40 20 60
<( '
vi 60 K ' 40 so 20 70
<( so ' 60 60 20 80
40 ' 80 70 20 90
'
' 1 00 80 20 1 00
20 '
' 1 20 90 20 1 10
lL 1 40 1 00 20 1 20
------------- x
0 20 40 60 80 1 00
Y (lncome)/GDP
e AD = C + I .
• OK · M i n i m u m level of expenditu re, i n c l u d i n g m i n i m u m C a n d
m inim um I .
• 45 l i n e : Y = A S .
°
• E q u i l i b r i u m is struck at point E, where AS = AD.

• E L is the desi red AD a s we l l a s desi red AS.
AD-line intersects the 45 ° AS-line at point E, so that E is the point

of equilibrium where AS = AD. OL is the equilibrium GDP in the
economy. Now, what the producers wish to produce is exactly equal
to what the households wish to buy in the economy. Or, that the
desired expenditure on output is equal to desired level of output = 100.
All output as planned by the producers is purchased by the buyers in the
economy. There are no unwanted or undesired stocks with the producers.
f>TS
Q. 1. Find equilibrium Y when : C = 100 + O.SY and I = 1 , 0 00 .
Ans. Eq u i l i briu m i s struck when:
Y = AD
Or, when Y =C+I
Substituting the va lues of C and I, we get:
Y = 10 0 + O.SY + 1 ,00 0
Or, Y - O.SY = 10 0 + 1 ,000
Or, 0.5Y = 1 , 1 00
, 100
Y = l = 2 ' 2 00 .
0.5
Q. 2. Find C at e q u i l ibri u m Y when : Y = 6,00 0 and C = 100 + 0 .75Y.
Ans. Given, C = 10 0 + 0.75Y
Or, C = 10 0 + 0.75 (6, 0 00 )
= 10 0
+ _J_i_ X 6,000
1 00
= 10 0 + 4,5 00 = 4,600 .

What happens if AS > AD?
When AS is more than AD (AS > AD), supply of goods and services
in the economy tends to exceed their demand. As a result, some
of the goods would remain unsold. To clear unwanted stocks, the
producers would plan a cut in production. Consequently, AS would
reduce to become equal to AD. This is how AS adjusts itself to
AD. Briefly, equilibrium is restored through a change in output or a
change in Y.
What happens if AS < AD?
low
When AS is less than AD (AS < AD), supply of goods and services
in the economy tends to be less than their demand. The existing
stocks of the producers would be sold out and the producers would
suffer the loss of unfulfilled demand. To rebuild the desired stocks and
ee
avoid the loss of unfulfilled demand, the producers would plan greater
rF
production. AS would increase to become equal to AD. This is how AS
Fr
converges with AD. Thus, equilibrium is restored through a change in
output or a change in Y.
or
(ii) S and I Approach and Equilibrium GDP
sf
u
or Equilibrium Income
k
Yo
According to this approach, equilibrium GDP or equilibrium income is
oo
achieved when S = I . We have already discussed S and I functions in

B
the previous chapter. A brief repetition is as under:

re
S-function
ou
We know, S = f(Y). S is positively related to Y. However at the

ad
lower level of income, S can be negative. Because, at lower level of

Y
income C may be greater than Y. S becomes negative to the extent

C > Y. We are considering a straight line 5-function called a linear
nd
Re
function.
Fi
I-function
As regards I-function, we are considering only autonomous I . It is
independent of the level of Y. Accordingly, it is a horizontal straight
line (shooting from the Y-axis).
Equilibrium GDP/Income: Tabular Presentation

Table 2 shows equilibrium GDP in terms of the equality between
S and I .

Table 2 . Equilibrium GDP/Income in terms of Equality
between S and I
Income (GDP) Consumption Saving Investment
(Y) (� crore) (C) (� crore) (S = Y - C) (� crore) (I) (� crore)
0 30 -30 20
20 40 -20 20
40 so -10 20
60 60 0 20
80 70 10 20
100 80 20 20
120 90 30 20
140 100 40 20
In Table 2, equilibrium is struck when:

S = I = �20 crore
Equilibrium Income (GDP) = �100 crore.
Equilibrium GDP/Income : Graphic Presentation

Fig. 6 shows S and I functions, and the equili brium GDP/ income.
y
80
C:
60
s
C:
40
K
g' 2 0
0 X
-3
Y'
• OK is consta nt i n vestment, i n d ependent of the level ofY.
• OK is -ve savi n g a n d is e q u a l to C when Y = 0.
• E i s the point of e q u i l i b r i u m where S = I .
• OT i s the eq u i l ibri u m i n come or e q u i l i bri u m G D P.
E is the point of equilibrium where S = I.

OT is the equilibrium GDP = 100.
Now, planned expenditure on output (AD) = planned output (AS)
in the economy, even when (owing to saving) entire income of the
households is not converted into expenditure. This is because loss
of expenditure by way of S is equally compensated by the gain of

expenditure by way of I . Income and expenditure being equal (or planned
output and expenditure on planned output being equal), there are no
unwanted or undesired stocks with the producers. Level of income/GDP is in
a state of equilibrium.
What happens if S > I?

In case S > I, it implies a situation when a fall in expenditure through 'S' is more
than the rise in expenditure through ' I '. Accordingly, aggregate expenditure in
the economy would be less than what is needed to buy the planned output.
Some output would remain unsold, and producers will have undesired stocks.
low
To clear their stocks, the producers would now plan lesser output. Lesser
output would mean lesser income. Lesser income would mean lesser saving.
The process would continue till S = I . Thus, the equality between S and I is
restored through change in the level of Y.
ee
What happens if S < I?
rF
Fr
In case S < I, it implies a situation when a fall in expenditure through 'S' is less
than the rise in expenditure through ' I '. Accordingly, aggregate expenditure
or
in the economy would be greater than what is required to buy the planned
output. It is a situation of higher AD than AS. The producers would suffer
sf
u
the loss of unfulfilled demand. This will prompt the producers to plan higher
output. Higher output would mean higher income, and higher income would
k
Yo
oo
mean higher saving. The process would continue till S = I . Here again, the
equality between S and I is restored through change in the level of Y.
B
re
Three Basic Assum ptions related to Equilibrium GDP

Three basic assumptions of the Keynesian theory must be noted:
(i) Short Period Analysis: Equilibrium GDP according to Keynesian theory is discussed only with
ou
ad
reference to short period of time. We have already discussed this assumption in detail in the
beginning of the chapter
Y
(ii) Two Sector Closed Economy: Initially, Keynes discusses the theory of equilibrium GDP in the
context of a two sector closed economy This is an economy which has no economic relations
nd
Re
with the rest of the world: there are no exports or imports. Also, there is no government sector,
so that taxes and subsidies are ruled out. Accordingly, AD = C + I (when only household sector
Fi
and producer sector are considered).

(iii) AS is Perfectly Elastic: Keynes assumes that AS is perfectly elastic. It means that we are
studying an economy in which there is an 'excess capacity': production capacity is lying
idle or there is unemployment of resources. So that, whenever there is a rise in AD, there is a
corresponding rise in AS (as excess capacity begins to be utilised). Thus, AS always aligns itself
with AD, without causing any change in the price level.

t>TS
Q. 1. Find equilibri u m S and equilibrium I when: Y = 4 , 4 00, M PC = 0.7 5 , and C = 10 0 .
Ans. Eq u i l i briu m is struck when:
Y =C+I
Or, when S =I
C at equilibri u m : C = C + M PC . Y
= 10 0 + 0.7 5 (4, 400)
= 10 0 + 3,300 = 3, 400
We know, M PS = 1 - M PC = 1 - 0.7 5 = 0 . 2 5
Thus, S at eq u i l i bri u m : S = - 100 + 0. 25 ( 4 , 4 00) (Note that, S = -c = - 100)
= - 100 + 1, 100 = 1,000
Alternatively: Y =C+S
S = Y - C = 4,400 - 3, 4 00 = 1,0 0 0
In equilibrium, S =I
We know, S = 1,0 00
Accordingly, I = 1,0 00
Q. 2 . Given that, S = -2 5 + 0.5Y and I = 5 ,0 00, find equilibri u m Y and equilibrium C.
Ans. In equilibri u m, S =I
So that, -2 5 + 0. 5 Y = 5 ,000
Or, 0. 5 Y = 5 ,000 + 2 5 => 0. 5Y = 5 , 02 5
5, 02 5
y = = 10, 0 50
0.5
S at e q u i l i b ri u m : S = -2 5 + 0. 5 ( 10, 05 0)
= -2 5 + 5 ,0 2 5 = 5 ,000
We know, Y =C+S
Or, C = Y-S
Thus, eq u i l i bri u m C = 10,0 5 0 - 5 ,000
= 5 ,0 5 0.
Q. 3. Given C = 4 0 0 + 0.9V and I = 4,000, find : (i) equilibri u m Y, (i i ) S and C at equilibrium Y.
Ans. Eq u i l i briu m Y is found when, Y = C + I
Su bstituting the va l ues, we get:
Y = 4 0 0 + 0.9Y + 4 ,00 0
Or, Y - 0 .9Y = 4 00 + 4, 000 => O. lY = 4, 4 00
4 , 4oo
Thus, Y = = 44' 000
0.1
C at equilibri u m : C = C + M PC . Y = 400 + 0 . 9 ( 4 4, 000)
= 4 0 0 + 39,60 0 = 40,00 0
S at e q u i l i b ri u m : S = -C + M PS . Y
= - 4 00 + 0 . 1 (44,000)
= - 4 00 + 4 ,400
= 4 ,0 00
Alternatively, i n equilibri u m, S =I
Since I = 4 ,000 (given), S m ust be equal to 4 , 00 0 .

4. SH I FT I N EQU I LI BR I U M:
I M PACT O F AD DITI O NAL I NVESTM ENT (Lil)
I ncrease in i nvestment causes increase in the level of AD. Accord ingly,
AD fu nction sh ifts u pward . Fig. 7 i l l ustrates how it i m pacts the
eq u i l i bri u m G D P.
I mpact of Increase in I nvestment (M) on Equilibrium GDP
y
AD 1 = C + I + M
low
AD = C + I
0
<i::
';2- F eq uili bri u m GDP
i ncreases from OJ to OK.
ee
rF
Fr
E
or
sf
u
"'---'---'_____.,______K._______ X
Y (l ncome)/GDP
k
Yo
• Point "A" indicates initial equilibrium w h e n AD = C + I
oo
and equilibrium GDP = OJ
• Point 'B" indicates equilibrium when AD = C + I + Lil and
equilibri u m GDP = OK. It shows the im pact of Lil.
B
re
OJ is the i n itial level of eq u i l i b ri u m G D P. D u e to add itional

i nvestm ent (M ) , the AD-fu nction sh ifts u pward . It is now indicated by
ou
ad
C + I + M . It causes an i ncrease in eq u i l i bri u m G D P from OJ to OK.

Y
Add itional Investment has Multiplier Effect

nd
Re
I n Fig. 7, owing to an add itional i nvestment (M), level of income

i ncreases from OJ to OK. I ncrease i n i ncome = JK. Com pare it with
Fi
the size of add itional i nvestment (M) = E F. You will find increase in
income is more than the increase i n i nvestment (J K > EF). Th is offers
the conclusion that add itional i nvestment carries a multiplier effect on
the level of GDP ( income or output) . Th is brings us to the concept of
m u lti pl ier.

5. INVESTM ENT M U LTIPLIER AN D ITS M EC HAN ISM
The Concept of Multiplier
We have seen how additional investment (M) causes additional
output (�Y) in the economy. We have noted that increase in output/
income (�Y) is many times more than the increase in investment (M).
The factor by which the increase in output/income is greater than
the increase in investment is called investment multiplier or output
multiplier. It is measured as the ratio between increase in output/
income and increase in investment.
Investment multiplier or output multiplier refers to the 'number of times by

which the increase in output/income (!l Y) exceeds the increase in investment (M)'. It F@C U S
is measured as the ratio between change in output/income and change in investment. ZO N E
Here, K = Multiplier
[ Ll Y = Change in output/income
K = �Y
M M = Change in investment. l
I l lustration
If investment increases by t 1 5 crore and as a consequence, income
increases by t 60 crore, it implies that increase in income (�Y) is 4 times
the increase in investment (M). Accordingly, multiplier ( K) = 4.
60 =
K = t:,,.y =
!:,,.I
4
15
Relationship between M ultiplier and

MPC (Marginal Propensity to Consume)
There is a direct relationship between multiplier and MPC. Higher the
value of MPC, higher the multiplier and vice versa . In fact, multiplier
is often estimated with reference to MPC, as under:
1
K = 1- MPC
This equation establishes a direct relationship between MPC and K .
I l l u stration
If MPC = 0.5,
And, if MPC is 0.8,

Thus, increase in MPC implies increase in the value of multiplier.

1
How do we find that K = _
1
t. Y
We know that, K = ill . (i)
We also know that, Y=C+I (in a state of equilibrium)
Accordingly, t.Y = t.C + Af
Or, Af = t.Y - t.C
(Here, Af = Change in investment; t. Y = Change in income; and t.C = Change in consumption.)
Putting the value of Af in equation (i), we get
t.
K = t. Y yt.C
-
low
Dividing right hand side of the equation by t. Y,
t. Y
K t. / yt. C =
=
+c
t. Y - t.Y l - t.Y
or K =
l _ �PC ( -. · MPG = �� )
Since MPC + MPS = 1 , o r MPS = 1 - MPC, we can also write that,
ee
K = MPS
7
rF
Fr
Implying that multiplier is the reciprocal of marginal propensity to save. Higher the value of MPS,
lower the value of K.
or
Let us understand the logic behind the direct relationship between
sf
u
MPC and multiplier. It runs like this:
k
Yo
• Additional investment (M) means additional expenditure in the
oo
economy; additional expenditure means additional income (�Y) in
B
the economy.
• Thus, if M = 100, then �Y = 100, as soon as investment expenditure
re
is incurred.
ou
• Let us take this �Y as increase in income in the round-1.

ad
• This �Y (= 100) would be split into �C and �S. Because a part of

Y
income is spent and a part of it is saved.

• In round-2, �C would be converted into �Y (because �C is
nd
Re
expenditure and expenditure causes income).

Fi
Here, comes an important point:

Higher value of MPC would mean higher �C.
Example: If MPC = 0.4, then �C = 0.4(100) = 40.
If MPC = 0.6, then �C = 0.6(100) = 60.
Accordingly, �Y in round-2 (which is equal to �C) would depend on
the value of MPC. Higher MPC would mean higher �Y.
• Conversion of �C into �Y continues in various rounds. And, in all
the rounds, higher MPC would cause higher �C and therefore,
higher �Y.

• Hence the conclusion that, higher the value of MPC, higher is the
generation of income caused by a given increase in investment. Or
that, higher the MPC, higher is the value of investment multiplier.
I
There are so many rounds of increase in income (f'.. Y) caused by increase in investment (M). In the
1st round, f'.. Y = M. But in each subsequent round, f'.. Y = f'..C. Since the value of f'..C depends on MPC,
we can conclude that higher MPC implies higher f'..C and, therefore, higher f'.. Y in different rounds
of income generation. Implying that, higher MPC causes higher value of investment multiplier. The
section on multiplier mechanism should explain this point further.
t>TS
Q. 1. I n an economy, government makes some additiona l investment. Find its va l u e when M PC = 0.5 and
increase i n income = t 1,000.
Ans. We know,
K ( m u lti p l ier) = !;
1
We a lso know that, K =
l - M PC
1
Substituting the va lue of M PC, K =
1 _ 0.5
= __!_ = 2
0.5
K = - and M = 1, 000
!::..Y
We know,
!::..I
1, 000
Thus, -- = 2
!::..I
1, 000
M = -- = 500
2
Additional investment by the govern ment = t 500.
Q. 2. If M PC = 0.75, how m uch additional i nvestment is req uired to i ncrease i ncome by t 600? Also, find the
m u lti p l ier.
Ans. K ( m u lti p l ier) = 1 _ �PC
1 -1-
= = =4
1 - 0.75 0. 25
K =�
!::..Y
We know,
So that,
!::..
M = Y
K
600
=
= 150
4
Thus, additiona l investment of t 150 is req u i red to increase i ncome by t 600 and the va l u e of
m u lti p l ier = 4.

Q. 3. Find M PC when i nvestment m u ltiplier = 1.
Ans. K ( m u ltip l ier) = 1 _
�PC
1
Given that, =1
1 _ M PC
=> 1 = 1 - M PC
=> M PC = 1 - 1 = 0
Thus, when K = 1, M PC = 0.
Q. 4. Find the val ue of m u lti plier when M PC = M PS.
Ans. We know, M PC + M PS = 1
When M PC = M PS, each para m eter m ust be eq ual to 0.5.
low
1 1
Now, K = M PS = O.S = 2 .
Multiplier Mechanism
ee
Table 3 illustrates the multiplier mechanism. It is based on the
rF
Fr
assumption that MPC = 0.5.
Table 3 . Multiplier Process (Assumption: MPC = 0.5)
or
Increase in Change in Induced Change Lea kage or
Round Investment Income (flV) in Consumption Saving
sf
u
Expend iture (� crore) (M PC = 0.5) (� crore)
(� crore) (� crore)
k
Yo
1 100 100 50.00 50 .00
oo
2 50 25 .00 25.00
B
3 25 12.50 12 .50
re
4 12.50 6.25 6.25

5 6.25 3 . 12 3.12
ou
3.12 1. 56
ad
6 1.56
7 1.56 0.78 0.78
Y
8 0.78 0.39 0.39

9 0.39 0.20 0.20
nd
Re
10 0 . 20 0 . 10 0 . 10
Fi
Tota l 100 200 100 100

(Figures approximated up to 2 deci mal points.)
(i) Table 3 shows that as a result of initial increase in investment
by � 100 crore, there is increase in income by � 100 crore in
round-1. Our assumption is that MPC is 0.5. Hence, because of
the increase in income by � 100 crore, consumption will increase
by � 50 crore and remaining � 50 crore will be saved.
(ii) In round-2 , because of expenditure of � 50 crore on consumption,
there will be an increase in income by � 50 crore. Now, �Y (= � 50
crore) would be split into �C = � 25 crore and �S = � 25 crore.

(iii) On account of increase in consumption expenditure by t 25 crore,
there will be increase in income by t 25 crore in round-3.
Now, AV (= t 25 crore) would be split into AC = t 12.5 crore and
AS = t 12.5 crore. Accordingly, in round-4 income will increase
by t 12.5 crore.
(iv) In different time periods, as shown in the table, income will go
on increasing as a result of increase in consumption expenditure.
Total increase in income = t 200 crore. Since, increase in
investment (AI) = t 100 crore, and increase in income (AV)
= t 200 crore, it follows that multiplier = 2.
ll.V 200
K = fl. = 100 = 2
I
1
Or, K = 1- MPC
1 = -1- =
2
1- 0.5 0.5
Obviously, higher MPC would have caused greater increase in income,
implying a higher value of multiplier.
Forward Action and Backward Action of Multiplier

Multiplier action is 'forward' when there is a multiple increase in
income caused by an increase in investment.
On the other hand, multiplier action is 'backward' when there is a
multiple decrease in income caused by decrease in investment.
Thus, if investment increases by t 100 crore and MPC = 0.5, there
will be increase in income 2 times the increase in investment. This is
forward action multiplier.
AV = KAI
= 2(100) = 200
1
K = 1 - MPC
1 = -1- =
2
1- 0.5 0.5
On the other hand, if investment decreases by t 100 crore and MPC
= 0.5, there will be decrease in income 2 times the decrease in
investment. This is backward action multiplier.

AV = K ( -AI )
= 2(- 100)
= -200

1
K = 1 - MPC
1 = -1- = 2
1 - 0.5 0.5
Briefly, in case of forward action multiplier, the equilibrium level
of income increases, and in case of backward action multiplier, the
equilibrium level of income decreases.
t>TS
Q. 1. B riefly explain the m u ltiplier p rocess.
low
Ans. The working of the m ultip l ier assum es the following process:
ee
rF
Fr
M ------• M ------• LiC ------• M
Cha nge i n investment ca uses cha nge i n income . As a result, there is change in con s u m ption.
or
Consum ption expend itu re of one person is a n i ncome of the other. H ence, change i n consum ption
leads to cha nge in i ncome. This process continues ti l l LiC red uces to zero. M PC is the core factor in the
sf
u
process of income generation. H igher the M PC, g reater is the conversion of income into consu m ption
expenditure. Accord ingly, greater is the generation of income. Beca use, ultimately it is expenditure
k
Yo
which is converted into income. Expenditu re is a n injection into the i ncome generation process,
oo
saving is a leakage.
B
Q. 2. What will be the va lue of m u ltiplier if entire additiona l income is converted into additiona l
con s u m ption?
re
Ans. I n such a situation, LiC = LiY (or cha nge in consumption = cha nge i n income) or that
Li( = 1
ou
M PC = -
ad
Y
Accordingly, K (or m u ltiplier) wou ld be:

1 =- 1-= -
1 oo
K = =
nd
Re
1 - M PC 1 - 1 0
The m u ltiplier va l u e wou l d tend towa rds i nfi nity.
Fi
Q. 3. In an economy i nvestment expenditure increased by t 400 crore and m a rginal p ropensity to consume
is 0.8. Ca lcu late increase in i ncome and i ncrease in saving.
1 1 1
Ans. M u ltiplier ( K ) = = --- = -- = s
1 - M PC 1 - 0.8 0. 2
M PS = 1 - M PC = 1 - 0.8 = 0.2
I ncrease i n I ncom e = K x Lil = 5 x 400 = t 2,000 crore .
I ncrease i n Saving = M PS x Li Y = 0.2 x 2,000 = t 400 crore.

Power Poi nts & Revision Wi ndow ----------------
Equi l ibrium Output i m p l ies e q u i l i b r i u m i n co m e as wel l as eq u i l i b ri u m e m ployment. It a lso i m plies
j 1 e q u i l i b r i u m G D P w h e n we a re consideri ng a closed economy.

Equi l i brium is Struck when AS = AD ( i m plyi ng that p l a n n e d output = p l a n ned dema n d ) .
O r, w h e n S = I ( i m plyi ng that p l a n n e d savi n g = p l a n ned i nvest m e n t ) .
Equilibrium Situation is that situati o n w h e n w h a t is plan ned t o be prod u ced is exactly e q u a l to
what p l a n n e d to be pu rchased d u ri ng a given period of ti m e . The prod ucers do not suffer: ( i ) t h e
loss d u e t o excess stocks, or ( i i ) t h e l oss d u e t o lack o f stocks. W h e n AS = A D : act u a l stocks (with
prod u ce rs) = desired stocks (with prod u ce rs) .
Adjustment Mechanism: W h e n AS > AD o r when AD > AS, the eq u i l i b ri u m is restored t h rough cha nges
i n AS ( p l a n ned output), as it is assu med to be pe rfectly elastic, owi n g to the existen ce of excess capa city
in the eco n omy.
Shift in Equ i l ibrium occ u rs when add iti o n a l i nvestment ca uses i n c rease in the l eve l of i ncome t h rough
l a n u pwa rd s h ift i n AD.

Additional investment has a m u lti p l ie r effect on the l evel of i nco m e . Add iti o n a l i nvestment ca uses a
positi ve m u lti p l i e r effect o n the l evel of i ncom e .
l nvestment M u lti plier is the rati o between cha nge i n i n m e a n d cha nge i n i nvestment.
�Y
K=
] Af
{ H e re, K = M u lti p l i e r; /'1Y = Cha nge i n i n co m e; /'1I = Cha nge i n i nvestment . )
Relation between M ultiplier a n d M PC: M u lti p l ie r is positi ve ly related t o M PC ( o r i nversely
re lated to M PS ) . H igher t h e M PC, h i g h e r the m u lti p l i e r and sma l l e r the M PC, s m a l l e r t h e
m u lti p l ie r w i l l be. Th us,
K = ---
1 - M PC
1
M PS
I nvestment M u ltiplier Works through Change i n Consu mption: I n iti a l i n c rease i n i n co m e
d u e t o i n iti a l i nvest m e n t expe n d itu re ca uses i n c rease i n co nsu m pti o n w h i ch ( because it is a n
expe n d i t u re) beco m e s some body's i n co m e aga i n . S o greater t h e a d d iti o n a l consu m pti o n (/'1C)
out of a d d iti o n a l i n come (/'1Y), greate r is the ge n e ratio n of i n co m e . O r, greate r the m a rg i n a l
propensity t o consu m e {1'1C/1'1Y), greate r wi l l be the va l u e o f the m u lti pl i e r.
Forward and Backward Action of the Multiplier: I nvestment m u lti p l i e r works both ways, positive and
n egative .
( i ) Add itional i nvestm ent ca uses m u l ti p l e i n c rease i n i n co m e . This is fo rwa rd action of the m u lti p l i e r.
( i i ) Decrease i n i nvestment ca uses a m u lti p l e decrease i n i ncome. This is backwa rd action of the
m u lti p l ier.

rEX E RC I S Ej
1 . O bjective Ty pe Quest i o n s (Remembering & U n d e rsta n d i n g based Q uest i o n s)
A . M u lt i p l e C h o i ce Quest i o n s
Choose t h e correct option :
1. Si nce AS = C + S a n d AD = C + I, the eq u i l i brium w i l l be esta blished where C + S = C + I, or where:

(a) s = I (b) s > I
low
(c) S < I ( d ) a l l of these
2 . Eq u i l i bri u m level of i ncome/output and employment is viewed from which of the fol l owing
a p p roaches?
(a) AS = AD a p p roach ( b ) S = I a p p roach
(c) Both (a) and ( b ) ( d ) None o f these
ee
(a) a closed economy
rF
3 . Keynes th eory of GDP determ i n ation is based on the assu m ption of:
( b ) short pe riod a n a lysis
Fr
(c) AS is pe rfectly elastic ( d ) all of these
or
4. O n acco u nt of a n i njection of aggregate demand, eq u i l i b ri u m level of i ncome:
(a) increases (b) decreases
(c) rem a i n s constant (d) none of thesesf
u
5 . If aggregate demand i ncreases, aggregate s u p p ly wi l l i ncrease o n ly when th ere is:
k
(a) excess capacity
Yo
oo
(b) u n d e r uti l i sation of the existing resou rces
(c) over uti l i sation of the existing resou rces
B
(d) both (a) and ( b )

re
6. I ncrease i n t h e level o f em p loyment leads t o proportionate i n crease i n output, beca use:

(a) more efficient technology is used ( b ) technology re m a i n s constant
ou
ad
(c) l ess efficient technology is used (d) none of these

Y
7 . Keynes d iscusses eq u i l i bri u m level of output, using the concept of:

(a) autonomous i nvestment ( b ) i n d uced i nvestment
nd
(c) both (a) a n d ( b ) ( d ) none o f these

Re
Fi
8. I nvestment which is ind ependent of the level of income is ca l le d :

(a) autonomous i nvestment
(b) i n d u ced i nvestment ( i nvestment as i n d uced by the leve l of GDP i n the economy)
(c) fixed i nvestment
(d) i nve ntory i nvestment
9. Ex-a nte savi ng refers to:
(a) desired savi ng d u ring the pe riod of one yea r
(b) p l a n ned savi ng d u ri n g the period of one yea r
(c) actual savi ng d u ring the pe riod of one yea r
(d) both (a) a n d ( b )

10. M u lti plier =
ll. fl.y
(a) Y (b)
ll.S fl. I
fl. I fl.y
(c) (d)
ll.Y ll.C
11. If M PC = 0.9, then va lue of m u lti plier wi l l be:
(a) 6 (b) 9
(c) 10 (d) 12
12. M u lti plier is esti mated as:
1 1
(a) (b)
M PC 1 - M PC
1 1
(c) (d)
+
l M PC 1 - M PS
13. If M PS = !, the va l u e of m u ltiplier will be:
(a) 4 (b) 2
(c) 8 (d) 6
14. If M PC = 0, the m u lti p l ier will be:
(a) 1 (b) 0
(c) 2 (d) OC)
15. If M PC increases, va l u e of m u ltiplier wi l l :

(a) i ncrease ( b ) decrease
(c) rem a i n consta nt (d) i ncrease as much as the i ncrease in M PC
16. If m a rgi nal propensity to save d ecreases, the va l u e of the m u lti plier wi l l :
(a) i ncrease (b) decrease
(c) rem a i n consta nt (d) decrease as much as the decrease in M PS
17. If M PC = M PS, the va l u e of m u lti plier w i l l be:
(a) 0 (b) 1
(c) 2 (d) OC)
18. If enti re additional i ncom e is converted i nto additional cons u m ption, the va l u e of m u ltipl ier will be:
(a) 2 (b) 0
(c) 1 (d) OC)
19. If i nvestment increases from 400 to 550 a n d i ncome increases fro m 900 to 1,650, the M PS should
be equ a l to:
(a) 0 . 1 ( b ) 0.2
(c) 0.3 ( d ) 0.4
20. If i ncom e i ncreases from 2,500 to 3,900, a n d a utonomous i nvestment increases by 350, the M PC
should be:
(a) 0.9 ( b ) 0.8
(c) 0.75 ( d ) 0.6
Answers
1 . (a) 2 . (c) 3. (d) 4. (a) 5. (d) 6. ( b ) 7. (a) 8. (a) 9. ( d ) 10. (b)
1 1 . (c) 12. (b) 13. (a) 14. (a) 15. (a) 16. (a) 17. ( c ) 18. ( d ) 19. ( b ) 2 0 . (c)


1. refe rs to the desired l eve l of output i n the economy.
(Aggregate d e m a nd/Aggregate s u p p ly)
2. Eq u a l ity between AS a n d AD i m p l ies the eq u a l ity between . (Y a n d AD/Y a n d AS)
3 . When AS AD, actua l stocks with the p rod ucers is
= desired stocks with the
p rod ucers. (equal to/greate r tha n )
4. Ex-post i nvestment refers to i nvestment in the economy d u ring the period of
one yea r. (actua l/p l a n ned)
low
5 . K eynes d iscusses the theory of eq u i l i bri u m GDP i n the context of a n economy i n a state of
demand. (deficie nt/excess)
6. Owi ng to an additi o n a l i nvestme nt, l eve l of i ncome ( i n c reases/decreases)
7. M u lti plier =
( M�C / 1 - � PC )
ee
8. M u lti plier action is when there is a m u lti p l e i ncrease i n i ncome ca used by an
rF
Fr
increase i n i nvestment. (forwa rd/backwa rd )
9 . M u lti plier is the of m a rg i n a l p ropensity to save .
( reci p rocal/perce ntage expression)
or
10. When the leve l of savi ng increases by � 300 cro re a n d i ncome increases by � 900 crore, va l u e of
sf
u
m u lti p l i e r wi l l be (2/3)
k
Yo
oo
Answers
1. Aggregate supply 2. Y a n d AD 3 . equ a l to 4. actual 5. d eficient
B
1
6. increases 7. 8. forwa rd 9 . reciproca l 10. 3
1 _ M PC
re
ou
ad
C. True or Fa lse
Y

1. When Y > AD, the p rod ucers suffer l osses because of excessive stocks. (Tru e/Fa lse)
nd
Re
2. In the context of eq u i l i bri u m G D P, desired i nvestment expe n d itu re is

assumed to be a utonomous. (Tru e/Fa l s e )
Fi
3 . The 45 line i n d i cates that AS a n d GDP a re ide ntical to each other.

°
(Tru e/Fa lse)
4. S < I i m p l ies a situation when a fa l l i n expe nd itu re t h rough 'S' is l ess
than the rise in expe n d itu re t h rough 'I'. (Tru e/Fa l s e )
5 . An open economy has no economic re lations with rest of the world . (Tru e/Fa lse)
6. If M PC = 0.5, va l u e o f m u lti p l i e r wi l l b e 2 . (Tru e/Fa lse)
7. H igher M PC ca uses higher va l u e o f i nvestment m u lti pl i e r. (Tru e/Fa lse)
8. When i nvestment m u lti pl i e r is 1, the va l u e of m a rgi n a l p ropensity
to consu m e is a lso e q u a l to one. (Tru e/Fa lse)

9 . Autonomous i nvestment cu rve is a vertica l stra ight l i n e s hooti ng from the X-axis. (Tru e/Fa lse)
10. In case of backwa rd action m u lti p l i e r, the eq u i l i bri u m l evel of i ncome decreases . . (True/Fa lse)
Answers
1. Tru e 2. Tru e 3 . True 4. Tru e 5 . Fa lse 6. Tru e 7. Tru e 8. Fa lse 9. Fa lse 1 0 . Tru e
D. M atch i n g t h e Correct Statements
Col u mn I Colu mn I I
(a) AS < A D ( i ) S o m e o f t h e goods would re main u n sold
(b) Eq u i l i brium G D P ( i i ) Ex-a nte investment
(c) Pe rfectly el a sti c AS ( i i i ) No excess ca pacity in the economy
(d) Savi ng ( iv) Negatively related to i ncome
1
(e) Multi plier (v)
1 - M PS
Answer
(b) Equ i l i briu m G D P -(ii) Ex-a nte i nvestment
items in Column I:
Col u mn I Colu mn I I
(a) Ex-a nte savi ng (i) P l a n ned output
(b) Mu l ti plier (ii) AS = AD
(c) Aggregate supply ( i i i ) Mu lti plier = 5
(d) Eq u il i b ri u m income ( iv) Desired saving
M
SI
(e) MPC = 0 . 8 (v) -
Answers
(a) - (iv), ( b) -( v), (c) - (i), (d ) - (ii), (e) - (iii)
E . 'Very S ho rt Answe r' Objective Type Questions

1. G ive the mea n ing of aggregate demand.
Ans. Aggregate d e m a n d is the tota l demand for goods a n d services i n a n economy, meas u red i n terms of
tota l expenditure .
2. Define aggregate supply.
Ans. Aggregate s u p ply refers to p l a n ned output i n the economy. Th is is the output which the prod ucers
wish to p rod uce d u ring a n accou nti ng yea r.

3 . H ow do you defi n e eq u i l i bri u m level of i n come?
Ans. Eq u i l i b r i u m l evel of i n come is that level of i n come where AS = AD. Also, eq u i l i b ri u m i n come is struck
when S = I.
4. What is a utonomous i nvestment?
Ans. Autonomous i nvestment refe rs to i nvestment which is i n d e pend ent of the rate of i nte rest and the
l evel of GDP i n the economy.
5 . What is mea nt by ex-a nte i nvestment?
Ans. Ex-a nte i nvestment refers to desi red (or p l a n n e d ) i nvestment corresponding to d iffere nt i ncome
l evels i n the economy.
6. What is meant by ex-post i nvestment?
low
Ans. Ex-post i nvestment refe rs to actua l i nvestment in the economy d u ring the period of one yea r.
7. What a re 'd esi red stocks' with the p rod ucers?
Ans. Des i red stock is that leve l of stock where AS = AD and the prod ucers a re in a state of eq u i l i bri u m .
8. What a re 'actual stocks' with t h e p roducers?
Ans. Actual stocks i n c l u d e both desired as wel l as u ndesired stock. It ca n be ca l c u l ated as:
ee
Closing stock - Open i ng stock
rF
Fr
9 . When a re actual stocks greater than the desired stocks?
Ans. When aggregate d e m a n d fa l l s short of the expectations of the prod ucers, a n d some output re m a i n s
or
u nsol d .
1 0 . W h e n a re actual stocks less than t h e desired stocks? sf
u
Ans. When aggregate s u p ply fa l l s short of aggregate demand, a n d the producers suffe r a l oss d u e to
u nfu lfi l led d e m a n d .
k
Yo
oo
11. Define investment m u lti p l ier.
Ans. I nvestment m u l ti p l i e r is the ratio of a cha nge i n i n come to a given cha nge i n i nvestment.
B
12. G ive a formula of multiplier.

re
Ans. M u lti pl i e r ( K ) = :; .
ou
ad
1 1
Also, K = 1 - M PC = M PS .
Y
13. If the va lue of m u lti p l ier is 4, what will be the effect on the i ncom e of a n economy if i nvestment
nd
i ncreases by � 100 crore?

Re
Ans. I n come w i l l i ncrease by � 400 crore .

Fi
1 4 . If m a rgi nal propensity t o save is 0.25, h o w m a ny ti mes will income i ncrease i n response t o a given
i ncrease i n investment?
Ans. 4 ti mes.
15. If m a rgi nal propensity to consume is 0.5, what will be the va lue of the m u lti p l ier?
Ans. M u lti pl i e r = 2 .
1 6 . F i n d out t h e va lue o f t h e m u lti p l ier, i f M PC is zero.
Ans. M u lti pl i e r = 1 .
2. Reason-based Questions (Comprehension of the Subject-matter)
Read the fol l owing statements ca refu l l y. Write True or Fa lse with a reason .
1. I ncrease i n i nvestment causes a backwa rd shift i n the equ i l i briu m level of income and output.
Ans. Fa lse. I ncrease in i nvestment ca uses increase in AD. Accord i ngly, it wou l d lead to a forwa rd sh ift i n
t h e eq u i l i b ri u m leve l o f i n come a n d output.
2. I n case AS = AD, there is a n obvious equ a l ity between S a n d I.
Ans. True. The e q u a l ity between AS a n d AD i m p l ies the e q u a l ity between S a n d I. Accord i ngly, there is
o n ly one level of eq u i l i b r i u m output when AS = AD a n d S = I.
3 . Ex-post i nvestment ca nnot be less than ex-a nte i nvestment.
Ans. True. Because, ex-post i nvestment includes investment both i n desired as wel l as u ndesired stocks (with
the producers) while ex-a nte investment i ncludes investment only in desi red stocks.
4. In the context of eq u i l i bri u m G D P, desired AS = d esi red AD.
Ans. True. Eq u i l i bri u m G D P is achieved where desired AS = desired AD. Actual AS is always eq u a l to actua l
AD, as i n nati o n a l i n come accou nti ng.
5 . Actual AS is a l ways eq u a l to actual AD.
Ans. True. Beca use i n the esti m ation of act u a l AD, we assume that u nsold stocks a re p u rchased by the
p rod ucers themselves. In other words, u nsold stocks a re treated as i nve ntory i nvestment of the
p rod ucers.
6. The p rod u cers suffer losses when actual stocks a re less than the desi red stocks.
Ans. True. When the act u a l stocks a re l ess than the d es i red stocks, the prod ucers suffe r the loss of
u nfu lfil led dema n d .
7. M u ltiplier p rocess assu mes t h e existence o f excess ca pacity i n t h e economy.
Ans. True. Without excess capacity, output ca n not i ncrease i n res ponse to the i ncrease i n i nvestment
d u ring the short period .
8. There is a d i rect relationsh i p between M PC a n d va l u e of i nvestment m u lti p l ier.
Ans. True. The re is a d i rect relationship between M PC a n d va l u e of i nvestment m u lti p l i e r. H igher the va l u e
o f M PC, h i g h e r t h e i nvestment m u lti plier a n d vice versa. Beca use,
1
K = 1 - M PC
9. Eq u i l i bri u m level of output increases proportionate to the i ncrease i n i nvestment i n the economy.
Ans. Fa lse. I ncrease i n i nvestment has a m u lti p l i e r effect on the eq u i l i bri u m l evel of output. Accord i ngly,
output increases p roportionately greate r than the i ncrease i n i nvestment.
10. I n the Keynesi a n model of eq u i l i bri u m G D P, AS is assumed to be pe rfectly elastic.
Ans. True. In the K eynesian model of eq u i l i b r i u m G D P, AS is assu med to be pe rfectly elastic, i m p lying that
AS coi n cides with AD at all l evels of AD.
1 1 . I n the Keynesian model, short period eq u i l i bri u m is d iscussed with reference to consta nt price leve l .
A n s . True. Price l evel rem a i n s constant beca use K eynes ass u m es that A S is pe rfectly elastic owing t o the
existen ce of excess ca pacity.
12. Output a lways i ncreases when AD i ncreases.
Ans. Fa lse. In res ponse to i ncrease in AD, output increases only ti l l fu l l e m p l oyment eq u i l i b ri u m is struck
i n the economy.
13. If I > S, level of Y m u st rise.
Ans. True. When I > S, it i m p l ies that AD > AS. It wi l l lead to a rise in the level of output. But only up to the
point of fu l l e m p l oyme nt, or only ti l l the existen ce of excess ca pacity in the economy.

14. Eq u i l i bri u m G D P refers to a situation when : actual stocks = desired stocks.
Ans. True. Eq u i l i bri u m G D P is atta i ned when act u a l stocks = desired stocks . It i m p l ies that the prod ucers
do not suffer the b u rden of u nwa nted stock or the loss of u nfu lfi l l ed d e m a n d .
15. Eq u i l i bri u m G D P refers t o a situation when : i njections = withdrawa ls.
Ans. True. Eq u i l i b r i u m GDP is achieved when S = I. Since S refers to withdrawa l of expe nd itu re ( known
as withdrawa l i n terms of S) from the circu l a r flow a n d I refe rs to i njection of expen d itu re i nto the
c i rcu l a r flow. At the point of eq u i l i briu m, i njections = withdrawa l s .
1 6 . Perfectly elastic A S m e a n s A S adjusts itself t o a l l levels o f AD.
Ans. True. Perfectly elastic AS i m p l ies that whenever AD is greater than or less than AS, it is AS that adj u sts
itse lf to AD to restore the eq u i l i b ri u m . Adj ustment of AS becomes poss i b l e beca use of the existence
of excess capacity i n the economy.
low
17. Autonomous i ncrease i n i nvestment a lways ca u ses a n a utonomous increase i n i ncome.
Ans. Fa lse. W h i l e i nvestment is a utonomous, increase i n i n come is i n d uced t h rough i ncrease i n expe nd itu re
which depends u pon the m a rginal p ropensity to consume.
18. Va l u e of m a rginal p ropensity to save a n d i nvestment m u ltiplier a re i nversely related .
Ans. True. M a rgi n a l p ropensity to save ( M PS) a n d m u lti p l i e r a re i nve rsely related . H igher the M PS, l owe r
ee
the m u lti p l i e r a n d lower the M PS, h igher the m u l ti p l i e r, as K = .
rF M�S
Fr
19. Zero M PC i m plies zero m u lti p l ier.
Ans. Fa lse. Beca use M u lti pl i e r ( K )
1 _ � PC
=
or
1 1
When : M PC = O , K = -- = - = 1 sf
u
1-0 1
The refore, when m a rgi n a l propensity to consume ( M PC) is zero, the va l u e of m u lti p l i e r w i l l be one.
k
Yo
It means that i ncrease i n i ncome w i l l j u st be e q u a l to increase i n i nvestment.
oo
20. When i nvestment m u lti plier is 1, the va l u e of m a rginal p ropensity to consume is a lso 1.
B
Ans. Fa lse. When i nvestment m u lti p l i e r is 1, m a rginal p ropensity to consume is zero. This is beca use:
re
M u lti p l i e r ( K )
l - �PC
=
G iven K 1, we may write that

ou
ad
1
1 - M PC l
Y
1 1 - M PC
nd
Re
M PC = 1-1 = 0
Fi
21. Va l u e of i nvestment m u lti plier va ries between zero a n d infinity.

Ans. Fa lse. Va l u e of i nvestment m u lti p l ie r va ries between one a nd i nfi n ity. The m i n i m u m va l u e of
i nvestment m u l ti p l i e r is 1. It ca n neve r be less than one beca use M PC is neve r negative . At least it
is = 0, and at most it is = 1 .
I n case M PC = 0,
1 1 1 =
I n case M PC = 1, K 1 - M PC 1-1 o oo
= = =
So that, va l u e of K ( m u lti p l ier) always va ries between 1 a n d CXJ.

22. If the ratio of m a rginal p ropensity to cons u m e a n d m a rgi nal propensity to save is 8 : 2, the va l u e of
i nvestment m u lti p l ier will be 4.
Ans. Fa lse. Beca use, if the ratio of margi nal propensity to consume and m a rginal propensity to save is
8 : 2 (or 4 : 1), M PC wi l l be 0.8 a n d M PS = 0.2 ( beca use M PC + M PS = 1 and M PC is 4 ti mes M PS). I n
such a case,
1
K = 1 - M PC
_1_ _1_
= = =5
1 - 0.8 0 . 2
Deta ils:
Let us ass u m e t h a t M PC = 4x and M PS = lx, as ratio o f M PC and M PS = 4 : 1 .
W e know,
M PC + M PS = 1 => 4x + lx = 1
1
=> 5x = 1 => x = - = 0 . 2 ( i m plying M PS = 0.2)
5
Accordingly, M PC = 4 x 0.2 = 0.8.

1. In a situation when planned S > planned I, i nventory i nvestment of the prod ucers is expected to be
l a rger than d esi red . Do you agree?
Ans. When plan ned S > plan ned I, some output wou l d rem a i n u nsold a n d p rod ucers wi l l have u ndesired
stock of goods. H e nce, the given statement is correct.
2 . H igher saving i n d uces greater i nvestment. Com ment.
Ans. The given statem e nt is incorrect. Accord i ng to K eynes, savi ng ca uses a leakage i n the c i rcu l a r flow of
income. H igher saving implies lower consumption which reduces the inducement to invest.
3. Is actual stock equ a l to d esi red stock with the p roducers only in a state of fu l l e m ployment?
Ans. N o, eq u a l ity between desired stock and actual stock with the prod ucers refe rs to the state of
eq u i l i bri u m where AS = AD. This may occ u r with or without the state of fu l l e m p l oyment.
4. Is it correct that a tax on the households red u ces their M PC?
Ans. N o, it is not correct. A tax on the households o n ly red u ces their d isposa b l e i ncome.
5 . If I < S, AS tends to contract. Defend or refute.
Ans. The above state ment is correct. When I < S, prod ucers will have u ndesired stock. In o rder to clear
their stock, the prod ucers would l i ke to prod uce less output implying AS tends to contract.
6. Is S a l ways a vi rtue, as it is a sou rce of i nvestment?
Ans. Saving is not always a vi rtue. Savi ng is a vice as we l l . I ncreasing S ca uses a cut in con s u m ption
expend itu re. I m plying a cut i n AD. Accord i ngly, economy may be d rive n i nto a state of
u nd e re m p l oyme nt/u n e m p l oyment.
7 . Do yo u agree that by ra ising the level o f i nvestment i n the economy, the govern ment i nte nds to
ra ise the va l u e of output m u lti p l ier?
Ans. N o, by ra ising the level of i nvestment, the government i ntends to i ncrease the leve l of AD i n the
economy. That has not h i ng to do with the m u lti p l ier wh ich, i n tu rn, depends on m a rg i n a l propensity
to cons u m e of the cons u m e rs. Hence, the given state ment is i ncorrect.
8. Why do we consider i m po rts as a negative com ponent of AD?
Ans. I m ports a re considered as a negative component of AD, beca use i m po rts a re opposite of exports
which is a positive com ponent of AD.

9 . I n a n economy i ncome i ncreases by � 10,000 as a resu lt of a rise in i nvestment expenditu re by
� 1,000. Ca lculate:
(i) I nvestment m u lti p l ier.
(ii) M a rginal p ropensity to consu me.
Ans. G iven, i ncrease i n i ncome (AV) = � 10,000
I ncrease in i nvestment expend itu re (AI) = � 1,000
( i ) We know,
l:!.V 10, 000
I nvestment m u lti p l i e r ( K ) = � = OOO = 10
l,
1 1
( i i ) We a lso know, K = 10 =
low
1 - M PC
=> 1 - M PC
1
1 - M PC = - => 1 - M PC = 0. 1
10
=> M PC = 1 - 0. 1 = 0.9
ee
( i ) I nvestment m u lti pl i e r = 10.
rF
Fr
( i i ) M a rgi n a l propensity to consu m e = 0.9.
10. I n a n economy, 75 per cent of the i ncrease i n income is spent on consu m ption. I nvestment is
i ncreased by � 1,000 crore. Ca lculate :
or
(i) Tota l i ncrease i n i ncome.
sf
u
(ii) Tota l i ncrease i n cons u m ption expenditure.
Ans. (i) 75 per cent of the i ncrease in i n come is s pent on cons u m pti o n .
k
Yo
l:!.C 75
M PC = 0.75
l:!.V = l OO =
oo
l l 1-
B
M u lti p l i e r ( K ) = -
= = =4
l _ M PC 1 - 0.75 0.25
re
l:!.V
W e know, K=
l:!.I
ou
ad
=> AY = K x AI
Y
=> AV = 4 x 1,000 = 4,000

( i i ) I ncrease in con s u m ption expe n d itu re (AC)
nd
Re
= M PC x AV
!cV , so that AC = M PC x AV)
Fi
= 0.75 x 4,000 ( " . " M PC =

75
= 4,000 = 3,000
l QO X
( i ) Tota l increase in i n come = � 4,000 crore .
( i i ) Tota l increase i n consu m ption expend itu re = � 3,000 crore.
11. If a utonomous expend itu re by the govern ment increases by � 5,000, find i ncrease i n equ i l i b ri u m
G D P when half o f i ncom e i s a l ways spent on the p u rchase o f goods for consu m ptio n .
1
Ans. AV = x AA
l M PC
-
(where A is autonomous expend itu re by the government)

If h a lf of i ncome is always s pent on the p u rchase of goods for con s u m ption, it i m p l ies that M PC = 0 . 5 .
Th us,
1 5, 000
AV =
1 - 0 .5
x 5, 000 = = 1 0, 000
o.s
I ncrease in eq u i l i bri u m G D P = � 1 0, 000 .
12. Find i ncrementa l i nvestment when eq u i l ibrium G D P i ncreases by � 50,000 a n d half of a d d itional
i ncome is a l ways saved i n the economy.
Ans. Cha nge i n savi ngs = 5 0 , 000 x � = 25, 000
dS 25, 000
We know, M PS = = 0 .5
dY 5 0 , 000
=
l
We know, M u lti p l i e r ( K ) = =
l - �PC M PS
dY
O r, K=
di
dY
N ow, M PS = 0 .5, we get LH =
dK
5 0, 000
2
= 25, 000
I ncrease in G D P by � 5 0 , 000 is ca used by i ncrease in i nvestment of � 25, 000 .

13. The savi ng fu nction of a n economy is S = -200 + 0.25V. The economy is i n eq u i l ibrium when income
is eq ual to � 2,000. Calculate:
( i) I nvestment expenditure at eq u i l i bri u m level of i ncome.
( i i) Autonomous consu m ption.
( i i i) I nvestment m u l ti p l ier.
Ans. ( i ) G iven, S = -2 00 + 0 .25V
I ncome (Y) = � 2, 000
At the eq u i l i b ri u m leve l, S =I
-2 00 + 0 . 25V =
I
I = -2 00 + 0 .25 (2, 000 )
I = -2 00 + 5 00 = 3 00
(ii) At Y = 0 , S = -2 00 + 0 .25 ( 0 )
-S -2 -
= 00
Autonomous con s u m ption (C) = - (S)

= - (-2 00 ) = 2 00
1
(iii) I nvestment m u lti p l ier ( K ) =
1 _ �PC = M PS
1
K = 0 .25 = 4 ( M PS = 0 .25)
(i) I nvestment expe nd itu re at eq u i l i b r i u m level of i ncome = � 3 00 .
(ii) Autonomous consu m ption = � 2 00 .
(iii) I nvestment m u l ti pl i e r = 4.

14. I n a n economy the consu m ption fu nction is C = 500 + 0.75V where C is consu m ption expend iture
a n d Y is i ncome. Calculate the eq u i l ibrium level of i ncom e a n d consu m ption expend itu re when
i nvestment expend itu re is � 5,000.
Ans. G ive n, C = 5 00 + 0 .75V
I nvestment expend itu re (I) = � 5, 000
At eq u i l i bri u m , Y =C+I
Y = 5 00 + 0 .75V + 5, 000
Y = 5,5 00 + 0 . 75V
Y - . 75V = 5,5 00
0
0 . 25V = 5,5 00
5, 5 00
low
Y = 0 = 22, 000
.25
When Y = 22, 000 , C = 5 00 + 0 .75 (22, 000 )
= 5 00 + 16,5 00 = 17, 000
Eq u i l i bri u m l evel of i ncome � 22, = 000 .
ee
Eq u i l i bri u m l evel of consu m ption expenditu re = � 17, 000 .
rF
15. I n a n economy S = -50 + 0.SY is the savi ng fu nction (where S = savi ng a n d Y = national i ncom e) a n d
Fr
i nvestment expend itu re is � 7,000. Ca lcu late:
(i) Eq u i l ibrium level of national i ncome.
or
( i i) Consu m ption expenditure at equ i l i bri u m level of nationa l income.
Ans. ( i ) G iven, S = -5 0 + O .SY sf
u
I nvestment expe nd itu re (I) = � 7, 000
k
Yo
At the eq u i l i b ri u m l eve l, S =I
oo
=> -5 0 + O .SY = 7, 000

O .SY = 7, 000 + 5 0
B
O .SY = 7, 0 5 0
re
7, 0 5 0
Y = O.S = 14, 1 00
ou
( i i ) At Y = 14, 1 00
ad
Savi ng, S = -5 0 + 0 .5 ( 14, 1 00 )

Y
= -5 0 + 7, 0 5 0
S = 7, 000
nd
Re
Con s u m ption expend itu re, C = Y - S

Fi
= 14, 1 00 - 7, 000 = 7, 1 00
Alternative M ethod
At eq u i l i bri u m leve l,
Savi ng = I nvestment
Savi ng = 7, 000
Con s u m ption expend itu re, C =Y-S
= 14, 1 00 - 7, 000 = 7, 1 00
( i ) Eq u i l i bri u m l evel of national i ncome = � 14, 1 00 .

( i i ) Consu m ption expend itu re at eq u i l i bri u m l evel of national i ncome = � 7, 1 00 .

16. G iven, the consu m ption fu nction, C = 150 + 0.6V, where C = consu m ption expenditure,
Y = i ncome and i nvestment expenditure = � 2,000. Ca lcu late:
( i) Eq u i l ibri u m level of national income.
( i i) Consu m ption expenditure at eq u i l ibrium level of national income.
( i i i) Saving at eq u i l ibri u m level of national i ncome.
Ans. ( i ) G iven, C = 150 + 0.6V
I nvestment expe nditure (I) = � 2,000
At the eq u i l i b ri u m leve l, Y =C+I
Y = 1 5 0 + 0.6V + 2,000
Y = 2,150 + 0.6V
Y - 0.6V = 2,150
0.4V = 2,150
2, 150
Y = � = 5, 375
(ii) Consum ption, C = 150 + 0.6 (5,375)

= 150 + 3,225 = 3,375
( i i i ) W e know that, Y =C+S
=> S =Y-C
= 5,375 - 3,375 = 2,000
Alternatively,
G ive n : C = 150 + 0.6'{, we ca n write that
S = -150 + 0.4V ( " . · M PC = 0.6, accord i ngly
M PS = l - 0.6 = 0.4)
O r, S = -150 + 0.4 (5,375)
= -150 + 2,150
= 2,000
( i ) Eq u i l i b r i u m leve l of national i n come = � 5,375.
( i i ) Con s u m ption expen d itu re at eq u i l i b r i u m leve l of national i n come = � 3,375.
( i i i ) Savi ng at eq u i l i b ri u m leve l of national i n come = � 2,000.
17. In an economy, the consu m ption fu nction is 250 + 0.5V and the i nvestment expend itu re is � 500. Is
the economy in eq u i l i brium at an i ncome level � 2,000? Justify you r answer.
Ans. N o, the economy is not i n a state of eq u i l i b ri u m .
G iven, consum ption fu nctio n (C) = 250 + O .SY
I nvestment expend itu re (I) = � 500
Leve l of i n come (Y) = � 2,000
At the eq u i l i brium l evel,
Y =C+I
Y = 250 + O .SY + 500
Y = 750 + O .SY
Y - 0.SY = 750

O .SY 750
=
750
Y = = 1 500
0.5 I
The eq u i l i b ri u m l evel of i n come = � 1,500. The given i n come (� 2,000) is greate r than eq u i l i b r i u m
l evel o f i ncome (� 1,500). Therefore, the economy is n ot i n eq u i l i bri u m .
18. I n a n economy, t h e a utonomous consu m ption is � 200 a n d m a rgi nal p ropensity t o consume
is 0.6. If the eq u i l ibri u m level of income is � 1,000, then the a utonomous i nvestment is
� 300. Is it correct? J u stify you r answer.
Ans. N o, it is not correct.
G iven, a utonomous consu m ption (C) = � 200
M a rgi n a l propensity to con s u m e ( M PC) = 0.6
low
Eq u i l i b r i u m level of i n come (Y) = � 1,000
Y =C+I
Or, Y = C + M PC (Y) + I
1,000 = 200 + 0.6 ( 1,000) + I
ee
rF 1,000 = 200 + 600 + I
Fr
I = 1,000 - 800
= 200
or
Th us, it is proved that the given statement is fa lse. Beca use the correct va l u e of autonomous
i nvestment is � 200.
sf
u
19. An economy is i n eq u i l i briu m . Calcu late the m a rginal p ropensity to save from the fol lowing:
National income = � 500.
k
Yo
Autonomous consu m ption = � 30.
oo
I nvestment expenditu re = � 70.

B
Ans. G iven, nati o n a l i ncome (Y) = � 500

re
Autonomous con s u m ption (C) = � 30

I nvestment expend itu re (I) = � 70
ou

ad
S =I
Y
Or, -C + M PS (Y) = I
-30 + M PS (500) = 70
nd
Re
500 ( M PS) = 70 + 30
500 ( M PS) = 100
Fi
100
M PS = = 0.2
500
M a rgi n a l propensity to save = 0.2.
20. "Government plans Massive Public Investment to Boost Economy." [International Business Times]
Expl a i n the manner i n which it is expected to h a p pen.
Ans. Indian economy is passing t h rough a phase of economic slowd own . Private i nvestment is n ot
forthco m i ng beca use of ( i ) the lack of AD, a n d ( i i ) the lack of i nfrastructu re . I nvestment by the
govern ment wou l d lead to a rise i n AD, as i nvestment i nvolves expe n d iture a n d expend itu re i n d u ces
d e m a n d . Th us, gove rn ment i nvestment wou ld a d d ress the problem of deficient AD.

Second, i nfrastructu re is expected to be the focus of government i nvestment. Accord ingly, the
p roblem of d eficient i nfrastruct u re wou l d a lso be a d d ressed .
Th us, we can conc l u d e that massive p u b l i c i nvestment is expected to boost the I n d i a n economy.
21. "Banks need to channelise household savings into financial system." [India lnfoline News Service]
What is the economic va lue of this statement i n the context of the I n d i a n economy?
Ans. I n d ia lacks fi nancial inclusion. M ost of households stay away from the fi nancial system ( briefly, the
banking syste m ) . They d o not have their ba n k accou nts. Accord ingly, their savi ngs rem a i n as i d l e cash
bala nces at home. The b a n ks a re advised to open zero ba l a n ce accou nts i nvolving m i n i m u m poss i b l e
formal ities. T h i s will encourage the sma l l accou nt holders t o p a r k their savi ngs i n the ba n ks. The
b a n ks can conve rt these savi ngs i nto i nvestment by way of loans to the i nvestors . Thus, u n p roductive
household savi ngs may be conve rted i nto prod uctive i nvestment. Th is w i l l m a ke a sign ificant
contri bution to the process of growth and developm ent.

1. Why should people save when saving, as a withdrawa l from the circu lar flow of income, ca uses G D P
t o shrink?
Ans. It is true that saving ca uses a lea kage from the c i rcu l a r flow of i ncome; accord i ngly, GDP tends to
s h r i n k . But, people save to foster their self-i nte rest. To the i n d ivid u a l s a n d households, savi ng is a
vi rtue as it yields i nterest-income. So, what is true at the micro-leve l need not necessa rily be true at
the macro-l eve l . This is just a micro-macro pa radox.
2. If h igher level of expenditure leads to h igher level of AD and h igher level of AD leads to h igher level
of output (G D P), why can't I n d ia i ncrease its AD (expenditu re) by printing more notes a n d thereby,
achieve higher l evel of G D P.
Ans. The observation that increase i n expe nd itu re ( i m plying a s h ift i n the l evel of AD) leads to h igher leve l
of G D P is based on the assu m ption that there is a n excess ca pacity i n the economy. So that, wheneve r
AD increases, the prod ucers a re i n d u ced to prod uce more by uti l is i ng the u n uti l i sed p rod uction
capacity. I n the I nd i a n economy, the problem is not of uti l is i ng the excess capacity. I n stead, it is the
p roblem of lack of prod uction capacity. I n a situation when add itional prod u ction capacity is not
ava i l a b l e (or we a re not i n a position to i ncrease AS i n response to increase i n AD) a ny i ncrease i n AD
by pri nting more notes wou l d only lead to greater p ress u re of demand on the ava i l a ble goods and
services. It wou l d fu e l i nflation, without ca using a ny i ncrease i n G D P.
3 . 'Ci rcu lar Flow of Money' model suggests that the economy finds its equ i l i bri u m (AD = AS) when
i njections a re exactly equal to withd rawa ls. Explain how, citi ng a n exa m ple of one type of withd rawa l
a n d one type of i njection.
Ans. I nvestment is a n exa m ple of i njection (which ra ises the level of GDP) a n d savi ng is a n exa m ple of
withd rawa l (which l owe rs the l eve l of G D P ) . Ci rc u l a r fl ow model suggests that if the enti re i ncome
generated is spent on the p u rchase of goods and services, then i ncome (AS) = expe n d it u re (AD) a n d
the eq u i l i b r i u m is struck.
The e q u i l i b r i u m is d i stu rbed if a part of i ncome is saved. Because, savi ng ca uses a situation of deficient
d e m a n d . H oweve r, if there is autonomous i nvestment ( i njection) equiva l e nt to saving (withd rawa l )
t h e n t h e d eficiency o f d e m a n d is corrected, a n d t h e economy fi n d s its eq u i l i b ri u m .

1. The va l u e of m u lti p l ier i s : (choose the correct a lternative)

1 1
(a) (b)
M PC M PS
1 1
(c) (d) [CBSE Delhi 2015]
1 - M PS M PC - 1
[(b)]
2. An economy is i n eq u i l i bri u m . Ca l c u l ate national i ncome from the fol lowi ng:
Autonomous consum ption = 100.
low
I nvestment expe nd itu re = 200. [CBSE Delhi 2015]
[ Page 447]
3. An economy is in eq u i l i bri u m . Find a utonomous con s u m ption from the fol l owing:
N ational i n come = 1,000.
M a rgi n a l propensity to consu m e = 0.8.
ee
I nvestment expe nd itu re = 100.
rF [CBSE Delhi 2015]
Fr
[ Page 447]
4. An economy is i n eq u i l i bri u m . Find m a rgi n a l p ropensity to consume from the fol l owing:
or
sf
u
I nvestment expe nd itu re = 200. [CBSE Delhi 2015]
[ Page 447, 448]
k
Yo
oo
5. If M PC = 1, the va l u e of m u lti p l ie r i s : (choose the correct a lternative)
(a) 0 (b) 1
B
(c) betwee n O a n d 1 ( d ) i nfi n ity [CBSE {Al) 2015]

re
[(d)]
6. An economy is i n eq u i l i bri u m . Ca l c u l ate the i nvestment expe nd itu re from the fol l owing:
ou
ad
N ational i n come = 800.

Y
Autonomous consum ption = 100. [CBSE (Al} 2015]

[ Page 448]
nd
Re
7. An economy is i n eq u i l i bri u m . Ca l c u l ate the m a rgi n a l propensity to save from the fol l owing:
Fi

I nvestment = 120. [CBSE {Al} 2015]
[ Page 448]
8. An economy is in eq u i l i bri u m . Ca l c u l ate the national i n come from the fol l owing:
I nvestment expe nd itu re = 150. [CBSE {Al} 2015]
[ Page 448, 449]

9 . If M PC = 0, the va l u e of m u lti p l i e r i s : (choose the correct a lternative)
(a) 0 (b) 1
O
(c) betwee n a n d 1 ( d ) i nfi n ity [CBSE (F) 2015]
[(b)]
10. An economy is i n eq u i l i bri u m . Ca l c u l ate m a rg i n a l propensity to save from the fol l owing:
I nvestment expe nd itu re = 200. [CBSE (F) 2015]
[ Page 449]
11. An economy is i n eq u i l i bri u m . Find the i nvestment expend itu re from the fol l owing:
N ational i n come = 750.
M a rgi n a l propensity to save = 0.4 [CBSE (F) 2015]
[ Page 449, 450]
12. An economy is i n eq u i l i bri u m . Ca l c u l ate a utonomous consu m ption from the fol lowi ng:
I nvestment expe nd itu re = 150. [CBSE (F) 2015]
[ Page 450]
13. In an economy i nvestment is i ncreased by � 300 cro re . If m a rgi n a l propensity to consume is � ,
ca l c u l ate i ncrease i n national i ncome. [CBSf Delhi 2016]
[ Page 450]
14. Suppose m a rgi n a l propensity to consu me is 0.8. H ow much i ncrease in i nvestment is req u i red to
increase national i n come by � 2,000 crore? Ca lculate. [CB.SE Delhi 2016]
[ Page 450]
15. In an economy an i ncrease in i nvestment by � 100 crore led to 'increase' in national i ncome by
� 1,000 crore . Find margi n a l propensity to consu me. [CB.SE Delhi 2016]
[ Page 451]
16. An economy is in eq u i l i bri u m . Ca l c u l ate m a rg i n a l propensity to consu m e .
N ational i n come = 1,000
Autonomous consum ption expe nd itu re = 200.
I nvestment expe nd itu re = 100. [CB.SE (AJ) 2016]
[ Page 451]
17. An economy is in eq u i l i bri u m . Find i nvestment expenditure.
M a rgi n a l propensity to consu m e = 0.8. [CBSE (Al) 2016]
[ Page 451]
18. An economy is i n eq u i l i bri u m . Find i nvestment expenditure.
M a rgi n a l propensity to consu m e = 0.8. [CBS£ (Al) 2016]
[ Page 452]

19. Derive the two a lternative cond itions of expressi ng nati o n a l i n come eq u i l i b ri u m . Show these
eq u i l i bri u m cond itions on a s i ngle d iagra m . [C8SE (F) 2016)
[Page 2 15, 253, 254]
20. Find eq u i l i b r i u m nati o n a l i ncom e .
I nvestment expe nd itu re = 1, 100. [CBSE (F) 2016]
[Page 452]
21. An economy is i n eq u i l i bri u m . Find m a rgi n a l p ropensity to consu me.
low
N ati o n a l i n come = 2,000. [CBSE (F) 2016]
[Page 452, 453]
22. An economy is in eq u i l i bri u m . Find a utonomous consu m ption expend itu re .
N ati o n a l i n come = 1, 600.
ee
rF [CBSE (F) 201 6]
Fr
[Page 453]
23. An economy is i n eq u i l i bri u m . From the fol l owing data a bout a n economy, ca lculate autonomous
or
con s u m ptio n :
(a) I ncome = 5,000.
sf
u
(b) M a rg i n a l p ropensity to save = 0 . 2 .
(c) I nvestment expend itu re = 800. [ C8SE Delhi 201 71
k
Yo
[Page 454]
oo
24. An economy is i n eq u i l i bri u m . Fro m the fol l owing d ata a bout a n econo my, ca lcu late i nvestment
B
expe nd itu re :
re
( a ) I ncome = 10,000.
(b) M a rg i n a l p ropensity to consume = 0.9.
ou
(c) Autonomous con s u m ption = 100. [ CBSE Delhi 201 71

ad
[Page 454]
Y
25. An economy is i n eq u i l i bri u m . From the fol l owing data, ca lculate autonomous consu m ption :
(a) I ncome = 10,000.
nd
Re
(b) M a rg i n a l p ropensity to save = 0 . 2 .

(c) I nvestment = 1,500. [CBSE Delhi 201 71
Fi
[Page 454, 455]

26. Ass u m i ng that i ncrease i n i nvestment is � 1,000 crore a n d m a rgi n a l p ropensity to con s u m e is 0.9,
expla i n the working of m u lti p l i e r. [CBSE Delhi 201 71
[Page 228, 229]
27. Ass u m i ng that increase i n i nvestment is � 800 crore and m a rgi n a l p ropensity to con s u m e is 0.8,
expla i n the working of m u lti p l i e r. [C8SE Delhi 201 71
[Page 228, 229]
28. Ass u m i ng that i ncrease i n i nvestment is � 900 crore and m a rgi n a l propensity to consu m e is 0.6,
expla i n the working of m u lti p l i e r. [CBSE Delhi 201 71
[Page 228, 229]

29. If the m a rgi nal propensity to co nsume is greate r than m a rg i n a l p ropensity to save, the va l u e of the
m u l ti p l i e r wi l l be (choose the correct a lternative ) :
(a) greater t h a n 2 ( b ) less than 2
(c) e q u a l to 2 ( d ) e q u a l to 5 [CBSE (Al) 201 7]
[(a)]
30. An economy is i n eq u i l i bri u m . From the fol l owing data, ca lculate the m a rgi n a l propensity to save :
(a) I n come = 10,000.
(b) Autonomous consum ption = 500.
(c) Cons u m ption expend itu re = 8,000. [CBSE {Al) 201 7]
[Page 455]
31. When aggregate demand is greater than aggregate s u p ply, i nventories:
(a) fa l l ( b ) rise
(c) do not cha nge ( d ) fi rst fa l l, then rise [CBSE {F) 201 7]
[(a)]
32. An economy is i n eq u i l i bri u m . From the fol l owing data, ca lculate i nvestment expe nd itu re .
(a) M a rgi n a l propensity t o consu m e = 0.9.
( b ) Autonomous cons u m ption = 200.
(c) Level of i n come = 10,000. [CBSE {F) 201 7]
[Page 455]
33. I n a n economy, i nvestment increased by 1, 100 a n d as a result of it i ncom e increased by 5,500. Had
the m a rgi nal propensity to save been 25 per cent, what wou l d have been the increase i n i ncome?
[Page 456] [CBSE {F) 201 7]
34. Defi n e i nvestment m u lti p l i e r. H ow is it related to m a rg i n a l propensity to consume?
[Page 225] [CBSE 2018]
35. What a re the two a lternative ways of d ete rm i n i ng eq u i l i b r i u m l evel of i n come? How a re these
related? [CBSE 2018]
[Page 2 15, 253, 254]
36. What is ex-a nte consum ption? Disti nguish between autonomous consu m ption and i n d u ced
consum ption. [CBSE 2018]
[ Ex-a nte cons u m ption refe rs to desired consu m ption (or p l a n ned cons u m ptio n ) at d iffe rent l evels of
i ncom e i n the economy.
Autonomous_s:onsu m ption refe rs to m i n i m u m le�el of cons u m ption, even when i n come is zero. It is
i n d icated by C i n the consum ption fu nction : C = C + bY.
I n d uced consu m ption cha nges as the l evel of i ncom e cha nges i n the economy. It is d etermi ned by
the m a rgi nal propensity to cons u m e . Thus:
C= C+� => ex-a nte consum ption
autonomous
cons u m ption
J L i n d u ced
cons u m ption]
37. Discuss the working of the adj u stment mechanism i n the fol lowing situations:
(a) Aggregate demand is greater than aggregate s u p ply.
( b ) Ex-a nte i nvestments a re lesser than ex-a nte savi ngs. [CBSE 2019 (58/1/1)]
[Page 220, 222]

38. If i n a n economy:
Cha nge i n i n iti a l i nvestments (Al ) = t 500 crore.
M a rgi n a l propensity to save ( M PS) = 0 . 2 .
Find the va lues o f the fol l owing:
(a) I nvestment m u l ti pl i e r ( K ) .
( b ) Cha nge i n fi n a l i ncome (..W) . [CBSE 2019 (58/1/1)]
[Page 456]
39. If in an economy:
Cha nge i n i n iti a l i nvestments = t 700 crore.
low
Find the va lues o f the fol l owing:
(a) I nvestment m u l ti pl i e r ( K ) .
[Page 457]
ee
Cha nge i n i n iti a l i nvestment = t 1, 200 crore.
rF
Fr
Find the va lues of:
(a) I nvestment M u lti p l i e r ( K ) .
or
sf
u
[Page 457]
41. State the m e a n i ng of ex-a nte savings. [CBSE 2019 (58/2/1)]
k
Yo
[Page 2 15]
oo
42. Discuss the adj u stment mecha nism i n the fol l owing situations:
B
(a) Aggregate demand is lesser than aggregate s u p p ly.

( b ) Ex-a nte i nvestments a re greater than ex-a nte savi ngs.
re
[CBSE 2019 (58/2/1)]

[Page 220, 222]
43 . Ca l c u l ate cha nge in fi n a l i ncome, if m a rg i n a l propensity to co n s u m e ( M PC) is 0.8 a nd cha nge in i n iti a l
ou
ad
i nvestment is t 1,000 crore . [CBSE 2019 (58/2/1)]

Y
[Page 457]
44. Esti mate the cha nge in i n itia l i nvestment if m a rgi n a l p ropensity to save ( M PS) is 0 . 10 a n d cha nge i n
nd
fi n a l i ncome is t 15,000 crore. [CBSE 2019 (58/2/2}]

Re
[Page 457, 458]

Fi
45. Esti mate the cha nge in fi n a l i ncome if m a rg i n a l propensity to consu m e ( M PC) is 0.75 and cha nge i n
i n iti a l i nvestment is t 2,000 crore . [CBSE 2019 (58/2/3))
[Page 458]
46. State the fol l owing statement as true or fa lse. G ive va lid reasons.
Accord ing to Keynesi a n theory of e m p l oyment, ex-a nte savi ngs a n d ex-post savi ngs a re always
eq u a l . [CBSE 2019 (58/3/2} ]
[ Fa l se . Ex-a nte savings a re those savi ngs which people i ntend to m a ke i n the economy d u ring the
period of one yea r. Ex-post savi ngs refer to act u a l savi ngs i n the economy d u ring the period of one
yea r. So, the two may or may not be eq u a l . ]

47. Describe the adjustme nts that may ta ke place i n a n economy when ex-a nte savi ngs a re less than ex-
a nte i nvestments. [CBSE 2019 (58/4/1}]
Or
Describe the adj u stment mecha n ism, if in a n economy, the p l a n ned savi ngs a re lesser than the
p l a n ned i nvestments. [CBSE 2019 (58/5/2)]
[Page 222]
48. Describe the adj u stments that may ta ke place i n a n economy when ex-a nte aggregate demand is
greater than ex-a nte aggregate s u p p ly. [CBS£ 2019 (58/4/2)]
[Page 220]
49. Describe the adj u stments that may ta ke place in a n economy when ex-a nte savi ngs a re greate r than
ex-a nte i nvestments. [CBSE 2019 (58/4/3))
Or
Describe the adj u stment mecha n ism, if in an economy the p l a n ned savi ngs a re more than the
p l a n ned i nvestments. [CBSE 2019 (58/5/1))
[Page 222]
50. What is meant by the "Effective Demand Pri n c i ple" i n Keynesian theory of e m p l oyment? Discuss
using a sched u l e or a d iagra m . [CBS£ 2019 (58/4/1)]
[Page 254]
51. Describe the adj u stment mecha nism if ex-a nte aggregate demand is lesser than ex-a nte aggregate
s u p p ly. [CBS£ 2019 (58/5/3)]
[Page 220]
52. Discuss briefly the relationsh i p between m a rginal propensity to save and i nvestment m u lti pl i e r, u s i ng
a hypothetica l n u m e rica l exa m p l e . [CBSE 2019 (58/5/1}]
[Page 225, 226]
53. The savi ng fu nction of a n economy is give n as:
S = -25 + 0. 25V
If the p l a n ned i nvestment is � 200 crore, ca l c u l ate the fol l owing:
( i ) Eq u i l i b r i u m level of i ncome i n the economy.
( i i ) Aggregate demand at i n come of � 500 crore. [CBSE 2019 (58/5/1}]
[Page 458]
54. The savi ng fu nction of a n economy is give n as:
S = (-) 10 + 0· 20Y
If the ex-a nte i nvestments a re � 240 crore, ca lculate the fol lowi ng:
( i i ) Additional i nvestments which w i l l be needed to dou b l e the present l evel of eq u i l i b r i u m
i ncom e . [CBSE 2019 (58/5/2)]
[Page 458, 459]
55. The savi ng fu nction of an economy is give n as:
S = (-) 50 + O . l OY
If the ex-a nte i nvestments a re � 450 crore, ca lculate the fol lowi ng:
( i i ) Additional i nvestments which wi l l be needed to ga i n a n add itional i n come level of
� 3,000 crore. [CBSE 2019 (58/5/3)]
[Page 459]

1. What is the d ifference between ex-a nte i nvestment a nd ex-post i nvestment?

[ H i nt : Ex-a nte i nvestment refers to 'desi red (or p l a n ned) i nvestment' correspond ing to d iffe rent
i n come l evels in the economy. Ex-post i nvestment refers to 'actu a l i nvestment' in the economy
d u ring the period of one yea r. ]
2. Measu re the l eve l o f ex-a nte aggregate demand when a utonomous i nvestment a nd con s u m ption
expe nd itu re (A) is � 50 cro re, a nd M PS is 0.2 and l evel of i n come (Y) is � 4,000 crore. State whether
the economy is i n eq u i l i b ri u m or not (cite reasons).
[ H i nt : We know that, AD = C + I
Or, AD = C + M PC (Y) I
low
+
Or, AD = C + I + M PC (Y)
= 50 + 0.8 (4,000) [ M PC = 1 - M PS = 1 - 0. 2 = 0.8]
= 50 + 3, 200
= � 3,250 crore
ee
Y = AS = � 4,000 crore
rF
Fr
Since, AS > AD, the economy is not i n the eq u i l i b ri u m .
Note: I n the context of eq u i l i b r i u m G D P, a l l i nvestment is considered as a utonomous i nvestment.]
or
sf
u
k
1. Briefly exp l a i n the concept of eq u i l i b r i u m output. [Page 214]
Yo
oo
2. What a re the basic assu m ptions of Keynes theory? [Page 222]

3. Exp l a i n the concepts of ex-a nte saving a nd ex-a nte i nvestment. [Page 215]
B
4. Exp l a i n the concepts of ex-post saving a nd ex-post i nvestment. [Page 215]

re
5. Eq u a l ity between AS a n d AD i m p l ies the eq u a l ity between S a n d I. Write eq uations to prove this
fact. [Page 215, 253, 254]
ou
ad
6. What is meant by i nvestment m u lti p l ier? Exp l a i n with the h e l p of a s u ita b l e exa m p l e . [Page 225]
Y
7. Exp l a i n the relationsh i p between m a rg i n a l p ropensity to con s u m e a n d i nvestment m u lti plier.

[Page 225]
nd
8. What do you mean by forwa rd action a n d backwa rd action of m u lti p l ier? Exp l a i n with the h e l p of a
Re
s u ita b l e exa m ple. [Page 229, 230]

Fi
9. Exp l a i n the m ea n i ng of i nvestment m u lti p l i e r. What ca n be its m i n i m u m va l u e a n d why? [Page 225]
B. Questions of 6 m a rks each

1. Exp l a i n the theory of dete r m i nation of eq u i l i b r i u m level of output and i ncome with the help of
aggregate demand and aggregate supply c u rves . [Page 21 6-219]
2. Exp l a i n the dete rm i n ation of eq u i l i b ri u m l evel of i n come using 'savi ng-i nvestment' a p p roac h . U se
d iagra m . [Page 220-222]
3. Exp l a i n the eq u i l i b r i u m l evel of i ncome with the h e l p of Consum ption + I nvestment (C + I) cu rve .
If p l a n ned saving is greater than p l a n ned i nvestment, what adj ustme nts wi l l bring a bout eq u a l ity
between the two? [Page 21 6-219, 222]

4. I n a n economy p l a n ned i nvestment exceed plan ned savi ngs. H ow wi l l the e q u a l ity between the two
be ach ieved? Exp l a i n . [Page 222]
5. Why m u st aggregate demand be e q u a l to aggregate s u p ply at the eq u i l i b ri u m l evel of i n come a n d
output? Exp l a i n w i t h the h e l p o f a d iagra m . [Page 21 6-220]
6. Defi n e i nvestment m u l ti p l i e r. What is the relationsh i p betwee n i nvestment m u lti p l i e r a n d m a rgi n a l
p ropensity t o consume? [Page 225]
7. Exp l a i n the working of i nvestment m u lti p l i e r with the h e l p of a n u m e rica l exa m p l e . [Page 228, 229]
8. Exp l a i n with the h e l p of n u merica l exa m p l e how an i ncrease in i nvestment in an economy affects its
l evel of i ncome. [Page 226-229]
9. I n poor cou ntries l i ke I nd ia, people spend a h igh percentage of their i n come so that APC a n d M PC a re
high. Yet, va l u e of the m u lti p l i e r is low. Why?
[ H int: Working of the m u lti p l ie r process is based on one fu n d a me nta l assu m ptio n : that there exists
excess capacity in the economy, so that whenever cons u m ption expe nditure rises ( i m plying i ncrease
in d e m a n d ) there is a correspond ing i ncrease in prod uction ( i m p lyi ng i ncrease i n i ncome). But poor
cou ntries l i ke I nd ia, lack in p rod u ction capacity. Acco rd i ngly, whe never d e m a n d i ncreases (in terms
of i ncrease i n con s u m ption expe nditure), there is i ncreasing p ressu re of demand on the existi ng
output ( i m plying i nflation or rise i n p rices) rather than the increase i n output or i n come.]
DOs and DON'Ts

1. Equ i l i br i u m level of income (where AS = AD, or S = I) i s determ i ned primarily by the l evel of AD,
because AS is assu med to be perfectly elastic. But, do remember, that a situation of any divergence
diseq u i l ibrium (a situation when AS > AD or AS < AD) is corrected only through changes in AS. [Revisit
Page 220 for detai l s ]
2. You m ust understand that multiplier is not rel ated to APC (average propensity to cons ume) . I nstead,
it is rel ated to M PC (ma rg i n a l propensity to consume) . Why? Because, multipl ier shows change in
income a s a result of change i n i nvestment a n d M PC shows change i n consu m ption as a result of
change in i ncome. Accordingly, it is MPC which is rel ated to the concept of multiplier, not the APC
(wh ich j u st shows the ratio between total consu m ption and total i ncome) .
3. I ncrease in C is a n injection into the circ u l a r flow of i n come. But, only when i ncrease in C is not related
to increase in Y. An i njection occu rs when there is i ncrease in C for reasons other than the increase in Y.
So that, there is an u pward s hift in con s u m ption function which leads to a n upward s h i ft i n AD function.
Accord i n g ly, the economy shifts to a higher level of eq u i l ibrium G D P.
I ncrease i n C because of i ncrease i n Y does not cause a s h i ft i n C-functio n . It only causes a movement
along the C-functio n .
........... • Simultaneous Equality between AS and AD as wel l as between S and I

The fol l owing figure shows s i m u lta neous equal ity between AS and AD, as well
as between S and I.
Eq u i l i brium is attai ned at point E when AS = AD, as i n Fig . B(A), and at poi nt E*
when S = I, as in Fi g . 8(8) .

y (Al
AD = C + I
0
<r:
V)
<r:
"----'-----,----------x
Y ( l n come)/G DP
y (Bl
s
low
-V)- r ----�---------
ee
Y (lncome)/GDP
rF
Fr
s
y•
or
Equal ity between A S a n d AD a t point E [ i n Fig. 8(A)] i m p l ies the
equality between S and I at poi nt E* [in Fig. 8(8)]. There is one and
only one equili brium GDP when AS = AD or when 5 = I . I n either
sf
u
case, the equilibrium GDP = OL
OL is the eq u i l ibri u m level of income. It is to be noted that the eq ual ity between
k
AS and AD i m p l ies the eq u a l ity between S a n d I; and eq ual ity between S a n d I
Yo
oo
i m p l ies the eq u a l ity between AS a n d AD. Accord i n g ly, there is one a n d only one
level of eq u i l i bri u m i ncome when AS = AD, a n d S = I.
B
• Concept of AED (Aggregate Effective Demand)

re
AED refers to that level of AD where AS = AD. Thus, AED a lways corresponds to
the eq u i l i brium level of i ncome i n the economy. It is cal led 'effective' as it is this
ou
ad
level of AD which actually determ i nes the eq u i l i bri u m between AS and AD; AS
j u st coi ncides with AD, beca use AS is assumed to be perfectly elastic.
Y
Check Fi g . 9 for fu rther i l l u stration. y

nd
AD fu nction shows different levels

Re
of aggregate demand. But it is only AD

Fi
at poi nt E that AS = AD. At poi nt E,

level of a g g regate demand = EL.
Hence, EL is aggregate effecti v e
demand, which i s effective in stri king
an equ i l ibrium between AS and AD.
As regards a sched ule indicati ng Y (lncome)/GDP
AED, students are advised to see • E i s the point of e q u i l i b r i u m wh ere AS = AD.
Ta ble 1 , page 21 8. In this table, AED • E L i s the l evel of demand where AS coincides with AD,
and the eq u i l ibrium GDP is ach ieved.
= 1 00, where AD = C + I and the • EL, therefore, is AED (agg regate effective demand).
economy is i n a state of eq u i l i brium.
Ill
T
....
• Some Essent;o/ Concepts,
-Full Employment Equilibrium and Underemployment Equilibrium
-Voluntary and Involuntary Unemployment
-Full Employment and Natural Unemployment
• Problem of Deficient Demand
• Problem of Excess Demand
• Measures to Correct Deficient and Excess Demand
I. SOME ESSENTIAL CONCEPTS

Knowledge of some concepts is essential before we take up a detailed
description of the problem of deficient demand and excess demand.
These concepts are: ( 1) full employment & underemployment
equilibrium, (2) voluntary & involuntary unemployment, and (3) full
employment & natural unemployment.
(I) Full Employment Equilibrium and

Underemployment Equilibrium
Equilibrium is struck when AD = AS or when S = I. But, it need
not necessarily correspond to the situation of full employment
(when resources are fully utilised) in the economy. AD and AS may
be equal even when resources are not fully utilised or when there
is unemployment in the economy. Here is an illustration: Let us
assume that fuller utilisation of the resources leads to output worth
10 billion US dollars during an accounting year. But, the producers
may plan output and the households may plan expenditure on
output worth 8 billion US dollars only. So that, resources worth
2 billion US dollars of output remain unutilised. But, the equilibrium is
255
struck simply because planned output (AS) and planned expenditure
on output (AD) are equal (= 8 billion US dollars). Thus, we can
think of two possible situations of equilibrium: (i) full employment
equilibrium, and (ii) underemployment equilibrium. Full employment
equilibrium is struck when planned AS = planned AD along with
fuller utilisation of the resources. With reference to the above
illustration, full employment equilibrium is struck when planned AS =
planned AD = 10 billion US dollars. Underemployment equilibrium
is struck when planned AS = planned AD but resources are still not
fully utilised; so that, there is excess capacity in the economy. With
low
reference to the above illustration, underemployment equilibrium is
struck when planned AS = planned AD = 8 billion US dollars.
F@CUS Full employment equilibrium refers to that situation in the economy when AS = AD
(or S = I) along with fuller utilisation of resources. So that there is no excess capacity or
ZONE
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unemployment in the economy.
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Fr
Underemployment equilibrium refers to that situation in the economy when AS = AD
(or S = I) but without fuller utilisation of resources. Accordingly, there is unutilised
capacity or excess capacity (or unemployment) in the economy even in a state of
or
equilibrium.
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(2) Voluntary and Involuntary Unemployment
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Voluntary unemployment refers to a situation when people choose to
B
remain unemployed, even when jobs are available. They may not be
willing to work at all, or not willing to work at the existing wage rate.
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I Voluntary unemployment occurs when some people are not willing to work at all, or are not willing
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to work at the existing wage rate.

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Involuntary unemployment refers to the situation when some people

nd
are not getting work, even when they are willing to work at the
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existing wage rate. It is a situation when AD is not enough to induce

Fi
fuller utilisation of the existing resources. Accordingly, planned output

is lower than the potential output (full employment output). There
is excess capacity in the economy, and some people are forced to
remain unemployed.
Problem of unemployment refers to the problem of involuntary
unemployment, not the problem of voluntary unemployment. If all
those who are willing to work (and able to work) at the existing wage
rate are getting work, the economy would be deemed to be in a state
of full employment even when there is voluntary unemployment in
the economy.

I
Involuntary unemployment occurs when some people are not getting work, even when they are
willing to work at the existing wage rate. The economy fails to create enough jobs because planned
output is lower than the potential output (full employment output), owing to lack of AD.
(3) Full Employment and Natural Unemployment

Full employment refers to a situation when all those who are able to
work and are willing to work (at the existing wage rate) are getting
work. It is a situation when, corresponding to a given wage rate,
demand for labour = supply of labour, and the labour market is
cleared (it is in a state of equilibrium).
I Full employment occurs when SL = DL corresponding to a given wage rate, so that labour market is
cleared and it is in a state of equilibrium.
Situation of Full Employment does not mean

a Situation of Zero (Involuntary) Unemployment
Students of economics must carefully note that in the economy,
a situation of full employment never implies a situation of 'zero
(involuntary) unemployment'. There always exists some degree of
unemployment, called 'natural unemployment'. This occurs owing
to the fact that there are constant changes in the supply-demand
parameters in the economy, and adjustment to these changes takes
time. While adjustments are occurring, some people continue to
remain unemployed. This is a situation of 'frictional and structural'
unemployment in the economy.
I
Full employment does not mean a situation of zero unemployment. Owing to constantly changing
supply-demand parameters in the economy (and the fact that adjustment to these changes takes
time), there always exists some frictional and structural unemployment. The minimum rate of
unemployment that must always exist in the economy is called natural rate of unemployment.
Frictional Unemployment
In the words of Gardner, "Frictional unemployment is the unemployment
associated with the changing of jobs in dynamic economy." It arises due
to immobility of labour, shortage of raw material, lack of information
regarding opportunities of employment, shortage of power, wear and
tear of machines, tendency of the workers to move from one job to
the other, etc.
Problem of Deficient Demand and Excess Demand 257

Structural Unemployment
In the words of Gardner, "Structural unemployment is the
unemployment that results from the long-term decline of certain
industries." It is associated with the structural changes in the economy
due to these situations:
(i) when other factors of production (other than labour) are in short
supply,
(ii) when labourers lack expertise for new emerging industries, and
(iii) when there is change in the production technique.
low
t>TS
Q. What is natural rate of unemployment?
Ans. It refers to the rate of unemployment which always exists in the economy even when labour market
ee
is in a state of equilibrium. It occurs due to:
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(i) frictional changes (changes related to shifting from one job to the other), and
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(ii) structural changes (changes related to new production technology).
Frictional changes lead to frictional unemployment, while structural changes lead to structural
or
unemployment.
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2. PROBLEM OF DEFICIENT DEMAND
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( I) Concept of Deficient Demand

B
Deficient demand means deficiency of AD. Demand is said to

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be 'deficient' when it is lower than what is required for the fuller

utilisation of resources. Or, AD is deficient when it does not permit
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ad
fuller utilisation of production capacity. Or, AD is deficient when

Y
there is excess capacity in the economy (implying underutilisation of

resources). According to Keynes, AD is deficient when it is less than AS
nd
corresponding to full employment in the economy.

Re
I
Fi
Def;c;ent Demand
AD < AS (corresponding to full employment in the economy)
Or
AD falls short of its full employment level
(2) Measurement of Deficient Demand:

Diagrammatic Illustration
Fig. 1 reflects measurement of deficient demand.

Measurement of Deficient Demand
y
Y (lncome)/GDP
In Fig. 1:
• AD F line shows the required level of AD for full employment in the
economy.
• AD p line shows planned AD which is lower than the full employment
AD.
• The vertical difference between ADF and ADp = EF
= Deficient demand.
(3) Causes of Deficient AD

In a two sector closed economy, deficiency of AD occurs largely due
to two factors:
(i) Reduction in Private Consumption Expenditure (C): Private
consumption expenditure is an important component of AD.
Reduction in private consumption expenditure causes a serious
deficiency in AD. Private consumption expenditure may reduce
owing to several reasons. However, the most important is
reduction in propensity to consume or increase in propensity
to save. In advanced economies, MPS tends to rise when
consumption reaches its peak.
(ii) Reduction in Private Investment Expenditure (I): Private
investment expenditure is the other important component of
AD. It may reduce in situations of poor business expectations. It
has happened in all market economies of the world in the year
2015-16.

In a four sector open economy, the following factors may also
contribute to the deficiency of AD:
(i) Reduction in Government Expenditure (G): The government may
cut its consumption expenditure or investment expenditure. This
may be because of the budgetary constraints of the government.
A cut in government consumption expenditure or investment
expenditure leads to a cut in AD.
(ii) Decline in Exports {X): We know, exports are an important
component of AD. A fall in exports implies a fall in expenditure
low
on the domestically produced goods and services. This leads to
a fall in AD.
(iii) Rise in Imports {M): Imports may rise when international prices
are lower than the domestic prices. Imports are a negative
component of AD. Accordingly, a rise in imports leads to a fall in
ee
AD.
rF
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(iv) Increase in Tax Rates: Increase in tax rates leaves lesser disposable
income with the people. It reduces their capacity to spend,
even when their propensity to spend remains the same. Lower
or
disposable income means lower level of AD.
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Briefly, we can say that the deficiency of demand is a situation when
planned AD is lower than its full employment level. It is indicated
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by a downward shift in AD function. The possible reasons are:
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(i) a reduction in C, (ii) a reduction in I, (iii) a reduction in G, (iv) a

B
reduction in X, (v) a rise in M, and (vi) increase in taxation.
I
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Deficiency of demand occurs when C, I, G and X components of AD tend to fall, or when

M component of AD tends to rise. It is indicated by a downward shift in AD from its full employment.
ou
ad
Y
(4) Consequences of Deficient AD:

Four Critical Situations in the Economy
nd
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Deficient AD leads to four critical situations in the economy, as under:

Fi
(i) Underemployment Equilibrium

Deficient demand leads to underemployment equilibrium.
Owing to the deficiency of AD, producers are not able to fully utilise
their resources (production capacity). Planned output remains less
than the potential output (output corresponding to fuller utilisation
of resources). Accordingly, underemployment equilibrium is struck in
the economy.
I Owing to deficiency of demand, equilibrium between AS and AD is struck at a lower level of GDP,
lower than the full employment level. This is called underemployment equilibrium

Fig. 2 illustrates this situation.
Underemployment Equilibrium
y Y=AS
ADF (Full
Employment AD)
ADp (Planned AD)
�r-:+----+---- Point of
Underemployment
Equilibrium
Underemployment
Equilibrium GDP
Aull Employment
,/
Equilibrium GDP
/
o��-----N�---�M----------x
Y (lncome)/GDP
In Fig. 2:
• Deficient demand = EF.
• Because of the deficiency of demand, equilibrium is struck
at point Q where AD p line intersects the 45 ° AS line. This is
underemployment equilibrium.
• Equilibrium GDP (corresponding to underemployment equilibrium)
= ON.
• ON < OM
t t
Full employment
Underemployment
equilibrium GDP equilibrium GDP
(or potential GDP)
(ii) Deflationary Gap

Deficiency of demand creates 'deflationary gap' in the economy. It
is a situation when lack of demand leads to deflationary pressures
in the economy. Inducement to invest is hurt. Low investment leads
to low output. Implying low income, and low demand once again.
The economy starts slipping into 'deflationary spiral', or 'low level
equilibrium trap'.
I Low AD� Low investment� Low output� Low income� Low AD

Consequently, the economy slips into 'deflationary spiral', or 'low level equilibrium trap'.

Measurement of Deflationary Gap
Deflationary gap is measured in terms of deficiency of demand. We
can say that:
Deflationary Gap = Deficiency of AD
Deflationary gap is measured as the difference between 'AD
corresponding to full employment' and 'planned AD which is lower
than the full employment AD'.
low
Measurement of Deflationary Gap
y
ADF (Full Employment AD)
E
0
ee
}yADe (Plaooed ADJ
�
rF
Fr
-0
"'
C
QJ
0 Deficient Demand
"' = Deflationary Gap
or
8::'
CJ)
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CJ)
CJ)
<(
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�-�------M�-----+X
Y (lncome)/GDP
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In Fig. 3:
Deflationary Gap = Deficient demand
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ad
= EF
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(iii} Undesired Stocks

nd
In a situation of low AD, producers are not able to sell all that they
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plan to sell (or wish to sell). Accordingly, undesired stocks tend to pile
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up.
Clearance of undesired stocks often lead to: (a) fall in prices, and
(b) fall in planned output for the year ahead. Both these factors
contribute to deflationary spiral in the economy.
(iv) Loss of Profits

Deficiency of AD causes loss of profits. This happens because:
(a) producers are not able to clear their stocks, and (b) undesired
stocks lead to 'price crash'.

Briefly, deficiency of demand hurts business expectations. Low
business expectations (or bearish business expectations) lead to low
investment, and low level of income and employment. Overall level of
economic activity reduces and the economy is caught in a 'low level
equilibrium trap', where low demand leads to low income and low
income leads to low demand.
3 . PRO B LEM O F EXC ESS D E MAN D
( I ) Concept of Excess Demand

Excess demand means excess of AD. Demand is said to be 'excess'
when it is more than what is required for the fuller utilisation of
resources. According to Keynes, AD is excess when it is more than AS
corresponding to full employment in the economy.
I
Excess Demand
AD > AS (corresponding to full employment in the economy)
Or
AD crosses its full employment level
(2) Meas u rem ent of Excess Demand:

D i agram matic I l l u stration
Fig. 4 reflects measurement of excess demand.
Measurement of Excess Demand

y
ADp (Plan ned AD)
0 ADF (Fu l l Employment AD)

::i;,
c)
C
ro
ro
CJ)
CJ)
CJ)
<(
�-�----�-------- x
Y (lncome)/GDP

In Fig. 4:
• AD F line shows the required level of AD for full employment in the
economy.
• AD p line shows planned AD which is higher than the full
employment AD.
• The vertical difference between AD p and ADF = EF
= Excess demand.
(3) Causes of Excess AD
low
Causes of excess demand are almost opposite to those of deficient
demand. Briefly, there are two principal causes of excess AD in a two
sector closed economy:
(i) Increase in private consumption expenditure (C) which may
occur owing to increase in propensity to consume or decrease in
ee
propensity to save. In countries like India, propensity to consume
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has tended to rise owing to a high degree of demonstration
effect. The poor try to spend more to live like the rich.
or
(ii) Increase in investment expenditure (I), which may occur owing to
bullish business expectations. (Business expectations are 'bullish'
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when the producers expect high returns from their investment.
k
Business expectations are 'bearish' when the producers do not
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expect high returns from their investment.)
In an open economy with government, there are following additional
B
causes of excess AD:

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(i) Increase in government expenditure (G), owing to its expanding

commitments for the development as well as welfare projects in
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the economy.
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(ii) Increase in exports (X), owing to lower domestic prices in relation

to international prices.
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( i i i ) Decrease in imports (M), owing to higher international prices

compared with domestic prices.
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(iv) A cut in tax rates leaving higher disposable income with the
people.
(4) Consequences of Excess AD:

Three Critical Situations in the Economy
Excess demand leads to three critical situations in the economy, as
under:

(i) Inflationary Gap
Excess demand causes 'inflationary gap' in the economy. In a situation
of excess demand, the level of output does not rise. In fact, it cannot rise
because factors are already fully employed (and technology is assumed
to remain constant). Output level remains constant corresponding
to full employment. On the other hand, excess demand generates
pressure of demand on the existing resources. Accordingly, cost of
production tends to rise, which leads to a rise in the general price
level in the economy. Keynes identifies this situation as a situation of
'inflationary gap' in the economy.
I
Excess AD ---+ Pressure of demand on the existing resources ---+ Rise in cost of production
---+ Rise in general price level ---+ Output level remains constant because resources are already
fully employed
Measurement of Inflationary Gap

Inflationary gap is measured in terms of 'excess demand'. We can say
that:
Inflationary Gap = Excess demand (or Excess AD)
Inflationary gap is measured as the difference between 'planned AD
which is beyond full employment level' and 'AD that corresponds to full
employment'.
Measurement of Inflationary Gap

y
Y = AS
ro ADF (Fu l l Employment AD)
ro
,.__....._____-JM'-----------+ X
Y (lncome)/GDP
In Fig. 5:
Inflationary Gap = Excess demand
= EF

(ii) Static GDP
Even when the level of AD is higher than its full employment level,
the level of G D P does not rise. It remains static. It is a situation when
higher demand fails to generate higher G D P in the economy. This
is because resources are already fully employed: there is no excess
capacity in the economy. Fig. 6 offers diagrammatic illustration of
excess demand and static G D P.
Excess Demand and Static GDP

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AD p (Planned AD)
ADF (Fu l l Employment AD)
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��----�L�---------+ X
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Y (l ncome)/GDP
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• Excess Demand = E F
• GDP = OL, w h e n AD corresponds t o fu l l e mp loyment
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• GDP = OL, even when AD is h i g h e r than its fu l l e m p l oyment level

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Fig. 6 shows that the equilibrium G D P remains constant {= OL), and

at full employment level, even when AD shifts from AD F to AD p. Thus,
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G D P remains unimpacted by excess demand.

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Here, comes an important observation:

When we say that G D P remains constant, we are referring to real
nd
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G D P, not the nominal G D P. In other words, we are referring to G D P

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at constant prices, not G D P at current prices. The fact that excess

demand leads to a rise in the general price level implies that G D P at
current prices will rise. Thus, in a situation of excess demand, quantum
of goods and services produced in the economy remains constant,
though the market value of goods and services (at the current prices)
tends to rise.
• In a situation of excess demand, quantum of goods and services produced in the economy remains
constant, though the market value of goods and services (at the current prices) tends to rise.

(iii) Excess Demand and Wage-Price Spiral
Excess demand leads to a wage-price spiral in the economy. It is a
situation when wages catch prices and prices catch wages. Accordingly,
the economy may be driven to a situation of hyper inflation (inflation
of very high magnitude).
This is how the wage-price spiral operates:
• Owing to excess demand, there is pressure of demand on the
existing resources. Consequently, cost of production (wages in
particular) tends to rise.
• Rise in wages (and the cost of production) leads to a rise in the
general price level.
• Rise in prices leads to a rise in cost of living.
• Rise in cost of living leads to rise in wages again.
Thus, wages catch prices, and prices catch wages. This spiral, if turns
into hyper inflation, becomes a serious threat to economic stability.
(iv) Loss of Profit

Like deficient demand, excess demand also causes loss of profit. Profit
is lost, because (owing to the lack of excess capacity), the producers
are not able to raise their supplies. In other words, there is a loss of
profit owing to unfulfilled demand in the economy.
Briefly, excess demand is not virtuous, but vicious. It generates
inflationary spiral in the economy. Devoid of any rise in GDP, excess AD
generates pressure of demand on the existing resources. Accordingly,
cost of production (particularly wage rate) rises. Rise in cost leads
to rise in prices. The economy is caught in the 'wage-price spiral', a
challenge to stability of the economy.
Inflationary Gap and Deflationary Gap-The Difference
I nflationary Gap Deflationary Gap
(i) It is the excess of AD ove r a n d a bove (i) It is the deficiency of AD from
its l evel req u i red to m a i nta in fu l l the l evel req u i red to mainta in fu l l
employment e q u i l i b r i u m i n the em ployment e quilibrium i n the
econo my. econo my.
( i i ) It occurs when AD > AS, correspon d i ng ( i i ) It occurs when AD < AS, correspond i ng
to fu l l e m p l oyment l evel. to fu l l e m p l oyment level.
(iii) Leve l of output is consta nt at fu l l (iii) Leve l of output is less than that at fu l l
employment. employment.
( iv) There is no unem ployment or (iv) There is u n e m p loyment or un de r-
u nd e re m p l oyment i n the econo my. employment i n the economy.
(v) It leads to wage-p rice s p i ra l : wages (v) It leads to low level eq u i l i b r i u m tra p :
catch prices and prices catch wages, low AD leads t o l o w i ncome, a n d low
w h i l e G D P remains consta nt. i ncome leads to low AD.

t>TS
Q. 1. How does propensity to consume affect AD-function ?
Ans. I ncrease i n the propensity to consume causes a n u pwa rd shift in the AD-function (th rough a n u pward
shift in the (-function). On the other hand, d ecrease i n the propensity to consume causes a downward
shift in AD-fu nction (through a downward shift in (-function) .
Q. 2. Accord i ng t o Keynes, price level rises o n l y after fu l l employment. Why?
Ans. P rice leve l does not rise before fu l l employment, beca use AS is assu med to be perfectly elastic. P rior
to full employment, AS tends to rise proportionate to any rise in AD. Accord i ngly, price l evel remains
constant. But after full em ployme nt is reached, AS stops rising in response to a rise in AD. Accordingly,
price l evel tends to rise.
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4 . MEASU RES TO CORRECT DEFICIENT AND
EXCESS DEMAND: FISCAL AND MONETARY
POLICIES
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Economic stability requires that the situations of excess demand and
deficient demand are corrected as fast as possible. Who does it? The
government does it through its revenue-expenditure policy (Fiscal
or
Policy), and the Central Bank (RBI) does it through its monetary
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policy. This bring us to the discussion of fiscal and monetary policies.
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Let us understand how these policies are used to combat inflationary
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gap (related to excess demand) and deflationary gap (related to
deficient demand).
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Fiscal Policy (Fiscal Measures)

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Fiscal policy refers to revenue and expenditure policy of the

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government. It is also called Budgetary Policy of the government. It

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focuses on stability of the economy by correcting the situations of

excess demand (inflationary gap) and deficient demand (deflationary
nd
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gap).
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F®CUS Fiscal policy refers to budgetary policy of the government (or revenue and expenditure
policy of the government) to correct the situations of excess and deficient demand in the
ZONE economy with a view to achieve the twin objective of'growth with stability'.
Components of Fiscal Policy and the Way these are Used

Following are the principal components of fiscal policy. Along with
each component, we are describing the way it is used to correct the
situations of excess and deficient demand.

(1) Government Expenditure
It is the principal component (or principal instrument) of fiscal policy.
The government of a country incurs various types of expenditure,
mainly:
(i) Expenditure on public works programmes such as the construction
of roads, dams, bridges, etc.
(ii) Expenditure on education and public welfare programmes.
(iii) Expenditure on the defence of the country and the maintenance
of law & order.
(iv) Expenditure on various types of subsidies to the producers with
a view to encourage production.
It is by changing any or all types of expenditure that the government
seeks to correct the situations of excess demand or deficient demand in
the economy. When there is excess demand, government expenditure
is reduced, and when there is deficient demand, government
expenditure is increased. A rise in government expenditure acts as
an 'injection' into the circular flow of income in the economy. It is
required when liquidity needs to be released to combat deflation.
Likewise, a cut in government expenditure acts like a 'withdrawal'
from the circular flow of income in the economy. It is required when
liquidity needs to be soaked to combat inflation.
(2) Taxes
Taxes are a compulsory payment made to government by the
household.
By increasing the tax burden on the households, the government
reduces their disposable income. Accordingly, AD is reduced or excess
demand is managed. On the other hand, by lowering the tax burden,
the government increases disposable income of the households.
Accordingly, AD is raised and deficient demand is managed.
(3) Public Borrowing/Public Debt
By borrowing from the public, the government creates public debt. In
a situation of deficient demand (or when AD needs to be increased),
the government reduces its borrowing from the public. So that
people are left with greater liquidity (or cash balances) and aggregate
expenditure remains high. On the other hand, when there is a situation
of excess demand (or when AD needs to be reduced), the government
steps up public borrowing by offering attractive rate of interest. This
reduces liquidity with the people. Accordingly, aggregate expenditure
also reduces and excess demand is managed.

(4) Borrowing from RBI (the Cental Bank)
Borrowing by the government from the RBI is another element of
fiscal policy. It is increased to fight deflationary gap, and reduced
to fight inflationary gap. Higher borrowing releases greater liquidity
in the economy, as required to correct deflationary gap (deficient
demand). When borrowing is reduced, the amount of liquidity in the
economy is also reduced, as desired to correct inflationary gap (excess
demand) in the economy.
@TS
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Q. What fiscal measu res would you recommend to correct d eficient demand?
Ans. Following fisca l m easures a re reco m m ended to correct deficient demand:
( i ) The gove r n ment should ste p up its expenditure [on ( a ) p u bl i c works p rogra m m es, ( b ) education
a n d p u b l i c welfa re, (c) subsidies to the p rod ucers, a n d ( d ) d efence and law & order] . H igher
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gove r n ment expe n d it u re a cts like a n injection i nto the circ u l a r flow of i n come i n the eco n omy.
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( i i ) The government should reduce tax burden on the households, so that they a re l eft with greater
cash ba lances. H igher cash bala nces with the people lead to higher level of AD.
( i i i ) The govern ment should raise more funds from the RBI so that there is a greater flow of liquidity
or
in the economy. H igher liquidity i m p l ies h igher level of AD.
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(iv) The government should plan a cut in public borrowi ng, so that, people a re left with greater
liqu idity (or cash balances). Greater cash ba lances i m p l ies h igher AD.
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B riefly, deficient demand is corrected when the government steps up its own expenditure a n d
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ensures that cash bala nces with t h e people are raised .
[Note: Students a re advised to write j u st a n o pposite a nswer i n case the q uestion relates to excess
B
demand.]
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Monetary Policy (Monetary Measures)

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We have already described the components of monetary policy and

the way these are used to correct the situations of excess demand
nd
(inflationary gap) and deficient demand (deflationary gap) in the

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economy in chapter 6. Here, we present a brief summary of that

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description. Application of monetary instruments to correct excess

demand and deficient demand is discussed separately, as under:
Application of Monetary Instruments
to Correct the Situation of Excess Demand
• Bank rate and repo rate are raised by the RBI . As a follow-up action,
market rate of interest is raised by the commercial banks. Cost of
borrowing rises. It lowers the demand for credit leading to a cut in
consumption and investment expenditure in the economy. Implying
a cut in AD, as desired to curb excess demand or inflationary gap.

• Reverse repo rate is raised by the RBI . This induces the commercial
banks to park their surplus funds with the RBI. Accordingly,
lesser funds are used as (RR-deposits for the creation of credit.
Availability of credit is reduced. It leads to a cut in AD. Excess
demand or inflationary gap is curbed.
• Pursuing the policy of open market operations. Securities are
sold by the RBI to soak liquidity. Accordingly, cash reserves of
the commercial banks are reduced, implying a cut in their credit
creation capacity. When the availability of credit reduces, AD shrinks.
Accordingly, excess demand is corrected.
• CRR is raised to lower credit creation capacity of the commercial
banks. Lesser availability of credit causes a fall in AD. Accordingly,
excess demand is corrected.
• SLR (Statutory Liquidity Ratio) is raised. It gives a warning signal
to the commercial banks to maintain healthy cash reserves with
themselves. Lesser funds are parked with RBI as CRR reserves.
Supply of credit is reduced and AD is lowered. Excess demand is
corrected.
• Margin requirement (minimum down payment that a borrower is
required to make as a percentage of his loan from the commercial
banks) is raised to restrict the availability of credit. Accordingly,
AD is reduced and excess demand is corrected.
• Moral pressure is exerted by the RBI on the commercial banks to
be selective and strict in lending when AD needs to be curbed to
correct the situation of excess demand or inflationary gap.
• Credit rationing is introduced, prescribing credit limits for different
sectors of the economy. This restricts the availability of credit.
Accordingly, AD is lowered and excess demand is corrected.
Briefly, dear money policy is pursued to curb excess demand. This
policy reduces the availability of credit and increases the cost of
credit. Lower demand for credit leads to a fall in AD, implying the
correction of excess demand.
Application of Monetary Instruments

to Correct the Situation of Deficient Demand
In a situation of deficient demand, AD needs to be raised. The RBI
pursues cheap money policy. Availability of credit is raised and cost
of credit is lowered. It is achieved by using the monetary instruments
exactly the opposite way these are used in a situation of excess
demand or inflationary gap. Avoiding repetition, we may state that
(for the correction of deficient demand), the availability of credit

is raised and the cost of credit is lowered through the following
monetary actions by the RBI:
• Bank rate and repo rate are lowered. Accordingly, cost of credit is
reduced and availability of credit is increased.
• Reverse repo rate is lowered, so that the commercial banks are
not induced to park their funds with the RBI to generate interest
income. Instead, they are prompted to use their funds for the
creation of credit.
• Securities are purchased to inject liquidity into the system. The
low
banks are left with more cash for the creation of credit.
• CRR is lowered to increase the supply of credit.
• SLR is lowered to enhance credit creation capacity of the commercial
banks.
• Margin requirement is lowered to raised the availability of credit.
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• Moral pressure is built on the commercial banks to be liberal in
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lending.
• Credit rationing, if already in force, is withdrawn to enhance the
or
availability of credit.
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Thus, RBI makes every effort to increase the supply of credit and
decrease the cost of credit. Easy availability of credit raises the demand
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for credit. Accordingly, AD is raised and deficiency of demand (or
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deflationary gap) is curbed.
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Monetary Policy and Fiscal Policy-The Difference

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Moneta ry Policy Fiscal Policy

( i ) It is the pol icy of correcting excess or (i) It is the pol icy of correcti ng excess or
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d eficient d e m a n d i n the economy by deficient demand i n the economy by

contro l l ing the s u p ply of cred it. managing reve nue and expenditure
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of the government.
(ii) It is p u rsued by the centra l ba n k of a ( i i ) It is p u rs u ed by the government of a
nd
country ( R B I i n I n d i a ) . country.
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( i i i ) Tools of moneta ry pol icy are: ba n k ( i i i ) Tools o f fiscal policy a re : government

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rate . repo rate, reverse re po rate, expenditure, taxes, p u b l i c borrowing

open ma rket operations, cash and borrowing fro m centra l bank.
rese rve ratio, statutory liquid ity
ratio, m a rg i n req u i rement, mora l
suasion a n d credit ratio ning.

Power Poi nts & Revision Wi ndow ----------
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Full Employment Equilibrium and Underemployment Equili brium
! Full E m p l oyment Eq u i l i b ri u m refe rs to t h at s i t u ati o n 1n the e co n o my w h e n AS = AD
(or S = I } a l o ng with fu l l e r u t 1 l 1sat 1 o n of l a b o u r. [AS = A D, corre s p o n d i n g to the s i t u a t i o n of fu l l
e m ployment.]
U nderemployment Equilibrium refe rs t o t h a t s i t u ation 1 n t h e e co n o my w h e n AS = AD ( o r S = I}
b ut without fu l l e r u t i l isat i o n of l a bo u r. [AS = A D, corres p o n d i ng to the situation of l ess than fu l l
j
e m p l oy m e n t . ]
Vol untary a n d Involuntary Unemployment
! Volu ntary Unemployment occu rs w h e n some peo p l e a re n ot w i l l i ng to work at a l l, o r a re not
w i l l i n g to work at the existi ng wage rate .
I nvol untary Unemployment refers to a situation w h e n peo p l e a re not getti n g work, even when they a re
j
w i l l i ng to work at the existi ng wage rate .
Full Employment and Natura l Unemployment
! Full Employment i s that situation i n the eco n o my when AS = AD a long with fu l l e r u ti l i sati o n of
reso u rces. B ut it does n ot mean a situation of zero u n e m p loyment i n t h e economy.
Natural Unemployment is that rate of u n e m p l oy m e nt ( m i n i m u m rate of u n e m p loym e nt) wh ich a l ways
j
exists i n the eco n o my, owi ng to co nsta ntly c h a ng i n g s u pply a n d d e m a n d p a ra m eters i n the eco n o my.
Deficient Demand is a situ ation w h e n : AD < AS (correspo n d i ng to fu l l e m ployment leve l ) .
! Deflationary Gap is measu red as t h e d ifference between 'AD-at fu ll e m ployment' and 'AD-at
underemployment'.
Causes of Deflationary Gap: ( i ) Red u ction i n private co n s u m ption expen d itu re, ( i i ) Red u ction i n
i nvestment expen d i t u re, ( i i i ) Red u ction i n gove rn m e nt expend itu re, ( iv) Decl i n e i n exports, (v) Rise
in i m po rts, (vi) I n crease i n tax b u rd e n .
Consequences of Deficient Demand: Deficient De m a n d ca uses Deflation a n d U n d e re m p loyment: W h e n
AD fa i l s t o catch u p w i t h A S o f fu l l e m ploy m e nt, a l l goods a n d s e rvices prod u ced i n the economy ca n not
be so l d . Accord i ng ly, profits sta rt s h ri n ki ng. Th is d isco u rages i nvestment a n d lowers the l eve l of i n co m e/
e m p l oyment i n t h e eco n omy. The eco n o my is ca ught i n a low l eve l eq u i l i bri u m tra p w h e re low AD causes
j
low output and low outp ut/i ncome ca uses low AD.
Excess Demand is a situation wh e n : AD > AS (correspo n d i ng to fu l l e m p l oyment l eve l ) .
! Inflationary G a p is measured as t h e d ifference betwee n 'A D-beyond fu l l e m pl oyment' a n d
'A D-at fu l l e m ployment'.
Causes of Inflationary Gap: Ca uses of i nflationary ga p a re j ust o p posite to the ( a bove stated )
ca uses of d eflation a ry ga p . These a re re lated t o a rise i n t h e va rious com pone nts o f AD, a rise that
co nti n ues to occ u r eve n when resou rces a re fu l ly util ised .
Consequences of Excess Demand: Excess D e m a n d causes I nfl ati o n : Because excess d e m a n d i s that l eve l
of AD w h i c h s u rpasses AS (at fu l l e m p loyment leve l }, it m ust ca use inflatio n . O utput ca n n ot be i n c reased
once fu l l e m p l oy m e nt i s rea c h e d . H e nce, AD beyo n d its fu l l e m p l oy m e nt l eve l wou l d o n l y gen e rate
pressu re of d e m a n d o n the existi ng s u p ply. I m plying i nflati o n . Th e eco n o my i s ca ught in a wage-price
s p i ra l : wages catch pri ces a n d p rices catch wages.

Correcting Excess and Deficient Demand Meas u res of correcti ng excess and deficient dema nd, include:
j
(i) fisca l measu res, a n d (ii) moneta ry measures. Fisca l measu res
relate to fisca l pol icy of the government, a n d moneta ry measures
relate to moneta ry pol icy of the centra l ba n k.
Fiscal Policy refers to the reve n u e a n d expe nditure pol icy (or budgeta ry pol icy) of the
govern ment to correct the situations of excess a n d deficient demand i n the economy
with a view to achieve 'growth with sta b i l ity'.
Components of Fiscal Policy a n d the way these a re used :
(i) Government Expenditure: I ncreased to correct deficient dema nd, and decreased to correct
excess dema n d .
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(ii) Taxes: Tax burden i s lowered t o correct deficient demand, a n d raised to correct excess demand.
(iii) Public Borrowing: Decreased to correct deficient demand, and increased to correct
excess d e m a n d .
(iv) Borrowing from RBI: I ncreased t o correct deficient dema nd, a n d decreased t o correct
ee
excess d e m a n d .
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Monetary Policy refe rs t o t h a t po l i cy w h i c h corrects excess a n d deficient d e m a n d b y regu l ati ng t h e
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cost o f credit a n d ava i l a b i l ity o f c redit i n t h e economy.
Com ponents of Monetary Pol icy a n d the way these a re used :
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(i) Bank Rate/Repo Rate: I ncreased to correct excess dema nd, and decreased to correct deficient demand.
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(ii) Reverse Repo Rate: I ncreased to correct excess d e m a n d a n d decreased to correct deficient dema n d .
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(iii) Open Market Operations: T h e centra l ba n k s e l l s secu rities t o correct excess d e m a n d a n d buys
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secu rities to correct deficient dema n d .
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(iv) CRR: Raised t o correct excess demand, a n d lowered t o correct d eficient dema n d .
(v) SLR: Raised t o correct excess d e m a n d , a n d l owered t o correct deficient d e m a n d .
B
(vi) Margin Requirement: Ra ised t o correct excess d e m a n d , a n d l owered t o correct deficient d e m a n d .

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(vii) Credit Rationing: I ntrod uced t o correct excess d e m a n d , a n d with d rawn (if a l ready i n force) to
correct deficient dema n d .
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(viii) Moral Suasion: Ba n ks a re advised t o p u rsue cheap money pol icy t o correct deficient demand, a n d
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dear money pol icy t o correct excess d e m a n d .

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rEX E RC I S Ej
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1 . Objective Type Questions (Remembering & U n de rsta n d i n g based Q u estions)
A. M u lt i p l e Choice Q u esti o n s
1. Full e m ployment equilibrium refers to a situation of:
(a) AD = AS (with fu l ler uti l i sation of resou rces)
( b ) zero u ne m p l oyment
( d ) none o f these

2 . Natura l u n e m ployment occ u rs d u e to:
(a) shortage of factors of prod uction
(b) ti me req u i red i n adj u sti ng to cha nge i n tech nology
(c) ti me req u i red in s h ifting from one job to the other
(d) both ( b ) a n d (c)
3 . Frictio n a l u n e m p loyment occ u rs d u e to :
(a) i m m o b i l ity of labour ( b ) lack of prod uction ca pacity
(c) l ow wage rate ( d ) none of these
4. Structura l u n e m ployment occurs due to:
(a) change i n tech nology (b) when factors (other than l a bo u r) a re in shortage
5 . Deficient d e m a n d leads t o :
(a) deflationary ga p (b) i nflationary ga p
6. Deflatio n a ry ga p is measu red a s :
(a) AD F + AD p (b) AD F + AD p
(c) AD F - AD p ( d ) none of these
[ N ote : H e re, AD F = F u l l e m p l oyment AD; AD p = P l a n ned AD corres pond i n g to u n d ere m p l oyment.]
7. Excess demand refers to a situation w h e n :
(a) AD > A S (correspond i n g t o fu l l e m p l oyme nt)
(b) AD < AS (correspond i n g to fu l l e m p l oyme nt)
(c) u nsold stocks tend to increase
(d) none of these
8. Excess demand leads to:
(a) i nflationary ga p ( b ) rise i n prices
(c) rise in e m p l oyment leve l ( d ) both (a) a n d ( b )
9. W h i c h o f the fol lowing does not lead to fa l l i n AD?
(a) Fal l i n private consumption expenditu re (b) Fa l l i n exports
(c) Fa l l in i m po rts (d) Fa l l in government expe nd itu re
10. Which of the fol l owing leads to i n c rease in AD?
(a) Fa l l i n i m po rts (b) I ncrease in i nvestment expenditure
(c) I ncrease i n government expe nditure ( d ) All of these
1 1 . I nflati o n a ry ga p :
(a) ra ises the leve l o f output ( b ) d oes not i m pact the leve l of output
(c) ra ises the genera l p rice leve l ( d ) both ( b ) a n d (c)
12. If the level of AD is to be ra ised (i m plying a n u pwa rd shift in AD cu rve) there should be:
(a) increase i n a utonomous i nvestment ( b ) increase i n a utonomous con s u m ption expenditure
13. Revenue and expenditure pol icy of the government to correct the situations of excess and deficient
demand is known as:
(a) moneta ry pol icy ( b ) fisca l pol icy

14. Which of the fol l owing compone nts of fisca l pol icy ca n be used to correct deficient d e m a n d ?
(a) I ncrease i n government expe nd itu re ( b ) Cut i n tax rates
(c) Cut in p u b l i c borrowing (d) A l l of these
15. Deficient or excess demand ca n be corrected t h rough :
(a) fisca l pol icy ( b ) moneta ry pol icy
(c) both (a) a n d ( b ) (d) none o f these
16. With a view to correcti ng inflationa ry ga p, which of the following fisca l pol icy measures should be
adopted ?
(a) I ncrease i n taxes ( b ) Red uction i n p u b l i c expe nd itu re
(c) I ncrease in p u b l i c debt (d) A l l of these
low
17. Which of the fol lowing com ponents of monetary pol icy ca n be adopted to correct excess demand?
(a) I ncrease i n ba n k rate ( b ) I ncrease in CRR
(c) I ncrease i n m a rg i n req u i rement (d) A l l of these
18. To correct the situation of deflationa ry ga p, the centra l bank:
(a) increases m a rgin req u i rement ( b ) decreases margi n req u i rement
ee
(c) increases cash rese rve ratio (d) both ( b ) a n d (c)
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19. By increasing the tax burden on the households, the govern ment intends to:
(a) correct the situation of deficient demand
( b ) correct the situation of i nflationary ga p
or
(c) correct the situation of excess demand
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(d) both ( b ) a n d (c)
20. Wage-price spira l is a conseq uence of:
k
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(a) i nflationary ga p ( b ) deflationary ga p
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( c) stagflation (d) both ( a ) a n d (c)
B
Answers
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1. (a) 2. (d) 3 . (a) 4. (c) 5 . (a ) 6. (c) 7. (a ) 8. (d) 9. (c) 10. (d)

11. (d) 12. (c) 13. ( b) 14. (d) 15. (c) 16. (d) 17. ( d ) 18. (b) 19. (d) 20. (a )
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Y

Choose appropriate word and fi l l i n the blank:
nd
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1. I n a state o f u ndere m ploym ent eq u i l i bri u m, there is ca pacity i n the economy.

( uti l ised/u nuti l ised )
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2. u n e m ployment refers to a situation when people choose to rema i n

u n e m p l oyed . (Vo l u nta ry/I nvol u nta ry)
3. u ne m p l oyment is associated with the changing of jobs i n dyn a m i c economy.
( Frictiona 1/Structu ra l )
4. _______ i n tax rates leaves lesser d is posa ble i ncome with t h e peo p l e . ( I ncrease/Decrease)
5. _______ demand ge nerates pressu re of demand on the existi n g resou rces.
( Deficie nt/Excess)
6. I m ports a re a _______ com ponent of AD. ( positive/negative)
7. _______ ga p is m e a s u red as the d ifference between 'plan ned AD which is beyond fu l l
e m ployment leve l' a n d 'A D that corresponds t o fu l l e m p l oyment'. ( I nflationary/Deflationary)

8. There is u n e m p l oyment or u ndere m ploym ent i n the economy i n a situation of
( i nflationary ga p/d eflationary ga p)
9. policy refers to reve n u e a n d expe nd itu re pol icy of the govern ment.
( Fisca l/M oneta ry)
10. Reve rse repo rate is by the RBI i n order to red uce the ava i l a b i l ity of credit i n the
economy. ( ra ised/red uced )
Answers
1. u n utilised 2. Vol u nta ry 3. Frictional 4. Increase 5. Excess
6. negative 7. I nflationa ry 8. deflationary ga p 9. Fisca l 10. ra ised
C. True or Fa lse
1. F u l l e m p l oyment eq u i l i bri u m refe rs to that situation in the economy when
AS = AD a l ong with fu l l e r uti l i sation of resources. (True/Fa lse)
2. N atu ra l u n e m p l oyment is a situation of 'frictional and struct u ral'
u n e m p l oyment i n the economy. (True/Fa lse)
3 . A rise i n government consu m ption expe nd itu re leads to a cut i n AD. (True/Fa lse)
4. AD is deficient when there is excess ca pacity i n the economy. (True/Fa lse)
5. I n a situation of excess demand, the price leve l does not rise. (Tru e/Fa lse)
6. Deflationary ga p is mea s u red i n terms of excess d e m a n d . (True/Fa lse)
7. Taxes a re a com p u l sory payment made t o government b y the household. (True/Fa lse)
8. H igher borrowi ng by the government from the RBI re leases greate r l i q u i d ity
i n the economy. (True/Fa lse)
9. Moneta ry pol icy is a lso ca l led budgeta ry pol icy of the govern ment. (True/Fa lse)
10. CRR is ra ised to increase cred it creation capacity of the com mercial ba n ks. (True/Fa lse)
Answers
1. True 2. True 3 . Fa lse 4. True 5 . Fa lse 6. Fa lse 7. True 8. True 9. Fa lse 10. Fa lse
Column I Column I I
(a) Un d erem ployment eq u i l i bri u m ( i ) No u n e m p loyment i n t h e economy
( b) I nvolu nta ry u n e m p loyment ( i i ) Excess capa city i n the economy
(c) P robl e m of u n e m p l oyment ( i i i ) P ro ble m of i nvol u ntary u n e m p loyment
(d) F u l l em p l oyment ( iv) A situation of zero unem ployment
(e) Natura l rate of u n e m p loym ent (v) Maxi m u m rate of u n e m p loyment that m ust
always exist i n the economy
Answer
(c) Problem of unem ployment - (iii) Problem of involu nta ry unemployment

items in Column I:
Column I Column I I
(a) F u l l em ployment eq u i l i bri u m ( i ) I nflationary ga p i n the economy
(b) Structura l u n e m ployment ( i i ) U n d erem ployment eq u i l i bri u m
( c ) Excess o f d e m a n d ( i i i ) P u rsued b y the centra l bank o f a cou ntry
( d ) Shortage of d e m a n d ( iv) Cha nge in t h e tech nique o f p rod ucti on
(e) Moneta ry pol icy (v) No excess ca pacity
low
Answers
(a) - (v), (b) - (iv), (c) - (i), (d) - (ii), (e) - (iii)
E . 'Very S h o rt A nswe r' Objective Type Questions
ee
1. What is fu l l e m ployment equilibri u m ?
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A n s . F u l l e m p l oyment eq u i l i bri u m is struck w h e n AS = AD along with fu l ler uti l i sation o f the resou rces .
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2. G ive the mea n ing of u ndere m ployment eq u i l i b ri u m .
Ans. U ndere m p l oyment eq u i l i br i u m is struck w h e n A S = AD b u t resou rces a re sti l l n o t fu l ly u ti l ised a n d
or
there is excess ca pacity i n the economy.
3 . What is vol u nta ry unemployment?
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Ans. Vol u nta ry u n e m p l oyment is a situation in which a worker is n ot wi l l ing to work at the cu rrent rate of
wage.
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4. G ive the mea n ing of invol u nta ry unemployment.
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Ans. I nvol u nta ry u n e m p l oyment is a situation in which a worker is wi l l i ng to work at cu rrent rate of wage
B
but d oes n ot get work.

5 . What is mea nt by fu l l e m ployment?
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Ans. F u l l e m p l oyment refers to a situation in which a l l those who a re a b l e to work and a re wi l l i ng to work
at the existi ng wage rate get work.
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6. What is the natu ra l rate of unemployment?

Y
Ans. N atu ra l rate of u n e m pl oyment is the m i n i m u m rate of u ne m p l oyment that m u st exist in the economy
even when the labour ma rket is i n a state of eq u i l i bri u m .
nd
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7. Defi ne frictional u n e m ployment.

Ans. Frictional u n e m pl oyment is that u n e m p l oyment which is associated with changing the jobs in a
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dyn a m i c economy.
8. Defi ne structura l unemployment.
Ans. Struct u ra l u n e m p l oyment is that u ne m p l oyment which is associated with struct u ra l cha nges in the
economy, l i ke cha nge in tech nology.
9. Does fu l l e m ployment mean zero u n e m ployment?
Ans. F u l l e m p l oyment d oes not mea n a situation of zero u ne m p l oyment. N atu ra l rate of u ne m p l oyment
( m i n i m u m rate of u n e m pl oyment) always exists i n the economy.
10. What is mea nt by deficient demand?
Ans. Deficient d e m a n d refers to a situation when aggregate demand is short of aggregate s u p ply
corresponding to fu l l e m ployment in a n economy.

11. What is mea nt by excess demand?
Ans. Excess d e m a n d refers to a situ ation when aggregate d e m a n d is i n excess of aggregate s u p ply
corresponding to fu l l e m ployment in a n economy.
12. Defi ne deflationary ga p.
Ans. Deflationary ga p is the shortfa l l i n AD from the level req u i red to m a i nta i n fu l l e m p l oyment i n the
economy.
13. Defi ne inflationary ga p.
Ans. I nflationary ga p is the excess of AD over and above its l evel req u i red to m a i nta i n fu l l e m ployment
eq u i l i bri u m in the economy.
14. How deficient demand i m pacts economic activity in the economy?
Ans. In a situation of d eficient dema nd, output l evel tends to red uce. Level of e m p l oyment a lso red u ces.
Th is leads to a fa l l in the level of i ncome and conseq u e ntly a fa l l i n AD. The economy is ca ught i n the
l ow level eq u i l i bri u m tra p .
1 5 . What ha ppens w h e n AD increases beyond its fu l l employment level?
Ans. When AD increases beyond its fu l l e m p l oyment level, output rem a i n s consta nt. But, the pressu re
of demand on the existi ng s u p p ly sta rts mou nti ng u p . This leads to a rise i n p rices. This i m p l ies a
situation of i nflati o n .
1 6 . H o w does price level ind icate t h e existence o f excess d e m a n d ?
A n s . When there is excess demand i n the economy, the p rice level t e n d s t o rise.
17. What does excess capacity mea n in the context of eq u i l i b ri u m GDP?
Ans. Existence of excess ca pacity poi nts to the deficiency of AD. It leads to u ndere m p l oyment eq u i l i b ri u m .
18. What i s fisca l pol icy?
Ans. Fisca l pol icy refers to reve n u e a n d expend itu re policy of the government to correct the situations of
excess a n d deficient d e m a n d in the economy.
19. What is moneta ry pol icy?
Ans. Moneta ry pol icy is the pol icy relati ng to the control of ( i ) s u p ply of money, a n d ( i i ) ava i l a b i l ity of
credit, a n d ( i i i ) cost of cred it ( rate of i nterest) with a view to com bati n g the situations of excess a n d
deficient d e m a n d i n the economy.
20. What ha ppens to the demand for credit in the economy when repo rate is increased?
Ans. When repo rate is increased, the commerci a l ba n ks, as a fol l ow-u p action, ra ise the ma rket rate of
i nterest (the rate at which the com m erci a l ba n ks lend money to the consumers and the i nvestors ) .
Th is red u ces demand for credit.
21. How should reverse repo rate be cha nged to check inflation ?
Ans. Reverse repo rate should be ra ised, so that the commercial ba n ks a re i n d u ced to park more fu nds
with the R B I to generate i nterest income. Accord ingly, less fu nds wou l d be used as CRR-reserves for
credit creati o n . This w i l l check i nflati o n .
2. Reason-based Questions (Comprehension o f the S u bject-matter)
Read t h e fol l owing statements ca refu l l y. Write True or Fa lse with a reason .
1. Once eq u i l i b riu m G D P is ach ieved, the level of output is the sa me; no m atter it is u ndere m ployment
eq u i l i b ri u m or fu l l employment eq u i l i b ri u m .
Ans. Fa lse. G D P level is l ower corresponding t o u ndere m ployment eq u i l i bri u m com p a red with fu l l
e m ployment eq u i l i b ri u m .

2. F u l l e m ployment i m plies zero u n e m p loyment when nobody is ever unemployed in the economy.
Ans. Fa lse. Even in a state of fu l l e m p loyment, there is always some m i n i m u m level of the u ne m p l oyment,
ca l led nat u ra l u n e m p l oyment.
3 . U ndere m ployment equilibri u m indicates excess capacity in the economy.
Ans. True. I n the situation of u n d erem p l oyment eq u i l i bri u m, AD is l ess than what is needed for fu l l
e m ployment o f t h e factors. I m p lying t h e existence of excess capacity i n t h e economy.
4. Excess demand leads to greater opportu n ities of e m ployment in the economy.
Ans. Fa lse. Excess demand is a situation when AD > AS correspond i n g to fu l l e m ployment i n the economy.
Accord i n gly, there is no possi b i l ity of greater e m ployment opportun iti es when there is excess
demand.
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5 . Low level eq u i l i bri u m tra p is the conseq uence o f excess d e m a n d .
A n s . Fa lse. Low l evel eq u i l i b ri u m tra p is the conseq uence o f d eficient d e m a n d .
6. Wage-price spira l is the conseq uence o f deficient d e m a n d .
A n s . Fa lse. Wage-p rice s p i ra l is the conseq uence o f excess d e m a n d . I n this situation, wages catch prices
and prices catch wages. Output ca n not i ncrease beca use resou rces a re a l ready fu l ly e m p l oyed .
ee
7. Increase in output beyond u ndere m ployment eq u i l i bri u m does not cause inflationary ga p.
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Ans. True. I ncrease i n output beyond u ndere m p l oyment eq u i l i bri u m does n ot cause i nflati o n a ry ga p
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beca use excess ca pacity exists i n the economy. I ncrease i n AD i n d uces p roportionate increase i n AS
at the existi ng price leve l .
or
8. Increase in AD beyond fu l l e m ployment does not cause increase in m a rket price o f t h e output.
Ans. Fa lse. I ncrease i n AD beyond fu l l e m p l oyment leads to increase i n market price of the output.
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H owever, the level of output does not increase.
9. To correct the i nflationary ga p, ava i l a b i l ity of credit should be increased.
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Ans. Fa lse. To correct i nflati o n a ry gap, ava i l a b i l ity of credit should be red uced . Red uction i n the ava i l a b i l ity
oo
of cred it wou l d cause a red uction in AD to correct the i nflationary ga p .
B
1 0 . To correct t h e deflation a ry ga p, the govern ment should increase taxation.

A n s . Fa lse. In o rder to correct the d eflati o n a ry ga p, the gove r n m e nt should red uce taxati o n . Lowe r
re
taxati o n wou l d i n c rease d i s posa b l e i ncom e . Accord i n gly, AD wou l d i n c rease to correct the
d eflati o n a ry ga p .
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ad
11. An increase i n AD m ust ca use a rise in genera l price level.

Y
Ans. Fa lse. An i ncrease i n AD may not ca use increase i n genera l price level i n a situation of excess ca pacity
in the economy.
nd
12. I n a situation of i nflationary ga p, ge nera l p rice level tends to rise.

Re
Ans. True. In the situatio n of i nflationary ga p, excess demand i m p l ies p ress u re of demand o n the existi ng
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resou rces. Conseq uently, cost of prod u ction rises ca using a rise in the genera l p rice leve l .
13. I n a situation o f deflationary ga p, l o w leve l o f AD leads t o low leve l o f AS.
Ans. True. U nder deflati o n a ry ga p or deficient demand, u nderem p l oyment eq u i l i br i u m occu rs at a point
where level of AD is less than that of fu l l e m p l oyment. Si nce AS is assumed to be perfectly elastic, it
a l igns itself to the l ow l evel of AD.
14. I nflationary ga p ca n be corrected by lowering the level of a utonomous i nvestment.
Ans. True. I nflati o n a ry ga p or excess demand ca n be corrected by red ucing autonomous i nvestment
expend itu re beca use i nvestment is a component of AD.
15. Deflationa ry ga p ca n be corrected by i ncreasing the leve l of AD.
Ans. True. Deflationary ga p ca n be corrected by increasing the level of AD. Beca use it is the deficiency of
AD that ca uses deflationary ga p .

16. Ba n k rate should be lowered i n a situation of inflationary ga p.
Ans. Fa lse. Ba n k rate should be increased i n a situation of i nflati o n a ry ga p i n o rder to l ower money s u p ply
i n the economy. I m plying that AD s h o u l d red uce.
17. CRR should be ra ised to com bat deflationary ga p.
Ans. Fa lse. CRR should be l owered to com bat deflationary ga p. This ra ises ca pacity of the commercia l
ba n ks to create cred it i n the economy. Th us, AD tends to rise.
18. SLR needs to be ra ised to com bat deflationa ry ga p.
Ans. Fa lse. SLR should be lowered to com bat d eflati o n a ry ga p. Th is ra ises ca pacity of the commercia l
ba n ks to create cred it i n the economy. Th us, AD tends to rise.
19. It is not possible to com bat i nflationary ga p without ca using unem ployment in the economy.
Ans. Fa lse. When i nflationary ga p is com bated, the economy is brought back to its fu l l e m p l oyment leve l .
H ence, n o q uestion o f decrease i n e m p l oyment.
20. When deflationa ry ga p is com bated, the level of e m ployment tends to rise in the economy.
Ans. True. Deflati o n a ry ga p ca uses a fa l l in the level of e m p l oyment. So that when deflati o n a ry ga p is
com bated, there is rise i n the e m p l oyment level i n the economy.

1. Eq u i l i b ri u m beyond fu l l e m ployment is a better situation (in terms of the level of G D P) than
eq u i l i b ri u m at fu l l e m ployment. Defend or refute.
Ans. The given statement is i ncorrect. Output rem a i n s consta nt even beyond fu l l e m p l oyment eq u i l i b ri u m .
Beca use, fu l l e m p l oyment eq u i l i b r i u m output i s t h e maxi m u m output.
2. What is the effect of deficient demand on output, employment a n d prices?
Ans. (i) Effect on Output: Deficient d e m a n d leads to low level of output.
(ii) Effect on E m ployment: Beca use deficient demand l owers the level of p l a n ned output, the level
of e m p l oyment is a lso l owered . A situation of u ne m p l oyment or u nd e re m p l oyment preva i l s i n
t h e economy.
(iii) Effect on Prices: Fa l l i n prices is the i m med iate conseq uence of d eficient d e m a n d . Beca use,
owi ng to l ow sales, stocks tend to p i l e u p, com pel l i n g the p rodu cers to l ower the prices.
3 . What is the effect of excess demand on output, e m ployment and prices?
Ans. (i) Effect on Output: In the situatio n of excess demand, output does not increase. The economy is
a l ready operati n g at fu l l e m p l oyment. So that the poss i b i l ity of increase in output is ru led out.
(ii) Effect on E m p l oyment: E m p l oyment will not increase beca use there is no i nvol u nta ry
u n e m p l oyment i n the economy. The economy has a l ready achieved fu l l e m p l oyment.
(iii) Effect on Prices: Excess demand only generates pressu re of demand on the existi ng flow of
goods and services in the economy. Accord i ngly, prices tend to rise.
4. Is a situation of u ndere m ployment better than that of over-em ployment beca use in a state of
u ndere m ployment price level does not rise?
Ans. No. U ndere m p l oyment leads to l ower level of i ncome ( l ower than the fu l l e m p l oyment). It ca uses a
fa l l i n AD a n d the economy might be d riven i nto a situation of low level eq u i l i b r i u m tra p .
5 . Even in a state o f fu l l employment, there i s a possibil ity o f a n increase in output. Is i t true?
Ans. No. In a state of fu l l e m p l oyment, output wi l l not increase if it is assu med that technology rem a i n s
consta nt.
6. Fisca l pol icy always aims at ra ising additional revenue for the government. Com ment.
Ans. The given statement is i n correct. Fisca l pol icy a i m s at m a i nta i n i ng a fisca l bala nce i n the cou ntry
which may req u i re add itional reven u e or add itional expend itu re by the govern ment.

7. Do you agree that fisca l pol icy a n d moneta ry pol icy a re opposite to each other?
Ans. N o, it is n ot correct. Fisca l and moneta ry pol icies a re com plementary to each other. Both a re
s i m u lta n eously p u rsued to com bat the situation of i nflationary or deflationary ga p .
8. Is it correct t o say t h a t the govern ment intervention t h rough fisca l a n d moneta ry pol icies is not
req u i red i n the m a rket economies which a re governed by the m a rket forces of demand and supply?
Ans. N o, it is n ot. Keynes su pported the existence of ma rket econom ies. But even he suggested that the
government i ntervention in these econom ies is essenti a l, when there a re i nflationa ry/deflationary
ga ps. It is o n ly t h rough governm ent i ntervention (through autonomous i nvestment by the
government) that the l ow level eq u i l i brium tra p ca n be broken i n the market economies .
9. Price of crude oil has drastically fallen in the international oil market.
low
Ca n you identify its negative i m pact on aggregate demand for the goods p rod uced i n I n d i a ?
A n s . A d rastic fa l l i n the p rice of crude o i l i n the i nternational ma rket wou l d lead to a n eq u a l ly d rastic fa l l i n
t h e level o f i ncome i n t h e oil-producing economies. To t h e extent I n d i a depends o n these econom ies
for its exports, it wou l d mea n a fa l l i n 'export' com ponent of aggregate dema n d . So that, aggregate
demand (for the goods produced in I n d i a ) is expected to fa l l .
10. Exemption limit for the payment of income tax has been raised from � 2 lakh to � 2.5 lakh, for the
ee
financial year 201 7-18.
rF
Fr
Do you t h i n k it wou l d h e l p correct the deficiency of demand eve n when M PC re ma i n s consta nt?
Ans. A rise in exem ption l i m it from � 2 l a kh to � 2 . 5 l a kh wou l d lead to a rise in d isposa ble i ncome of a
taxpayer by � 50,000. Let us assume that M PC = 0.5, a n d it rema i n s consta nt. It wou l d mean that
or
aggregate consum ption i n the economy wou l d increase by 0.5 x � 50,000 = � 25,000 per taxpayer.
Accord i n gly, deficiency of demand wou l d be corrected .
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Th us, we concl ude that a n increase i n exem ption l i mit relati n g to i ncome tax wou ld h e l p correct
deficiency of demand even when M PC remains consta nt.
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oo
11. Briefly state how moneta ry policy is used to correct deficient demand.
A n s . Fol l owi ng observations h i g h l ight h ow moneta ry pol icy is used to correct d eficient dema nd :
B
( i ) Ba n k rate/Repo rate is l owered, fol lowi ng which ma rket rate of i nterest is red u ced . Th is i m p l ies
re
a cut i n the cost of cred it. Accord i n gly, demand for cred it i ncreases. I m plying a rise i n AD, as
req u i red to correct deficient d e m a n d .
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( i i ) Reverse repo rate is lowered t o i n d uce ba n ks t o use their fu nds more for the creation o f cred it.
ad
( i i i ) Secu rities a re p u rchased by the RBI in the open ma rket to i nject l i q u i d ity i nto the system . This
Y
ra ises AD.
( iv) CRR and SLR a re lowered . This ra ises ca pacity of the commerci a l ba n ks to create cred it.
nd
Re
Ava i l a b i l ity of credit increases. Accord i n gly, AD tends to rise.

(v) M a rgin req u i rement is red uced . Th is m a kes credit more attractive. Accord i ngly, borrowing
Fi
increases ca using a rise i n AD.

(vi) Mora l pressu re is exerted by the centra l ba n k on the com mercial ba n ks to be l i bera l i n l e n d i ng,
so that demand for cred it increases and AD is ra ised .
(vi i ) Credit rationi ng, if a l ready i n force, is withdrawn . Ava i l a b i l ity of cred it become easy. Accord i n gly,
borrowing increases a n d AD rises.
Briefly, deficient demand is corrected by p u rs i n g cheap money pol icy. Cost of cred it (or rate of
i nterest) is decreased and ava i l a b i l ity of cred it is increased . Accord i n gly, demand for cred it rises a n d
AD tends t o rise.

1. U ndere m ployment is a critica l featu re of the I n d i a n economy. Ca n we rea l ly exp l a i n it in terms of
the deficiency of dem a nd?
Ans. Prof. Keynes b l a mes d eficiency of demand for u nd e re m p l oyment. But, it is with reference to such
econom ies which a re the victi m of recession/d epression a n d where deficiency of demand leads to
excess capacity. I n countries l i ke I n d ia, u n derem ployment is not related to excess ca pacity. I n stead, it
is related to the lack of prod u ction ca pacity. What India lacks is n ot demand to generate e m p l oyment,
but prod u ction capacity (ca pita l ) to engage the s u r p l u s l a bou r force. Which is why the government
is enco u raging F D I (foreign d i rect i nvestment) .
2. Do you t h i n k tackl ing slowdown i n ind ustrial production (due to low invest ment) should be the
priority of the Government in I ndia rather t h a n the h igh rate of inflation?
A n s . I nd i a n economy has been d rive n i nto co m p l ex situatio n of s l owdown i n i n d ust r i a l p rod u ctio n a l o ng
with a h igh rate of i nflati o n . If i n d u strial p rod u cti o n is to be stepped u p, cost of cred it ( rate of
i nterest) m u st be l owered by the com me rc i a l ba n ks . This req u i res that the gove r n m e nt l owers the
re po rate (so that the m a r ket rate of i nterest is l owered for the i nvesto rs) . But, if i nterest rate is
l owered a n d demand for cred it rises, two adve rse i m pacts ca n n ot be avoided : ( i ) l eve l of AD wou l d
rise w h i c h w i l l fu rth e r fu el the rate o f i nflation, a n d ( i i ) rising rate o f i nfl ati o n wou l d i n c rease t h e
g u l f between the 'haves' a n d 'have- nots'. H ig h rate o f g rowth ( a c h i eved t h rough l owe r rate of
i nterest) wou l d no l onger be an ' i n c l u s ive growt h'. I n stead, it wi l l be g rowth, that exc l u d es l a rger
secti o n s of the society.
It is, thus, recommen ded that the government should proceed very ca utiously. W h i l e the i n d ustria l
sector needs a big-push, the government m u st ensure that p roblem of i nflation is s i m u lta neously
a d d ressed .
3 . H ow, i n you r o p i n ion, the E u ropean econom ies ca n b rea k the dead lock of economic recession?
Write two suggestions.
Ans. (i) The government i n E u ropea n econom ies should sca l e up autonomous i nvestment. I ncrease in
a utonomous i nvestment wi l l ra ise the level of AD and brea k the dea d l ock of l ow i n d ucement to
i nvest.
( i i ) The government should enco u rage the domestic prod ucers to explore markets in rest of the
world . The government ca n d o it by offering export su bsidy, or by offering tax-brea ks to the
exporters.
4. Eve n when the ge nera l p rice leve l is rising (in the wa ke of i nflation) i n d ustria l p roduction is s h r i n ki ng.
H ow do you exp l a i n such a situation of stagflation i n I n d i a ?
A n s . During i nflation, rea l i ncome of the people tends to s h ri n k. Th is ca uses a fa l l i n AD, prom pti n g a cut
i n p roducti o n . P l a n ned output becomes l ower than the potenti a l output and a situation of excess
ca pacity ( u n uti l ised capacity) emerges in the economy. This is aggravated by the high cost of i n p uts
in the wa ke of i nflati o n . T h u s, i n d u strial p rod u ctio n sta rts s h r i n ki n g even when the genera l p rice
l eve l is rising. The eco nomy s l i d es towa rd s stagflati o n - a situ ati o n of stagnati o n in the m i d st of
i nflati o n .
5 . H o w w i l l t h e fl o w o f fu nds in t h e money m a rket b e i m pacted, i f C R R i s gradually lowered b y the
centra l ba n k?
Ans. CRR m a kes it mand atory for the commercia l ba n ks to keep some cash reserves (as a percentage of
their d e posits) with the centra l ba n k. These a re steril ised cash reserves or i d l e cas h reserves from
the viewpoi nt of the commercia l ba n ks . If CRR is gra d u a l ly l owered, these cas h reserves can be
p roductively uti l ised by the commercial ba n ks. Cash reserves ca n add to the stock of l i q u i d assets of
the ba n ks, a n d accord i ngly, e n h a nce their ca pacity to create cred it (on the basis of the existi ng SLR).
Accord i n gly, flow of fu nds i n the money ma rket wi l l i ncrease.

6. How wi l l i m plementation of the 7th pay com mission i m pact AD i n the economy?
Ans. I m plementation of the 7th pay com m ission is expected to increase d i s posa b l e i n come of the people.
It wou l d mea n increase i n aggregate d e m a n d for goods a n d services. It is hoped that increase in
AD wou ld brea k the dea d l ock of s l ow i n d ustrial growth i n the economy. With the rise i n i n d ustrial
p rod u ction, GDP growth rate is a lso expected to rise.
5. CBSE Questions- Past 5 yea rs

1. Exp l a i n the concept of i nflati o n a ry ga p . Exp l a i n the rol e of repo rate in red ucing this ga p .
[ Page 265, 270] [CBSE Delhi 2015]
low
2. Exp l a i n the concept of d eflati o n a ry ga p and the role of 'open ma rket operations' in red ucing this ga p.
[ Page 261, 262, 272] [CBSE Delhi 2015]
3. What is 'deficient demand'? Exp l a i n the role of 'ba n k rate' in removi ng it. [CBSE (Al) 201 5]
[ Page 258, 272]
4. What is 'excess demand'? Exp l a i n the rol e of 'reverse repo rate' i n removi ng it. [CBSE (Al) 2015]
ee
[ Page 263, 271]
rF
Fr
5. What is 'i nflationary ga p' ? Expla i n the role of cash reserve ratio in removing this ga p. [CBSE (F) 2015]
[ Page 265, 271]
or
6. What is 'deficient demand'? Exp l a i n the role of 'margi n req u i rements' i n removing this ga p.
[ Page 258, 272] [CBSE (F) 2015]
sf
u
7. Exp l a i n the role of taxation in red ucing excess d e m a n d . [CBSE Delhi 201 6]
[ Page 269]
k
Yo
8. Exp l a i n how contro l l i ng money su pply is h e l pfu l i n red ucing excess dema n d . [CBSE (Al) 201 6]
oo
[Money su pply refers to the tota l quantity or stock of money available in the economy at a point of time.
B
Contro l l i n g money s u p ply amou nts to contro l l i n g the demand for goods and services i n the economy.
re
Demand i n c l u des both con s u m ption expend itu re (C) as wel l as i nvestment expend itu re (I). Both C
a n d I a re i m porta nt com ponents of aggregate d e m a n d . Accord i ngly, when C a n d I a re red uced,
excess d e m a n d is a utomatica lly red uced .]
ou
ad
9. Exp l a i n how ca n government spending be h e l pfu l i n removi ng deficient d e m a n d . [CBSE (F) 201 6]
Y
[ Page 269]
10. Aggregate d e m a n d ca n be increased by: (choose the correct a lternative)
nd
(a) i ncreasing ba n k rate (b) sel l i ng government secu rities by Reserve Ba n k of I ndia
Re
(c) increasing cas h reserve ratio (d) none of the above [CBSE Delhi 201 7]
Fi
[(d)]
11. G ive the mea n i ng of i nvo l u nta ry u n e m p l oyment. [CBSE Delhi 201 7]
Or
Defi n e the term "invo l u nta ry u n e m p l oyment". [CBSE 201 9 (58/3/1)]
[ Page 256]
12. G ive the mea n i ng of u nd e re m p l oyment eq u i l i bri u m . [CBSE (F) 201 7]
[ Page 256]
13. Defi n e fu l l e m p l oyment i n a n economy. Discuss the situation when aggregate demand is more than
aggregate s u p p ly at fu l l e m p l oyment i ncome leve l . [CBSE 201 8]
[ Page 257, 263, 264]

14. I n the given figu re, what does the ga p 'KT' y
represent? State a ny two fisca l mea s u res -0
AD 1
C
<U
to correct the situation. AD
QJ
0
[CBSE 201 9 (58/1/1)]
<U
[ Page 258, 259, 269, 270] 01
�
01
01
<t
YF
I ncome
(Fu l l Employment Level of Income)
15. State the meaning of fu l l e m p l oyment. [CBSE 2019 (58/2/1)]
[ Page 257]
16. State the i m pact of "Excess Dema nd" u nd e r the Keynesian theory on e m p l oyment, i n a n economy.
[ Page 263-267] [CBSE 2019 (58/2/1)]
17. Show i nflationary ga p u s i n g a wel l l a bel led d iagra m . Suggest a ny two fisca l measu res to correct the
situation of i nflationary ga p. [CBSE 2019 (58/3/1)]
[ Page 265, 269, 270]
18. State the fol lowi ng statement as true or fa lse. G ive va l i d reason.
Accord i n g to Keynesia n theory of e m p l oyment, the state of fu l l e m p l oyment is obta i ned o n ly when
the economy is i n eq u i l i bri u m . [CBSE 2019 (58/3/1)]
[False. Keynes d iscu sses eq u i l i brium i n d ependent of the cond ition of fu l l e m p l oyment. There may o r
may n ot be a situation o f fu l l e m p l oyment at the point o f eq u i l i bri u m . Beca use, eq u i l i bri u m s i m ply
refers to a situation when the desi red AD = desired AS, no matter what the level of e m ployment is.
Thus, eq u i l i b ri u m may occur even when there is u ndere m p l oyment i n the economy. What matters is
that the p l a n ned l evel of output m u st match with the p l a n ned level of expenditure on the output.]
19. State the fol lowi ng statement as true or fa lse. G ive va l i d reason.
Accord i n g to Keynesian theory of e m p l oyment, a state of u ndere m p l oyment ca n never exist i n an
economy. [CBSE 2019 (58/3/3}]
[False. Accord ing to Keynesia n theory of e m p l oyment, a state of u ndere m p l oyment ca n exist i n
t h e economy. Th is state may occ u r a t that level o f i n come where eq u i l i b ri u m between A D a n d AS
ha ppens at l ess than fu l l e m p l oyment l eve l . I
20. State the meaning of the fol l owing:
( i ) Full e m p l oyment.
(ii) I nvol u nta ry u n e m p l oyment. [CBSE 2019 (58/5/1))
[ Page 256, 257)
1. What is deficient d e m a n d ?
[ H i nt : Deficient d e m a n d refers t o a situation when AD < A S corresponding t o fu l l e m p l oyment i n t h e
economy. It ca uses deflationary ga p.)
2. What is excess d e m a n d ?
[ H i nt : Excess demand refers t o a situation when AD > A S corresponding t o fu l l e m p l oyment i n t h e
economy. It ca uses i nflationary ga p.)

3 . H ow ca n the problems of excess a n d deficient demand be com bated ?
[ H i nt: Moneta ry a n d fisca l i n stru ments a re the key to com bat the p roblems of excess a n d deficient
d e m a n d . Fisca l i n stru ments relate to reve n u e and expen d itu re pol icy of the government. Moneta ry
i n stru ments relate to the reg u lation of money s u p ply i n the economy. To com bat excess demand, the
government needs to curb its expen d itu res a n d ra ise its reve n u e . On the moneta ry front, it needs
to p u rsue a Dea r Money Pol icy, m a ki n g ava i l a b i l ity of cred it tougher than before a n d s h ri n ki ng the
credit creation capacity of the com mercial ba n ks. To com bat deficient demand, on the other hand,
expend itu re needs to be sti m u lated while reve n u e needs to be cu rbed . On the moneta ry front,
Cheap Money Pol i cy needs to be p u rsued, facil itati ng easy ava i l a b i l ity of credit a n d e n h a ncing cred it
creation ca pacity of the commerci a l ba n ks.]
low
7. M isce l l a neous Q uestions a n d Reference to t h e Text for Answers

1. Exp l a i n vol u nta ry a n d i nvo l u nta ry u n e m p l oyment. [Page 256, 25 7]
2. What is deficient dema n d ? I l l ustrate with the help of a d iagra m . [Page 258, 259]
[Page 263, 264]
ee
3 . What is excess demand? I l l u strate with t h e h e l p of a d iagra m .
rF
4. What is deficient demand in an economy? What is its i m pact on output, e m p l oyment and prices?
Fr
[Page 258, 281, Q. 2]
5 . What is excess demand in macroeconom ics? H ow does excess demand affect the level of output,
e m ployment a n d p rices? [Page 263, 281, Q. 3]
or
6. Exp l a i n the m ea n i ng of deflationary ga p with the h e l p of a d iagra m . [Page 262, 263]
sf
u
7. Exp l a i n the m ea n i ng of i nflationary ga p with the h e l p of a d iagra m . [Page 265]
8. Differentiate between i nflationary ga p a n d deflationary ga p. [Page 267]
k
Yo
9. What is fisca l policy? What a re its va rious i n stru ments? [Page 268-270]
oo
10. What is moneta ry pol icy? State its fou r i n stru ments. [Page 2 70-2 72]
B
11. What is mea nt by d eficient demand i n macroeconomics? State two mea s u res to correct it.
[Page 258, 268-2 72]
re
12. G ive the mea n i ng of excess demand i n macroeconom ics. G ive a ny two moneta ry policy mea s u res to
correct it. [Page 263, 2 70, 2 71 ]
ou
ad
13. H ow does repo rate affect the ava i l a b i l ity o f cred it? [Page 2 70, 2 72]
14. H ow do open ma rket operations affect the ava i l a b i l ity of cred it? [Page 2 71, 2 72]
Y
15. H ow do cha nges in cas h reserve ratio affect the ava i l a b i l ity of cred it? [Page 2 71, 2 72]
16. H ow does lowering or ra ising of m a rg i n req u i rem ent affect the ava i l a b i l ity of cred it? [Page 2 71, 2 72]
nd
Re
17. What h a p pens i n a n economy when credit ava i l a b i l ity is restricted a n d cred it is made costl ier?
[Page 2 70, 2 71 ]
Fi
B . Questions o f 6 m a r ks each
1. What do you u ndersta nd by the concept of fu l l e m p l oyment? Does it refer to a situation of zero
u n e m p l oyment? [Page 257]
2. What is mea nt by d eficient d e m a n d ? Expla i n its ca uses a n d conseq u ences. [Page 258-263]
3. What is mea nt by excess demand? Exp l a i n its ca uses a n d conseq uences. [Page 263-267]
4. Ana lyse the disti nction between deficient demand and excess demand i n a n economy. [Page 258, 263]
5 . Exp l a i n the concept of deflationary ga p with the help of a d iagra m . What is its i m pact on output a n d
p rices? [Page 261-263]
6. Exp l a i n the concept of i nflationary ga p with the h e l p of a d iagra m . What is its i m pact on output a n d
p rices? [Page 265]

7. Disti nguish between i nflationary ga p a n d deflationary ga p . Show d eflationary ga p on a diagra m .
Ca n t h i s ga p exist a t eq u i l i b ri u m level of i n come? Exp l a i n . [Page 261, 262, 265, 267]
8. H ow ca n the problems of excess a n d deficient d e m a n d be corrected? [Page 268-272]
9. What is fisca l policy? H ow is it used to correct excess a n d deficient d e m a n d ? [Page 268-270]
10. What is moneta ry policy? H ow is it used d u ri n g the situations of excess d e m a n d a n d deficient
demand? [Page 2 70-2 72]
11. What is the difference between fisca l pol icy a n d monetary pol icy? Exp l a i n i n b rief two m ethods of
fisca l pol icy to control excess d e m a n d . [Page 269, 2 70, 2 72]
12. Exp l a i n the p roblem of excess demand in an economy with the h e l p of a diagra m . Exp l a i n the role of
repo rate in correcti ng it. [Page 263, 264, 2 70]
13. What is deficient d e m a n d i n macroeconom ics? Show it on a diagra m . Exp l a i n the role of open ma rket
operations i n correcti ng it. [Page 258, 259, 2 72]
14. H ow a re changes in fisca l policy h e l pfu l in contro l l i n g excess d e m a n d a n d d eficient d e m a n d ?
[Page 268-270]
15. Does eq u i l i b ri u m beyond 'fu l l e m p l oyment' i m p ly a higher level of output compa red to 'fu l l
e m ployment eq u i l i b ri u m ' ?
[H i nt: N o, a ny eq u i l i briu m beyond fu l l employment does not im ply a higher level o f output. After fu l l
employment level is reached, there is no q uestion o f a ny increase i n output, sim ply because more
resou rces a re not ava i lable (and because tech nology is assumed to remain consta nt) . Accord i ngly, a ny
eq u i l i briu m beyond fu l l employment only i m p l ies a situation of eq uality between AS and AD with higher
ma rket va lue of the existi ng level of output (fu l l employment level of output) . Market va lue of the existi ng
output wi l l increase sim ply beca use excess demand leads to a rise i n the genera l price level.]
DOs and DON'Ts

1. Deficient demand or deflationary gap causes a fa l l in the l evel of employment. B ut, do not j u m p to a
reverse conclus ion that excess demand or i nflationary gap i ncreases the level of employment. You
must understand that inflationary gap occurs only after a situation of ful l employment is reached; hence
there is no question of increase i n employment in a situation of excess demand or inflationary gap.
2. Remember, there is a lways a confl i ct between (i) high G D P growth, and (ii) the rate of i nflation. If the
rate of inflation is to be curbed, C R R, SLR and repo rate are to be kept high. But, h i gher the l evel of these
parameters, l ower is the ava i l a b i l ity of cred it i n the ma rket. Lower ava i l a b i l ity of cred it leads to lower
investment and therefore, lower G D P growth.
• H ow Govern ment Expenditure I m pacts Equ i l i brium I ncome or G D P

- A Diagrammatic P resentation
When the govern ment comes i nto p ictu re, we are dea l i ng with a th ree sector
economy. It i nclu des:
(i) household sector,
(i i) the prod ucing sector, a n d
(i i i) t h e government sector.
Accord i n g ly, tota l expenditure i n the economy (or components of AD) wou l d
incl ude:
(i) cons u m ption expen d iture (C),

(ii) private i nvestment expend iture (I), and
( i i i) govern ment expend iture (G) .
• Equ i l i brium I ncome/G D P i n a 3-Sector Economy
For the sake of s i m p l icity, we assume government expend iture to be consta nt
(a utonomous) l i ke private i nvestment expen diture. So that (l i ke I-fu nction),
the government expend iture is i n d icated by a horizonta l stra ight l i ne. Fi g . 8
i l l ustrates the eq u i l ibrium i ncome (G D P) i n a th ree sector economy.
Eq u ilibrium Income (GDP) i n a 3-Sector Economy
y
low
C+ I+G
5 C+I
ee
::S,
<..'.)
"""'. T
u
rF
Fr
L
or
sf
u
��-----� S --------+ X
Y ( l ncome)IGDP
k
Yo
• A D now consists o f C , I a n d G .
oo
• G i s assumed t o b e constant = LT.
Accordingly, C + I + G is parallel to C + I.
• The vertical distance between C + I + G and C + I is equal to
B
LT = government expenditu re.

• Q is the point of eq uilibrium.
re
• OS is equilibrium level of output (GDP).
Govern ment expend itu re is assu med to be consta nt and equal to LT Accord i n g ly,
ou
ad
C + I fu nction (AD without government expen d iture) shifts u pwa rd to become

Y
C + I + G function (AD with government expend iture) . The two fu nctions (AD with
govern ment expen d iture and AD without government expend itu re) are shown
nd
as para l lel to each other, beca use G (government expend itu re) is assu med to
Re
be constant. Eq u i l i b r i u m is struck at point Q where C + I + G fu nction i ntersects

Fi
the 45 ° l i ne. Here, des i red AD = des i red AS. Eq u i l ibri u m i ncome (G D P) = OS.
• H ow does the G overnment Correct the Situations of
Deficient Demand and Excess Demand?
We con sider these situations one by one.
Deficient AD i n a 3-Sector Economy and its Correction by the Government
We know, deficient demand is a s ituation of deflationary gap. The economy is
driven i nto a state of low level eq u i l i bri u m trap . Low AD ca uses und erem p loyment:
factors of prod uction a re not fu l ly employed . Planned output rema ins low. It
leads to low level of i ncome. Beca use i n comes a re low, once aga i n there is low

AD. The cycle of low AD and low i ncome becomes repetitive. The market forces
fai l to brea k this repetitive cycle. The government must step i n . It m ust ra ise
the level of AD by increasing government expend iture.
y ti.G Clears Deflationary Gap (ab)
Y = AS
ADp (C + I + G)
g over n m e n t expe n d i t u re.

Th i s i s e q u a l
t o d eflati o n a ry g a p.
�-�---�---�-----------x
S T
Y (l n c o m e)/G D P
• C + I + G i s planned A D corresponding to underem ployment.
• .6.G is additional government expend iture and is equal to deflationary gap.
• .6.G is added to C + I + G to increase AD to the level of fu l l employment.
• .6.G being eq ual to ab plugs the deflationary gap.
• OS is output corresponding to underemployment eq uilibrium.
• OT is output corresponding to ful l employment equilibrium.
This is achieved by adding L'iG to C + I + G.
Fig 9 shows the situation of deficient demand in a 3-sector economy. It a l so

shows how this deficient demand is corrected through add itiona l government
expenditure (�G) . Deficient demand (deflationary gap) is ind icated by ab and
the government fi l l s u p this deficiency by making add itional expenditure
exactly equal to ab.
The level of AD which earl ier was C + I + G (corresponding to underemployment
eq u i l i brium) is now ra ised to C + I + G + �G (correspond ing to fu l l employment
eq u i l i brium) . Eq u i l ibri u m level of output which earlier was OS is now ra ised
to OT. Now, eq u i l i brium is achieved with fu l l employment of the factors of
production. Low level eq u i l i bri um trap is broken. Th us, �G acts as an i njection
i n the circu lar flow of i ncome i n the economy.
I
!lG (additional government expenditure) acts as an injection in the circular
flow of income in the economy It raises the level of AD to the extent required
for full employment of the factors of production. The economy breaks the low
level equilibrium trap Actual output = Potential output (= full employment level
of output), and the state of deflation and unemployment is corrected.
Excess Demand in a 3-Sector Economy and its Correction by the Government
Excess demand is a s ituation of i nflationary gap. The economy is over-heated :
AD rises beyond fu l l employment level of AS. The general price level tends
to rise, while the level of rea l output remains constant. Such a situation
often pushes the economy i nto a wage-price spiral, as a l ready noted . The
government i ntervention becomes essential to check the rising AD. It does it
by way of red ucing its own expenditure.

Fig 1 0 shows the situation of excess demand/inflationary gap i n a 3-sector
economy, and the way it is eliminated by a cut in govern ment expenditure.
-Ll.G Eliminates Excess Demand (ab)
y
Y = AS
low
Y (lncome)/GDP
ee
• A D p : Planned AD beyond fu ll employment
• AD F : Full e m ployment AD.
rF • ab : Excess demand.
Fr
• -8G A cut in government expenditure = ab (excess dema nd).
• OL : Full employment equilibrium output.
• Q : Point of full em ployment e q u i l i brium.
Note: C + I + G add u p to AD which is more than its required level
for full employment eq uili brium GDP. A cut in g overnment
or
expend itu re (= -t!.G) reduces the level of AD to C + I + G - fj,G_
It is this level that restores full employment equilibrium GDP
sfin the economy. Excess demand is elimi nated.

u
OL is fu l l employment eq u i l i b r i u m output. It corresponds to AD F which is fu l l
emp loyment level o f AD. However, th ere i s excess demand i n the economy,
k
Yo
as i ndicated by AD p . Excess demand = AD p - AD F = ab. To e l i m i n ate this
oo
excess demand, the government red uces its expend iture by ab. Reduction in
B
govern ment expend itu re is i n d i cated by -�G (= ab) . As a resu lt, the level of AD is
brought down from AD p to AD F . The economy i s brought back to po i nt Q which
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is a point of fu l l employment eq u i l i bri u m . Thus, econom ic sta b i l ity is restore d .

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• D i scretionary a n d N on-d i screti onary Fiscal Instruments

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Non-discretionary fiscal instru ments refer to those fiscal instruments which start
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operating automatica lly on their own. These are also ca l led auto-stabi l isers. On
the other hand, discretionary i nstruments are those instru ments which are plan ned
nd
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by the govern ment to correct the situations of excess and deficient deman d . We
have a l ready discussed in deta i l s various discretionary instru ments. As regards
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non-d iscretionary instru ments, some i l l ustrations may prove to be usefu l .

A rise i n AD a utomatica l ly ra i ses tax revenue a n d a fa l l i n A D a utomatica lly
decreases tax revenue. Accord ing ly, taxation acts as a n a uto-sta b i l i ser i n the
economy. It lowers AD when excess demand is to be corrected . And, it ra i ses
AD when deficient demand is to be corrected . G ra nts and subsidies are other
exa m p l es of non-di scretionary fi scal i n struments or a uto-sta b i l i sers in the
economy. During peri ods of boom (when excess AD needs to be corrected),
g ra nts a n d subsid ies come down on thei r own, ca u s i n g a cut i n government
expend itu re a n d thereby a cut i n AD. During periods of depress ion, on the
other hand, g ra nts and subsid ies tend to rise. It i m p l i es a ri se i n government
expend itu re and therefore, a rise i n AD, a s desired to correct d eficient demand
during depression. Ill
h ·. / ., CHAPTER: 10
·///,;
. h'l BUDGET AND
/ THE ECONOMY
•
•
•
•
Concept of Government Budget
Objectives of Government Budget
Structure (or Components) of the Budget
Budget Receipts-Revenue Receipts
,,
-Capital Receipts
• Budget Expenditure-Revenue Expenditure
-Capital Expenditure
• Budget Deficit-Revenue Deficit
-Fiscal Deficit
-Primary Deficit
• Balanced and Unbalanced Budget
I. CONCEPT OF GOVERNMENT BUDGET

February-1 is a well known date in India when the Finance Minister
presents annual budget of the government for its approval by the
parliament. The budget unfolds:
(i) the financial performance of the government over the past one
year, and
(ii) the financial programmes and policies of the government for the
next one year.
As regards financial performance of the government, it is more like
a description of what happened during the past one year. Focus is
placed largely on the other part of the budget describing programmes
and policies of the government for the next one year.
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
291
(ii) expenditure aspect. On the revenue side, the budgetary policy
reveals expected receipts of the government. On the expenditure side,
it reveals expected expenditure of the government.
It is by managing the budgetary revenue and budgetary expenditure
that the government tries to achieve 'growth with stability'.
Thus, government budget is a statement of expected receipts and
expected expenditure of the government (for the financial year to
come) that reveals budgetary policy of the government to achieve the
twin objective of growth with stability.
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I
Government budget is a statement of expected receipts and expected expenditure of the
government (for the financial year to come) that reveals budgetary policy of the government to
achieve the twin objective of growth with stability.
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2. OBJECTIVES OF GOVERNMENT BUDGET
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Following is a brief description of some principal objectives of
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government budget (with special reference to the Indian economy):
(1) GDP Growth: GDP growth is the central objective of government
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budgetary policy. It is achieved in two ways: (i) by making public
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investment expenditure, and (ii) by inducing private investment
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expenditure (through tax rebates and subsidies).
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(2) Allocation of Resources: Private enterprises will always desire to

allocate resources to those areas of production where profits are
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high. However, it is possible that such areas of production (like

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production of alcohol) may not promote social welfare. Through

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its budgetary policy, the government of a country directs the

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allocation of resources in a manner such that there is a balance

between the goals of profit maximisation and social welfare.
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Production of goods which are injurious to health (like Cigarettes

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and Whisky) is discouraged through heavy taxation. On the

other hand, production of 'socially useful goods' (like, 'Khadi') is
encouraged through subsidies.
(3) Provision of Public Goods: Supply and demand forces in a market
economy do not allow enough production of public goods. These
are those goods which satisfy collective needs of the people. Law
& order and defence of the country are important examples of
public goods. It is through budgetary allocation of funds that
these goods are sufficiently provided to the people.

(4) Redistribution of Income and Wealth: Budget of the government
shows its comprehensive exercise on the taxation and subsidies.
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:
(i) By imposing taxes on rich 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.
(5) 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.
(6) 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.
(7) Economic Stability: Free play of market forces (or the forces of
supply and demand) are bound to generate trade cycles, also
called business cycles. These refer to the phases of recession,
depression, recovery and boom in the economy. The government
of a country is always committed to save the economy from
business cycles. Budget is used as an important policy instrument
to correct the situations of deflation and inflation. By doing it,
the government tries to achieve the state of economic stability.
Economic stability stimulates the inducement to invest and
increases the rate of growth and development.
Briefly, the government tries to manage its revenue and expenditure
in such a way that the GDP growth is accelerated, inflationary &
deflationary pressures are eliminated, and inequality is reduced. This
imparts stability to the process of growth.
Government Budget and the Economy 293

t>TS
Q. What do you mean by 'Fiscal Discipline'? What happens if fiscal discipline is not maintained in the
economy?
Ans. Fiscal discipline refers to the state of balance between revenues and expenditures of the government.
It calls for a necessary check on the expenditures in view of the limited revenues of the government.
Lack of fiscal discipline often causes excess expenditure. It leads to inflationary spiral. Cost of
production starts rising. High cost of production hurts the process of investment. Eventually, GDP
growth is hurt and its instability is challenged.
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3. STRUCTURE OF THE BUDGET
OR
COMPONENTS OF THE BUDGET
Structure of the budget refers to the components of budget. Two
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broad components of the government budget are:
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(i) Budget Receipts (including revenue receipts and capital receipts),
and
or
(ii) Budget Expenditure (including revenue expenditure and capital
expenditure).
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Details of both these components are discussed as under:
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Budget Receipts
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Budget receipts refer to estimated money receipts of the government

from all sources during the fiscal year.
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Broadly, the budget receipts are classified as:

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( 1) Revenue Receipts, and

(2) Capital Receipts.
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Following are the details:

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(1) Revenue Receipts

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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. Tax is a unilateral (or one-sided) compulsory
payment to 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.
t>TS
Q. Is borrowing by the government a revenue receipt?
Ans. No, because it creates a liability (for the government) of repayment.
Revenue receipts are broadly classified as tax receipts and non-tax receipts.
Constituents of Revenue Receipts
l ___
Tax Receipts ..-----• Non-tax Receipts
Income Tax
Corporation Tax
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F _ _s __
___ l i es
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Estate Duty
Gift Tax
Escheat
Income from
Public
I Special
Assessment
Income from the

Customs Duty Sale of Spectrum
Enterprises like 2G and 3G
Excise Duty
Grants/
GST (Goods and Donations
Services Tax)
Tax Receipts
A tax is a compulsory payment to the government by the households,
firms or other institutional units. The taxpayer cannot expect any
service or benefit from the government, in return.
I A tax is a compulsory payment made by an individual, household or a firm to the government without
reference to anything in return.
Types ofTaxes
Taxes are broadly classified as:
(i) Progressive and Regressive Taxes,

(ii) Value Added and Specific Taxes, and
(iii) Direct and Indirect Taxes.
(i) Progressive and Regressive Taxes
Taxes are classified as 'progressive' and 'regressive' depending on the
real burden of taxation. Details are as under:
(a) Progressive Tax: A tax is said to be progressive when the rate of
tax increases with an increase in income. So that, the real burden of
the tax is more on the rich and less on the poor. Example: Tax rate
is 1 0% for income between t 2 tot 5 lakh. It is 1 5% for income
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between t 5 tot 1 0 lakh, and so on. Thus, tax rate increases as
the level of income increases.
(b) Regressive Tax: A tax is said to be regressive when it causes a
greater real burden on the poor than the rich. If a person with
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t 1 ,00,000 as his monthly income pays 1 0% income tax (or pays
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t 1 0,000), he still has a balance oft 90,000 per month. But if
a person with t 5,000 as his monthly income has to pay 1 0%
income tax (or pays t 500), it might mean a cut in his essential
or
consumption leading to poor diet and therefore, poor health.
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Thus, a constant rate of taxation on the rich and the poor is a
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regressive tax, as it causes a greater real burden on the poor than
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the rich.
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(ii) Value Added Tax or VAT and Specific Taxes

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Depending upon tax base, taxes can be classified as:

(a) Value Added Tax or VAT: Value added tax is an indirect tax which
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is imposed on 'Value Added' at the various stages of production.

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Value added refers to the difference between value of output

and value of intermediate consumption. It is imposed at each
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stage of production. GST is an important form of value added

tax.
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(b) Specific Tax: When a tax is levied on a commodity on the basis

of its units, size or weight, it is called the specific tax.
(iii) Direct and Indirect Taxes

Taxes are classified as direct and indirect depending on their final
burden.
(a) Direct Tax: A direct tax is the one the final burden of which
is borne by the person on whom it is imposed. For example,
income tax is imposed on the income of a person and he himself

bears its burden. The burden of tax cannot be shifted to any
other person. Income tax, corporation tax, gift tax, wealth tax, Certain taxes are called
are examples of direct tax. 'paper taxes'_ These
I
refer to the taxes like
According to Prof. Dalton, 'A direct tax is really paid by the person on gift tax in India which
whom it is legally imposed" carry their significance
only on paper. These
taxes are of little or no
(b) Indirect Tax: An indirect tax is the one whose initial burden or significance in terms of
impact is on one person but he succeeds in shifting the burden their revenue yield.
to another persons. GST is an important example. It is levied on
the producers. They are to pay this tax to the government. But
they charge this tax from the buyers by adding it to the price of
the goods sold.
I According to Prof. Dalton, 'An indirect tax is imposed on one person but paid partly or wholly by
another."
Direct Tax and Indirect Tax-The Difference

Direct Tax Indirect Tax
(i) It is the tax which is finally paid by the (i) It is the tax which is imposed on one
person on whom it is legally imposed. person but is paid by another.
(ii) The burden of direct taxes cannot be (ii) The burden of indirect taxes can be
shifted to other person. shifted to others.
(iii) Direct taxes are generally (iii) Indirect taxes are generally regressive
progressive in nature. in nature.
Examples: Income tax, corporate Examples: GST, customs duty.
profit tax.
f>TS
Q. Explain through an example, how the burden of an indirect tax is shifted.
Ans. GST is an indirect tax. A shopkeeper pays GST to the government. But, the shopkeeper recovers this
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.
Non-tax Receipts
Non-tax receipts are those receipts which arise from sources other
than taxes. Some of the non-tax receipts are as follows:
(i) Fees: A fee is a payment to the government for the services that
it renders to the people.
Examples: Land registration fees, birth and death registration
fees, passport fees, court fees, etc.
It is to be noted that fee is not a payment (price) for commercial
service. It is a payment for administrative and judicial services
provided to the people.

(ii) Fines: Fines are those payments which are made by the law
breakers to the government. These are economic punishments
for breaking laws. The aim is not to earn revenue, but to make
people respectful to the laws.
(iii) Escheat: Escheat refers to that income of the state which arises
out of the property left by the people without a legal heir.
There are no claimants of such property. The government makes
revenue out of it.
(iv) Special Assessment: Special assessment is that payment which
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is made by the owners of those properties whose value has
appreciated due to developmental activities of the government.
Example: When as a result of construction of roads or provision
of sewerage system or construction of drains, etc., value of the
neighbouring property or its rental value appreciates, then a part
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of the developmental expenditure is recovered from the owners
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of such property by way of special assessment.
(v) Income from Public Enterprises: Several enterprises are owned
by the government. Examples: Indian Railways, Nangal Fertilizer
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Factory, Indian Oil, Bhilai Steel Plant, etc. Profit of these
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enterprises are a source of revenue for the government.
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(vi) Income from the Sale of Spectrum like 2G and 3G: Income from
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the sale of spectrum has emerged as a significant source of non
tax receipts of the government.
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(vii) Grants/Donations: Grants are also a source of government

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revenue. It is very common for the people to offer donations

and grants to the government when there are natural calamities
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like earthquake, floods and famines.

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(2) Capital Receipts

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Capital receipts are those money receipts of the government which

show the following two characteristics:
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(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 recei pts of the government
which either create a liability for the government or cause a reduction
in its assets.
In India, capital receipts of the government budget are often classified
as under:
' •
Capital Receipts )
(i) Recovery of
Loans
I
(ii) Borrowings and (iii) Other Receipts
Other Liabilities
(i) Recovery of Loans: The central government offers loans to the

state governments to cope with financial crises. When these
loans are recovered, assets of the government are reduced.
Accordingly, these are classified as capital receipts.
(ii) Borrowings and Other Liabilities: While lending creates assets,
borrowing creates liability. Accordingly, borrowings are to be
treated as capital receipts. It may be noted that 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.
(iii) Other Receipts: These include items like 'disinvestment'. It is
the opposite of investment. Disinvestment occurs when the
gove rnment sells off its shares of public sector ente rprises
to private sector. It involves transfer of ownership of public
sector enterprises to the private entrepreneurs, leading to
privatisation. Money received through disinvestment is treated
as capital receipt because it causes reduction in assets of the
government.
f>TS
Q. 1. What is disinvestment? Does it refer to revenue receipt or capital receipt of the government? Give an
example.
Ans. Disinvestment refers to withd rawal of existing investment.
Example: The Government of I ndia is making disinvestment by selling its shares in the Maruti Udyog.
It is a capital receipt of the government, as it reduces assets of the government.

Q. 2 . How are revenue receipts different from capital receipts in terms of their meaning and significance?
Ans. Following observations highlight the difference between revenue receipts and capital receipts:
Revenue Receipts Capital Receipts
(i) Difference in Meaning:
Reven ue receipts do not impact asset- Capital receipts impact asset-liability status of the
liability status of the government. government.
Assets and liabilities are not increased or Assets are lowered.
decreased. Or
Liabilities are raised.
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(ii) Difference in Significance:
(a) Revenue receipts do not leave any (a) Capital receipts often leave burden on future
burden on future generations. generations.
Example: Borrowings leave the burden on
future generations for the repayment of loans.
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(b) High revenue receipts (as tax receipts) ( b) High capital receipts (borrowings and
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point to sound fi nancial health of the disinvestment) point to poor financial health
economy. of the economy.
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Budget Expen d itu re
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Budget expenditure refers to estimated expenditure of the government
during the fiscal year.
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Like budget receipts, budget expenditure of the government is broadly
classified as:
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( 1 ) Revenue Expenditure, and

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(2) Capital Expenditure.

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(1) Revenue Expenditure

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Revenue expenditure of the government is that expenditure which

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shows the following two characteristics:

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(i) It does not create any asset for the government. For example,
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expenditure by the government on old-age pensions, salaries and

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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 liabil ities.

Important Items of Revenue Expenditure in the
Indian Government Budget
These are:
(i) Wage bill of the government.
(ii) Interest payments.
(iii) Expenditure on subsidies.
(iv) Defence purchases.
I
Important
As a matter of convention, all grants given by the centre to the state governments (and the
governments of Union territories) are treated as revenue expenditure, even when some grants may
result in the creation of assets .
(2) Capital Expenditure

Capital expenditure of the government is that expenditure which
shows the following two characteristics:
(i) It 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.
Important Items of Capital Expenditure in the
Indian Government Budget
These are:
(i) Expenditure on land and building.
(ii) Expenditure on machinery and equipment.
(iii) Purchase of shares.
(iv) Loans by the central government to the state governments or
state corporations.
Plan and Non-plan Expenditure
Budget expenditure (revenue expenditure + capital expenditure) is also
classified as plan and non-plan expenditure. Following is the difference:

(1) Plan Expenditure: Plan expen d itu re refers to that expenditure
which relates to ( i ) specified plans and program mes of
development, and ( i i ) assistance of the central govern ment to
the state governments. It i n cl udes both reven u e expenditure ( l i ke
assistance to the states) and capital expenditure ( l i ke expenditu re
on the constru ction of roads, bridges and hosp itals).
(2) Non-plan Expenditure: Broadly, all expenditure other than plan
expenditure is classified as non-plan expenditure. Specifically, non
In India, n o n - p l a n
expendit u re is a plan expenditure relates to expenditure on routine functioning of
the government. Or, it includes expenditure on such services as
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sign ifica nt pa rt of
the tota l government
expenditu re. Which is
of law and order, defence and subsidies.
why fisca l d isci p l i n e Thus, we can write that:
i n t h e cou ntry often
rem a i n s a serious Budget Expenditure = Revenue expenditu re + Capital expenditure
chal lenge.
Or
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=
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Budget Expenditure Plan expend itu re + Non-plan expend itu re
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Note
After the abolition of planning commission, the government is also considering to abolish the
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classification of budgetary expenditure as plan and non-plan expenditure.
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Structu re of Government B ud get at a Gla nce
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Government Budget J
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1
B
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Budget Recei pts Budget Expenditu re

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Reve n u e Capital
Expe nd iture Expen d i t u re
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(wage b i l l, i nterest ( l a n d and b u i l d i ng,

Reve n u e Recei pts Ca pita l Rece i pts machi nery & equipment,
payments, s u bsidies,
defe n ce p u rchases, p u rchase of shares, loa n s
nd
etc.) t o state governments, etc.)

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Borrowings Other P la n Non-p l a n

Recovery
and Other Receipts Expe n d i t u re Expenditure
of Loa n s
Liabi l ities (d isi nvestment)
Revenue expenditure - Revenue recei pts = Revenue Deficit

(Revenue expenditure + Ca pita l expenditure) - (Revenue recei pts + Capita l receipts other than borrowi n g s) = Fiscal Deficit
Fisca l deficit - I nterest payment = Primary Deficit
[Note: Structu re of the Govern ment Budget may also be stud ied in terms of
(i) Revenue Budget, and (ii) Capital Budget. Revenue Budget i n cl udes
revenue recei pts and revenue expen d itu re of the government. Capital
Budget incl udes capital recei pts and capital expen d itu re of the
govern ment . ]

t>TS
Q. 1. How are revenue expenditure different from capital expenditure in terms of thei r meaning and
significa nee?
Ans. Following observations highlight the difference between revenue expenditure and capital
expenditure:
Revenue Expenditure Capital Expenditure
(i) Difference in Meaning:

Revenue expenditure does not impact Capital expenditure impacts asset-lia bility status
asset-lia bility status of the government. of the government.
Assets and lia bilities a re not increased or Assets are raised.
decreased. Or
Lia bilities are lowered.
(ii) Difference in Significance:

(a) Revenue expenditure (subsidies and (a ) Capital expenditure (public investment)
law & order) focuses on welfare of the focuses on GDP growth. It directly
people. It does not directly contribute contributes to GDP growth.
to GDP growth.
(b) High revenue expenditure by the (b) High capital expenditure by the government
government (by way of subsidies or points to the lack of private investment in
old-age pensions) points to poverty the economy. Capital expenditure by the
of the people or backwardness of the government is raised when the economy is
economy. suffering from deflationary gap.
Q. 2. How are revenue budget different from capita l budget?

Ans.
Revenue Budget Capital Budget
(i) Revenue budget includes revenue receipts (i) Capital budget includes capital receipts and
and revenue expenditure of the government. capital expenditure of the government.
(ii) Revenue budget does not impact asset (ii) Capital budget impact asset-lia bility status
liability status of the government. of the government.
(iii) Revenue budget focuses on welfare of (iii) Capital budget focuses on GDP growth ( by
the people by way of DBT (direct benefit way of public i nvestment).
transfers) . It does not directly contribute
to GDP growth.
(iv) High revenue receipts in the revenue budget (iv) H igh capital receipts a re often related to
lead to low capital receipts (borrowings and compulsions of borrowings. It is a sign of a
disinvestment) in the capital budget. It is a backward economy.
sign of a growing economy.

4. BU DG ET D EFICIT: REVE N U E D E F I C IT,
FI SCAL DEFI CIT AN D PRI MARY D E F I C IT
[M EAN I N G , TYPES AN D M EASU REM ENT]
Wh at is Budget Defi cit?

Types of Budget Budget deficit (also called government deficit) refers to a situation
• B a l a n ced B u dget: when budget expenditures of the government are greater than the
Budget Recei pts budget receipts. Or, it is the excess of total expenditure (revenue
= Budget Expendit u re
expenditure and capital expenditure) over and above the total receipts
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• Deficit B u dget:
B udget Recei pts
(revenue receipts and capital receipts) of the government.
< B u dget Expenditure Budget Deficit = Total expenditure (Revenue expenditure
• S u r p l u s Budget: + Capital expenditure - Total receipts
Budget Recei pts
(Revenue receipts + Capital receipts)
> B u dget Expenditure
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BD = BE - BR, when BE > BR
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(Here, BD Budget deficit; BE = Budget expenditure; BR = Budget receipts.)
=
Types a n d Me as u rement
or
With reference to the budget of the Government of India, there are
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three important types of budget deficit. These are:
( 1 ) Revenue Deficit,
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(2) Fiscal Deficit, and
(3) Primary Deficit.
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(1) Revenue Deficit

Revenue deficit is the excess of revenue expenditure over revenue
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receipts.
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Revenue Deficit = Revenue expenditure - Revenue receipts

RD = RE - RR, when RE > RR
nd
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(Here, RD Revenue deficit; RE = Revenue expenditure; RR = Revenue

=
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receipts.)
Implications
(i) Because of revenue deficit, the government may have to cut its
expenditure on several welfare programmes in the country. This
leads to loss of social welfare.
(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. The ownership of public enterprises

may be lost to foreign companies. Consequently, economic control
of the foreigners may increase in the domestic economy.
I
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)
(2) Fiscal Deficit

Fiscal deficit is the excess of total expenditure over total receipts
(other than borrowings).
Fiscal Deficit = Total expenditure (Revenue expenditure + Capital
expenditure) - Total receipts other than borrowings
(Revenue receipts + Capital receipts other than
borrowings)
FD = BE - BR other than borrowings, when BE > BR other
than borrowings
(Here, FD = Fiscal deficit; BE = Budget expenditure; BR = Budget receipts.)
In fact, fiscal deficit is the estimation of total borrowings by the
government. It is often called 'Gross Fiscal Deficit'.
Gross Fiscal Deficit = (i) Borrowing from RBI + (ii) Borrowing from
abroad + (iii) Net borrowing at home
I Gross fiscal deficit shows estimated borrowing by the government to cope with its expenditures
during the year. Often it is expressed as a percentage of GDP
Implications
Fiscal deficit is an estimate of borrowings by the government. Greater
fiscal deficit implies greater borrowings by the government. It has
following implications:
(i) Inflationary Spiral: Borrowing from RBI is often linked to
inflationary spiral in the economy. This is how it happens:
Borrowing from RBI increases money supply in the economy.
Increase in money supply leads to increase in the general price
level. A persistent increase in the general price level (over a
period of time) leads to inflationary spiral. [ Borrowing from RBI
� Increase in money supply � Increase in prices � Inflationary
spiral. ]
(ii) National Debt: 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.

(i i i ) Vicious Circle of High Fiscal Deficit and Low GDP Growth:
H i g h fisca l deficit leads
Constantly high fiscal deficit leads to a situation where: (a) GDP
to low GDP g rowth growth remains low because of high fiscal deficit, and (b) fiscal
because of two reasons: deficit remains high because of low GDP growth.
(i) The g overnment lacks
funds for i nvestment, [ High fiscal deficit � Low GDP growth � High fiscal deficit. ]
and
(iv) Crowding-out: High fiscal deficit leads to 'Crowding-out Effect'.
(ii) Owing to h i g h fisca l
deficit, taxes a re This is a situation when high borrowings by the government
raised. This red uces (owing to high fiscal deficit) reduces the availability of funds (in
d isposa ble i ncome
of the people. Low the money market) for the private investors. Accordingly, overall
low
d isposa ble i ncome investment in the economy is reduced.
leads to low AD and
their l ow i n d ucement (v) Erosion of Government Credibility: High fiscal deficit (and
to i n vest i n the consequently, the mounting national debt) erodes credibility of
economy.
Also, low GDP g rowth
the government in the domestic as well as international money
leads to h i g h fisca l market. 'Credit rating' of the government (and the economy)
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deficit. Because,
is lowered. Owing to lower credit rating, global investors start
low GDP generates
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low revenue for the withdrawing their investment from the domestic economy.
government. Consequently, GDP growth is reduced.
Briefly, fiscal deficit must NOT be allowed to rise beyond manageable
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limits (about 3 per cent of GDP is considered to be manageable). High
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fiscal deficit signals fiscal indiscipline. It points to a situation when
GDP growth is low and unemployment is high. The economy slips into
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stagnation and revival becomes difficult without FDI (foreign direct
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investment).
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(3) Primary Deficit

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Primary deficit is the difference between fiscal deficit and interest

payment.
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Primary Deficit = Fiscal deficit - Interest payment

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PD = FD - IP
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(Here, PD = Primary deficit; FD = Fiscal deficit; IP = Interest payment.)

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While fiscal deficit shows borrowing requirement of the government

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inclusive of interest payment on the past loans, primary deficit shows

borrowing requirement of the government exclusive of interest
payment. In other words, primary deficit indicates government
borrowings on account of current year expenditures and current year
receipts of the government.
Implications
Implications of primary deficit are similar to those of fiscal deficit.
The only difference is that primary deficit does not carry the load
of interest payments on account of the past loans. Primary deficit

just indicates borrowings when: Current year expenditure > Current
year revenue.
Revenue Deficit, Fiscal Deficit and Primary Deficit-The Difference
,___
Revenue Deficit
(i_
Fiscal Deficit
_I_-_____-____,_____I________-_________(__I_
) t is th e excess o f (i) t is th e excess o f to ta l i) t
Primary Deficit
_------ffi
is th e di r n ce
e___,
_e_- f�
�CU S
revenue expenditure expenditure over total between fiscal deficit ZO N E
over revenue receipts. receipts, other than and interest paymen t.
Revenue Deficit borrowings . Primary Defi c it
= Revenue Fiscal Deficit = Fiscal deficit
expenditure = Budget expenditure - Interest payment
- Revenue receipts - Budget receipts
other than borrowings
(ii) It reff.ects the need I
(ii) It reff.ects the extent (i i) t reff.ects the extent
for borrowings by of borrowings by the of borrowings by the
the government to government when government when
manage its budgetary interest payment is interest paymen t is not
expenditure. accoun ted for. accoun ted for.
(iii) High revenue deficit (iii) High fiscal deficit (in (ii i) Primary deficit points
arises largely because terms of borrowings) to the need for
of low tax receipts points to the lack of borrowings even when
and high expenditure fiscal discipline in the interest payment on the
I
on subsidies. It points country. t is a hurdle existing loans is ignored.
to overall poverty in in the process of GDP It reff.ects continuous
the country. growth. lack offiscal discipline in
the country.
t>TS
Q. 1. What does zero primary deficit mean?
Ans. 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.
Q. 2. A government budget shows a primary deficit of � 6,900 crore. The revenue expenditure on interest
payment is � 400 crore. How much is the fiscal deficit?
Ans. Fiscal Deficit = Primary deficit + Interest payment
= � 6,900 crore + � 400 crore
= � 7,300 crore.
Q. 3. How can the gulf between capital expenditure and capital receipts be reduced without borrowing?
Suggest two ways.
Ans. (i) The government can resort to disinvestment: selling its stake in public sector enterprises, and
(ii) The government can sell its surplus land.
Q. 4. Can there be a fiscal deficit without a revenue deficit?
Ans. Obviously 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.

An Illustration on the Estimation of Various Types of Budget
Deficits
The illustration is based on the following set of data drawn from
Economic Survey, 201 8-1 9.
Revised Estimates on the Budgetary Status of the
Government of India (201 8-1 9)
Items � in crore
1. Revenue Receipts 17,29,682
low
2. Revenue Expendlture 2 1,40,612
3. Capital Receipts 7,27, 553
4. Capital Expenditure 3,16,623
5. Total Receipts (1+3) 24,57, 235
6. Total Expenditure {2+4) 24,57,235
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7. Recoveries of Loans and Other Receipts 93,155
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8. Borrowings and Other Liabilities 6,34,398
9. Interest Paym ent 5,87,570
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[Source: Economic Su rvey, 2018-19)
Using the estimation procedure discussed earlier, we get the following

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estimates of different types of budget deficit:
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( 1 ) Revenue Deficit = Revenue Expenditure - Revenue Receipts
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= � 21,40,61 2 crore - � 1 7,29,682 crore
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= � 4,1 0,930 crore

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(2) Fiscal Deficit

= Total Expenditure - (Revenue Receipts + Recoveries of Loans
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and Other Receipts)

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= � 24, 57, 2 3 5 crore - (� 1 7,29,682 crore + � 93,1 55 crore)

= � 6,34,398 crore
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Or
Fiscal Deficit = Borrowings and Other Liabilities
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= � 6, 34, 398 crore

(3) Primary Deficit = Fiscal Deficit - Interest Payment
= � 6, 34,398 crore - � 5,87, 570 crore
= � 46, 828 crore
[ Implying that:
Fiscal Deficit = Primary Deficit + Interest Payment
= � 46,828 crore + � 5,87, 570 crore
= � 6, 34, 398 crore]

5. BALANCED AN D U N BALANCED BU D G ET
( I ) Balanced Budget
A balanced budget is that budget in which government receipts are
equal to government expenditure.
Balanced Budget:
Government Recei pts = Government Expenditure
Merits and Demerits of Balanced Budget

Merits:
(i) The government does not indulge in wasteful expenditure.
(ii) A balanced budget ensures financial stability. It signals fiscal
discipline in the economy.
However, during the general depression of 1 930's, the policy of
balanced budget was severely criticised. It was then that the following
shortcomings of a balanced budget were highlighted.
Shortcomings or Demerits:
(i) Balanced budget does not offer any solution to the problem of
unemployment. Particularly, when unemployment is linked with
the lack of AD. It happened in most European Countries during
1 930's.
(ii) Balanced budget is not conducive to growth in less developed
countries. Kick-start of growth in these economies depends on
a big-push of investment expenditure by the government. This
often leads to deficit budget.
Does Balanced Budget Leave Aggregate Demand Unaffected in the Economy?
No is the obvious reply. This is how it happens
Balanced Budget means:
Government receipts = Government expenditure
Assume tax as the only source of government receipts,
Tax of (say) t 100 = Expenditure of t 100
Expenditure of t 100 increases AD by t 100.
Tax of t 100 does not decrease AD by t 1 00.
Tax of t 100 decreases disposable income of the people by t 100.
If MPC is assumed to be 0.5, then reduction in disposable income by t 100 would reduce
consumption (expenditure) by 0. 5 x t 100 = t 50 which is 'MPC times' decrease in income.
Thus, because of tax of t 100, AD would decrease by t 50 only
Net increase in AD = t 100 (increase in AD owing to government expenditure)
- t 50 (decrease in AD owing to tax) = t 50.
Thus, a balanced budget is expected to increase AD. Accordingly, balanced budget is a good policy
instrument to increase AD when the economy is close to achieving full employment.

(2) U n balanced Bu dget
An unbalanced budget is that budget in which receipts and expenditures
of the government are not equal. This may be a situation of: (i) Surplus
Budget, or (ii) Deficit Budget.
(i) Surplus Budget

This is a budget in which government receipts are greater than
government expenditures.
Surplus Budget:
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Estimated Government Receipts > Estimated Government Expenditures
Merits and Demerits of Su rplus Budget
Merits:
Surplus budget (when, receipts > expenditures) is desired when the
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economy is battling inflation due to excess AD. Surplus budget plugs
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the inflationary gap by lowering the level of AD. AD is lowered on
account of (a) rise in revenue collection by the government, and
or
(b) fall in government expenditure.
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Demerits:
As surplus budget tends to lower the level of AD in the economy, it
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is not desired during periods of depression. If surplus budget policy is
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constantly pursued by the government, AD may reduce to a level that

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causes unemployment in the economy. The economy may be driven

into a low level equilibrium trap.
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(ii) Deficit Budget

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This is a budget in which government expenditures are greater than

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government receipts.
Deficit Budget:
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Estimated Government Expenditures > Estimated Government Receipts

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Keynes and other modern economists stress significance of deficit

budget, highlighting its merits.
Merits and Demerits of Deficit Budget
Merits:
Keynes recommends deficit budget as a key instrument to correct
the state of depression. According to him, depression is that phase of
economic activity when the level of investment is low owing to the
low level of AD. Consequently, planned output is much lower than the
fu l l employment level of output. Unemployment becomes a national
problem. Deficit budget raises the level of AD i n two ways:
(a) D i rectly by way of h igh govern ment expen d iture, and
(b) I n d i rectly by i n d u cing greater ( i nvestment and consu m ption)
expend itu re by the people.
Demerits:
Deficit budget is not desired d u ri ng periods of i nflation . It is a period
when the AD exceeds AS at fu ll employment. Deficit budget in such
situations (when AS can not i ncrease) wou l d fu rther i ncrease the gu lf
between AD and AS. Conseq u ently, i nflationary gap wou l d rise and
wage-price spiral (when wages i ncrease with prices and prices i ncrease
with wages) may set i n .
Power Points & Revision Window -----------

1 1
Budget i s a state m e nt of expected rece i pts a n d expen d itu re of the gove r n m e nt over the period of a
fi n a n cial yea r, April 1 - M a rch 3 1 .
Objectives: ( i ) G D P g rowth, ( i i ) Allocation o f resou rces, ( i i i ) Provision o f p u b l i c goods, ( iv) Red istri bution
of i nco m e and wea lth, (v) Bala nced regional g rowth, (vi) E m ploy m e nt opportu nities, (vi i ) Eco n o m i c
sta bility.
Structure of the Budget i n c l udes ( i ) reve n u e b u d get s h ow i ng reve n u e recei pts a n d reve n u e expend itu re of
t h e govern m e nt, a n d ( i i ) ca pita l b u d get showi ng ca pita l recei pts a n d ca p ita l expe n d it u re of the govern m ent.
Loo ked at from a diffe re nt a ng l e, struct u re of the budget i n cludes: (i) b u d get recei pts ( i n clu d i ng reve n u e
recei pts a n d ca p ital recei pts), a n d ( i i ) budget expen d i t u res ( i n c l u d i ng reven u e expen d itu re a n d ca p ital
expend itu re ) .
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Budget Receipts a re the esti m ated money recei pts o f the govern ment from all sou rces d u ring a fiscal yea r.
Revenue Receipts a re those recei pts: ( i ) which do n ot ca use a ny red u ctio n i n assets [Example:
I n com e fro m p u blic s ecto r e nterprises], a n d ( i i ) which d o n ot c reate a ny l i a bility for the gove rn m e nt
[Example: Tax rece i pts of the gove r n m e nt] .
Capital Recei pts a re those recei pts: ( i ) wh ich create liability fo r the gover n m e nt [Example: F u n d s received
by the govern m e nt as loa ns], a n d ( i i ) which ca use red u cti o n in assets of the government [Example:
Disi nvest m e nt i n p u b l i c sector enterp rises ] .
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Budget Expenditure i s t h e esti mated expen d itu re o f the gove rn m e nt relating t o its d eve l o p ment a n d n o n -
d eve l o p ment progra m mes d u ri ng a fi sca l yea r.
Revenue Expenditure is that exp e n d i t u re by t h e gove r n m e nt ( i ) w h i ch does n ot ca use
I i ncrease i n government assets [Example: Expenditure o n law & order], and ( i i ) which does
not cause a ny red u ction in govern m e nt lia bil ity [Example: Expenditu re on old-age pensions] .
Capital Expenditure is that expe n d itu re by the gove rn m e nt ( i ) w h i ch ca uses i ncrease i n
gove rn m e nt a ssets [Example: Expe n d it u re o n the con structi o n o f roads], a n d ( i i ) which
causes red u cti o n i n gove rn m e nt l i a b i l ity [Example: Payment of loa n by the gove r n m ent] .
Plan Expenditure is related to s p ecified p l a n s a n d progra m mes of d eve l o p m e nt, as we l l as assista nce
of the centra l gover n m e nt to the state govern m e nts. [ Example: Expen d itu re o n the constructio n of
ca nals for i rrigati o n . ]
Non-plan Expenditure i s rel ated t o expenditure o n routi n e fu ncti o n i ng o f t h e gove r n m e nt.
[Example: (i) Expen d itu re on law & o rd e r, and ( i i ) Expend iture on d efe n ce & subsi d i es.]
Government Budget a n d the Economy 311

1Balanced Budget: Total expenditure = Total receipts.
! Surplus Budget: Total expenditure < Tota l receipts.
Deficit Budget: Total expenditure > Total receipts.
Budget Deficit is the excess of total expenditure over total receipts of the government.
! Types: ( i ) Reve n u e deficit, (ii ) Fiscal deficit, (iii) Pr imary deficit.
Revenue Deficit: Revenue expenditure - Revenue receipts.
! Implication: S i n ce revenue receipts and revenue expenditures are related largely to recurring expenses
of the gover nment (as on admi n i strati on and maintena nce), high revenue deficit gives a war ning to the
gover nment either to cut its expenditure or increase its tax/non-tax receipts.
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Fiscal Deficit: (Revenue expenditure + Capital expenditure) - (Revenue receipts + Capita l receipts other
than gover nment borrowing).
Implications: (i) I nflationary spiral, (ii ) N ational debt, (iii) Vicious circle of high fisca l deficit a n d l ow G D P
growth, (iv) Crowding-out, (v) Erosion o f gover nment credibility.
Primary Deficit: Fiscal deficit - I nterest payment.
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! Implication: Primary deficit i n dicates the extent to which the government needs to borrow to implement
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its budgetary programmes a n d policies for the year a h ead.
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Balanced Budget: It raises the level of AD in the economy, though moderately. It is recommended when
the econ omy is close to achieving full empl oyment.
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Surplus Budget: It is recommended when there is an inflationary gap and AD needs to be reduced.
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Deficit Budget: It is recommended when there is a state of depression a n d AD needs to be raised.
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rEX E RC I S Ej
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1 . Objective Type Questions (Remembering & U nd e rsta n d i n g based Questio n s)

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A. M u lt i p l e Choice Quest i o n s
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1. In the context of government budget, which of the following statements is correct?

(a ) It is a statement of expected a n nual receipts a n d expenditures of the government
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(b) It is a deta il of actua l receipts and expenditures of the gover nment in a fi na ncia l year
(c) It offers a detailed description of achievements of the government during the five year plans
(d) It indicates BoP status of the domesti c economy
2. Which of the following are the objectives of government budget?
(a ) Distribution of i ncome a n d wealth (b) Economic sta bility
(c) G D P growth (d) All of these
3 . Which of the following is a non-tax receipt?
(a ) Gift tax (b) Sales tax
(c) Donations (d) Excise duty

4. Progressive tax is a tax which is:
(a) cha rged at a decreasing rate when i ncome of the individual increases
(b) cha rged at an increasi ng rate when i ncome of the individual increases
(c) a fixed percentage of an individua l income
(d ) none of these
5 . Revenue earned by the government from the property without a ny lega l heir is ca l led :
(a) donation (b) escheat
(c) specia l assessment (d ) both (b) a n d (c)
6. A tax, the b u rden of which ca n be sh ifted on to others, is ca l le d :
(a) i n d i rect tax (b) direct tax
(c) wea lth tax (d ) none of these
7. Tax, the impact of which lies on the person on whom it is legally imposed, is known as:
(a) i n d i rect tax (b) direct tax
(c) value added tax (d ) none of these
8. Which one of the following is an indirect tax?
(a) Wealth tax (b) Excise duty
(c) I n come tax (d ) None of these
9. Which of the following is a direct tax?
(a) I n come tax (b) Excise duty
(c) Sales tax (d ) Custom duty
10. Tax that is i m posed on va lu e added at the va rious stages of p rod uction is known a s :
(a) corporate profit tax (b) direct personal tax
(c) value added tax (d ) none of these
11. G ift tax is a paper tax beca use :
(a) it is a n indirect tax (b) it is a direct tax
(c) it does not have significa nt revenue yield (d ) both (b) a n d (c)
12. Which of the fol l owing is not a non-tax rece i pt?
(a) Fees (b) Fi nes
(c) Gift tax (d ) G ra nts a n d donations
13. Which of the following is a part of the revenue expenditure in the I ndian Government budget?
(a) I nterest payments (b) Defence pu rchases
(c) Wage bi ll of the government (d ) All of these
14. Ca pita l recei pt is that recei pt of the government which :
(a) creates a l i a bi l ity (b) reduces the assets
(c) both (a) a n d (b) (d ) neither (a) nor (b)
15. Which of the fol l owing a re ca pita l recei pts of the government?
(a) Recovery of loa ns (b) Borrowings
(c) Disi nvestment (d ) All of these
16. Ca pita l expe nditure is that esti mated expen diture of the government by which :
(a) assets a re increased (b) lia bility is decreased
(c) both (a) and (b) (d ) assets and lia biliti es d o not cha nge
17. Deficit budget refers to that situation i n which government's budget expe n d itu re is:
(a) l ess than its budget receipts (b) more than its budget receipts
(c) equal to its budget receipts (d ) none of these

18. Fiscal Deficit =
(a) Tota l expenditure - Tota l receipts other than borrowing
(b) Revenue expen diture - Revenue receipts
(c) Capital expenditure - Capital receipts
(d) Revenue expen diture + Capita l expenditure - Revenue receipts
19. In which of the following ways, can deficit in budget be financed?
(a) Borrowi ng from R B I ( b ) Borrowing from the pub l i c
(c) Both (a) a n d (b) (d) Neither (a) nor (b)
20. Which of the following is/are implication/s of fiscal deficit?
(a) Crowdi ng-out (b) I nflationary spiral
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(c) Erosion of government credi bi lity (d) All of these
21. A budget is a balanced one when:
(a) Tota l expenditure = Tota l receipts (b) Total expenditure < Total receipts
(c) Tota l expenditure > Tota l receipts (d) none of these
22. Su rplus budget is that budget wherein:
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(a) Estimated revenue of the gover nment < Estimated expenditure of the gover nment
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(b) Estimated revenue of the gover nment > Estimated expenditure of the gover nment
(c) Estimated revenue of the gover nment = Estimated expenditure of the gover nment
(d) none of these
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23. The difference between fiscal deficit and interest payment is called :
(a) revenue deficit
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(b) primary deficit
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(c) budget deficit (d) capital deficit
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24. If primary deficit is � 3,500 and interest payment is � 500, then fiscal deficit is:
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(a) � 2,900 (b) � 4,000
(c) � 4, 100 (d) � 4,200
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Answers
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1. (a) 2. (d) 3 . (c) 4. ( b) 5. ( b) 6. (a) 7. ( b) 8. ( b) 9. (a) 10. (c)

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11. (c) 12. (c) 13. (d) 14. (c) 15. ( d) 16. (c) 17. ( b) 18. (a) 19. (c) 20. (d)
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21. (a) 22. ( b) 23. ( b) 24. ( b)

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B . Fill i n the B l a n ks
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1. The programmes and policies of the government as presented in the budget are known as
_______ policy of the government. (fiscal/monetary)
2. On the _______ side, the budgetary policy revea ls expected receipts of the gover nment.
(revenue/expenditure)
3. receipts do not create a ny corresponding lia bility for the gover nment.
(Revenue/Capital)
4. is the excess of total expenditure over tota l receipts, other than borrowi ngs.
(Budget deficit/Fisca l deficit)
5. A tax is said to be when it causes a greater real burden on the poor than the
rich . (progressive/regressive)
6. Fiscal discipline refers to the state of between revenues and expenditures of the
government. (bala nce/equilibrium)
7. Fiscal Deficit = _______ + I nterest payment. (Revenue deficit/Prima ry deficit)
8. A _______ budget is t h at budget in which government receipts a re equal to government
expenditure. (bala nced/u n ba l a nced)
9. Recovery of loa n is a receipt. (revenue/capital)
10. _______ expenditure creates assets for the government. (Revenue/Capital)
Answers
1. fiscal 2. revenue 3 . Revenue 4. Fiscal deficit 5. regressive
6. balance 7. P rimary deficit 8. balanced 9. capital 10. Capital
C. True or Fa lse

1. Revenue budget focuses on G D P growth by way of public i nvestment. (Tru e/False)
2. Expenditure o n old-age pensions is an example of revenue expenditure. (Tru e/False )
3. A consta nt rate of taxation on the rich and the poor is a progressive tax. (Tru e/False)
4. G reater fiscal deficit implies greater borrowi ngs by the government. (Tru e/False)
5. Revenue deficit leads to national debt. (True/False )
6. Bala nced budget offers the solution to the problem of unemployment. (True/False)
7. Surplus budget is a budget i n which government receipts a re greater
than government expenditures. (Tru e/False)
8. Prima ry deficit reflects the need for borrowi ngs by the government to
ma nage its budgeta ry expenditure. (Tru e/False)
9. Deficit budget is desired duri ng periods of inflation. (True/False)
10. Capita l receipts impact asset-lia bility status of the government. (Tru e/False)
Answers
1. False 2. True 3. False 4. True 5. False 6. False 7. True 8. False 9. False 10. True
D. M atch i n g the Correct Statements
Column I Column II
(a) Progressive tax (i) Rate of tax decreases with an increase in income
(b) Revenue expenditure (ii ) Impacts asset-liability status of the government
(c) Wealth tax (iii) An indirect tax
(d) Revenue deficit (iv) Revenue expenditure - Revenue receipts
(e) Defence of the country (v) Private goods
Answer
(d) Revenue deficit - (iv) Revenue expenditure - Revenue receipts

items in Column I:
Column I Column II
(a) Disinvestment (i) Govern ment expenditures > Govern ment receipts
(b) Capital expenditure (ii) Value of output - Value of intermediate consu mption
(c) Value ad ded (iii) Capital receipts
(d) Deficit budget (iv) Loans granted to state govern ments
(e) Borrowings (v) Withdrawal of existi ng investment
Answers
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(a) - (v), ( b) - (iv), (c) - ( ii), (d) - ( i), (e) - ( iii)
E. 'Very Short Answer' Objective Type Questions

1. What is government budget?
Ans. Gover nment budget is a statement of estimated receipts a n d expenditure of the government dur i ng
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a fi nancial year.
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2. What is meant by fiscal year in Ind ia?
Ans. I n I n d ia, fiscal year is the year which begins on April 1 a n d ends o n M arch 3 1 of the foll owing yea r.
3 . Define revenue budget.
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Ans. Revenue budget is the statement of estimated revenue receipts a n d estimated revenue expenditure
during a fiscal year.
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4. Define revenue receipts.
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Ans. Revenue receipts are those receipts which neither create a ny liability nor lead to any reduction in assets.
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5. Define revenue expend itu re.
Ans. Revenue expend iture is that expend iture of the government which neither creates assets for the
B
gover nment nor causes a reduction i n lia bilities of the gover nment.
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6. Define tax.
Ans. A tax is compulsory payment made by a n individual, household or a firm to the government without
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reference to a nyth i ng in retur n .

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7. What i s a d irect tax?

Y
Ans. A direct tax is that tax the fi nal burden of which falls on that very person who is lia ble to pay it to the
gover nment.
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8. What is an ind irect tax?

Ans. I n d irect tax is a tax on goods a n d services. Those who are lia b l e to pay this tax need n ot bear the fi n a l
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burden o f this tax.

9. What is a progressive tax?
Ans. Progressive tax is a tax that causes relati vely less rea l burd en on the poor a n d more on the rich.
10. Define regressive tax.
Ans. Regressive tax is a tax that causes relati vely more rea l burd en on the poor a n d less on the rich.
11. What is value added tax?
Ans. Value added tax is a n i ndirect tax which is imposed on 'va lue added' at the various stages of
producti o n . GST is an importa nt form of va l ue added tax.
12. Define capital budget.
Ans. Capita l budget is the statement of estimated capital receipts a n d estimated capital expenditure
during a fiscal year.

13. Define capital receipts.
Ans.Capita l receipts are those receipts which either create a lia bility or lead to reduction in assets.
14. Define capital expenditure.
Ans.Capita l expenditure is an expenditure which leads to creati on of assets or reduction in lia bilities.
15.Give two examples of capital receipts.
Ans. (i) Recovery of loans, and (ii) Borrowings.
16. Give two examples of capital expenditure.
Ans. (i) Expend iture on the purchase of land by the government.
(ii) Loans granted by the central government to state governments.
17. Defi ne plan expend itu re .
A n s . Plan expenditure is the expend iture which is related to some specified plan for the yea r.
18. Defi ne non-pla n expen d itu re.
Ans. Non-plan expenditure is the expenditure which is not related to any specified plan for the year.
19. Why is payment of i nterest a reven u e expe nditure?
Ans. Payment of interest is treated as a revenue expenditure, because it neith er reduces lia bility of the
payer nor adds to his assets .
20. Why a re su bsidies treated as reven u e expe n diture?
Ans. Subsidies are treated as revenue expenditure by the government, because this expenditure:
(i) does not reduce lia bi l ity of the government, nor
(ii) adds to assets of the government.
2 1 . Why is recove ry of loans treated as a ca pita l recei pt?
Ans. Recovery of loans is a capita l receipt because it leads to reduction in assets .
22. H ow is d isi nvestment by the government a ca p ita l recei pt?
Ans. Disinvestment by the government is a capital receipt, as it leads to a reduction in assets .
23. Defi ne bala nced budget.
Ans. Balanced budget is that budget in which government receipts are equal to government expenditure.
24. Defi ne surplus budget.
Ans. Surplus budget is that budget in which government receipts are more than government expenditure.
25. What is budgeta ry deficit?
Ans. Budgetary d eficit is the excess of total expend iture over tota l receipts of the government.
26. What is meant by reve nue deficit?
Ans. Revenue deficit is equa l to the excess of total revenue expend iture over the total revenue receipts.
Revenue deficit = Revenue expenditure - Revenue receipts
27. Defi ne fisca l deficit.
Ans. Fiscal deficit is equal to the excess of tota l expenditure over the sum of revenue receipts and capita l
receipts excluding borrowing.
Fiscal deficit = (Revenue expenditure + Capital expenditure) - (Revenue receipts + Capita l receipts
other than borrowing)
28. What is the sign ifica nce of measuring fisca l deficit?
Ans. The significance of measuring fisca l deficit is that it refl ects tota l borrowings of the government
during the financial yea r. Accumulated borrowings over the year reflect accumu lated burd en of
nationa l debt which is to be borne by the future generati ons.
29. Defi ne pri m a ry deficit.
Ans. Primary d eficit is the d ifference between fiscal deficit and interest payment.
Primary d eficit = Fiscal deficit - Interest payment

30. What is the sign ifica nce of pri m a ry deficit?
Ans. The significance of prima ry d eficit is that it reflects borrowings on account of current yea r expenditure
exceeding the current yea r receipts of the government. Interest payment on the accumulated
borrowings is not accounted for.
2. Reason - based Questions (Com prehension of the S u bject - matter)
Read t h e fol lowi ng statem e nts ca refu l l y. Write True or Fa lse with a reaso n .
1. Borrowing from the centra l ba n k by the government leads to i nflation as it increases the su p p ly of
money in the economy.
Ans. True. Because increase in the supply of money has a direct bea ring on the general price level
low
pa rticula rly in less developed countries where production capacity is highly limited .
2. Ba la nced budget is that budget i n which reven u e recei pts = reven u e expen diture.
Ans. Fa lse. Balanced budget is that budget in which total expend iture = total receipts.
3 . Revenue recei pts te nd to red uce l i a b i l ity of the govern ment.
Ans. Fa lse. Revenue receipts d o not affect asset/lia bility status of the government.
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4. Ca pita l expe nditure adds to assets of the government, or redu ces its l i a b i l ity.
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Ans. True. Capita l expenditure of the government creates assets for the government (th rough expenditure
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on capital goods projects) or reduces its lia bility (th rough repayment of loans) .
5 . Revenue recei pts do not i m pact asset a n d l i a b i l ity status of the govern ment.
or
Ans. True. Revenue receipts a re those receipts which d o not cause reduction in assets or increase in
lia bility of the government.
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6. Revenue expen d itu re red uces assets of the govern ment.
Ans. Fa lse. Revenue expenditure is that expenditure of the government which does not cause increase in
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assets or a reduction in lia bilities.
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7 . Ca pita l recei pts add to l i a b i l ities of the government.
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Ans. True. Capita l receipts a re those receipts which cause a reduction in assets or increase in lia bility of
the government.
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8. Ca pita l expe nditure red u ces ca pita l stock of the govern ment.
Ans. Fa lse. If incurred on the creation of assets (li ke construction of government buildings), capita l
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expenditure increases capital stock of the government.

9. Tax is a ca pita l rece i pt of the government.
Y
Ans. False. Tax is a revenue receipt of the government. It does not impact asset/liability status of the government.
10. Repayment of loan by the govern ment is a ca p ita l expe nd itu re .
nd
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Ans. True. Because repayment of l oan causes reduction in lia bilities of the government. Therefore, it is a
capita l expenditure.
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11. GST is a d i rect tax.

Ans. Fa lse. GST is an indi rect tax because it is levied on goods and services, and its burd en can be sh ifted
from sellers to the buyers.
12. A regressive tax ca uses a greater rea l b u rden on the ric h .
Ans. Fa lse. A regressive tax, by definition, causes a greater real burden on the poor.
13. Borrowing by the government is a measu re of reve n u e deficit.
Ans. False. Borrowing by the government is not a measure of revenue deficit. It is a measure of fiscal deficit.
14. Loa ns offe red by the centra l government to the state govern ment a re to be treated as ca p ita l
expe n d iture of the centra l government.
Ans. True. Because loans offered by the centra l government to the state government create assets for the
central government.

15. G ra nts by the government a re treated as reven u e expen d itu re.
Ans. True. All grants, as a matter of convention, are treated as revenue expenditure of the government.
16. Construction of fly-ove r is a reve nue expen diture of the government.
Ans. Fa lse. Construction of fly-over is a capital expenditure of the government because it adds to assets
of the government.
17. Expe n d it ure on law a n d order is a com ponent of p l a n expen diture.
Ans. Fa lse. Expenditure on law and order is a component of non-plan expenditure because it relates to
expenditure on routine functioning of the government.
18. Borrowing by the government is a com ponent of reven u e budget.
Ans. Fa lse. Borrowing by the government is a component of capital budget. Because, it increases l i a bi l ity
of the government.
19. Disi nvestment is a component of ca pita l b udget.
Ans. True. Disinvestment causes reduction in assets of the government. Therefore, it is a capital receipt of
the government.
20. Fisca l deficit is only a part of pri m a ry deficit.
Ans. Fa lse. Primary deficit is only a part of fisca l deficit. Fiscal deficit = Primary deficit + Interest payment.
2 1 . H igher reve n u e deficit always leads to h igher fisca l deficit.
Ans. Fa lse. Because fisca l deficit also depends on capita l receipts and expenditures of the government.
22. Fisca l deficit is ze ro in case there is no provision for borrowing in the govern ment b udget.
Ans. True. Because fiscal deficit is equal to total borrowing by the government.
23. Revenue deficit is the excess of ca pita l recei pts over a n d a bove revenue recei pts of the government.
Ans. Fa lse. Revenue deficit is the excess of revenue expenditure over revenue receipts .
24. Pri m a ry deficit does not include i nterest payment, w h i le fisca l deficit does.
Ans. True. Primary deficit is the difference between fiscal deficit and interest payment.

1. Revenue deficit can be managed through borrowing or disinvestment. But fiscal deficit can be
managed only through borrowing. Do you agree? State reason in support of your answer.
Ans. The statement is true. Because disinvestment is already included as an item of capita l receipt in
the estimation of fisca l deficit. So that, borrowing is the only window availa ble to manage fisca l
deficit. On the other hand, estimation of revenue deficit does not account for borrowing as well as
disinvestment. So that, both these windows are ava ilable to manage revenue deficit.
2. A persistent recession leads to low revenue receipts of the government. Comment.
Ans. Economic recession is a situation when low AD leads to l ow investment and therefore, l ow growth
rate of G D P. When growth rate of G D P fa lls, tax revenue of the government (through direct as well as
indirect taxation) tends to suffer. Implying sl owdown of revenue receipts of the government during
recession.
3 . A rise in fiscal deficit when the government revises salary structure of its employees leads to a rise
in primary deficit as well. Comment.
Ans. Revision of salary structure enhances revenue expenditure of the government. It would mean a rise
in fisca l deficit of the government. If interest payments are constant, a rise in fiscal deficit would
amount to a rise in primary deficit as well (Fiscal deficit - Interest payment = Primary deficit) .
4. Is it correct that if revenue budget balances, capital budget also balances.
Ans. N o, the given statement is incorrect. Because revenue budget shows revenue receipts and revenue
expenditure while capital budget shows capita l receipts and capital expenditure.

5. Is government budget a statement of government receipts and expenditu re over the past one year?
Ans. N o, government budget is a statement of estimated receipts and expenditure of the government for
the fiscal year which is to begin.
6. Budgetary deficit points to failu re of the government to manage its budget. Defend or refute.
Ans. The a bove statement is incorrect. Budgetary d eficit refl ecting borrowing by the government may in
fact be a part of designed strategy of the government to accelerate the pace of growth or to achieve
macro sta bility in the economy.
7. Do you agree that revenue deficit increases when the government fails to recover its loans?
Ans. N o, it is incorrect. Revenue d eficit is the excess of revenue expenditure over revenue receipts . While
the recovery of loans by the government is a capita l receipt.
8. Is balanced budget always the best budget?
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Ans. N ot necessarily. A moderate fiscal d eficit (around 3%) is found to be conducive to growth, when
investment is l ow because of l ow AD.
9. Is income tax in India regressive in natu re?
Ans. N o, income tax in India is progressive in nature. Because tax rate increases with increase in income.
10. Does non-plan expenditu re contribute to social welfare?
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Ans. Yes, non-plan expend iture does contribute to soci a l welfare. Most of the non-plan expenditure
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consists of expend iture on subsidies and the maintenance of law and ord er in the country. Both
these categories of expenditure are welfare-oriented .
11. Briefly describe how the government budget contributes to the process o f growth and stability.
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Ans. The government budget contri butes to growth, because a significant percentage of budgetary
expenditure is committed to the growth and expansion of public sector enterprises. The government
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a lso offers subsid ies to the producers to ma intain high l evel of production of the essenti a l goods.
Sta bility is promoted by combating inflation through fisca l d iscipl ine and combating deflation through
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liberal spending by the government. Fiscal discipline aims at lowering AD during inflati on. Libera l
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spend ing promotes AD during deflati on.
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12. Distinguish between revenue budget and capital budget.

Ans. That part of the government budget which shows revenue account (including revenue receipts and
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revenue expenditure) is known as revenue budget. That part of the government budget which shows
capita l account (including capita l receipts and capital expend iture) is known as capita l budget.
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13. Government has raised its expenditure on free services like ed ucation and health to the poor.
Explain the economic value it reflects.
Y
Ans. Two observations can be made in this respect :

(i) H igher expenditure on health is expected to make our workforce strong and efficient. Rise in
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efficiency implies a rise in productivity which leads to a rise in G D P. It is an index of economic growth.
(ii) H igher expenditure on educati on is expected to boost skill formation in the country. It facilitates
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the use of new technology. Appl ication of new technology would shift PPC of the economy to
the right. Implying a higher level of output with the same resources.
14. Find P rimary Deficit from the following data:
Items (f in crore)
(i) Revenue deficit 8,8 00
(ii) Fisca l d eficit 1 1, 600
(iii) Interest payment by the government 1, 600
Ans. Primary Deficit = Fisca l d eficit - Interest payment by the government
= " 1 1, 600 crore - " 1, 600 crore
= " 1 0, 000 crore
Primary deficit = " 1 0 , 000 crore.

15. Calculate Revenue Deficit, Fiscal Deficit and P rimary Deficit from the following data :
Items (' in crore)
(i) Revenue expenditure 22,2 5 0
(ii) Capita l expenditure 28,000
(iii) Revenue receipts 17,7 5 0
(iv) Capita l receipts (net of borrowing) 20,000
(v) I nterest payments 5 ,000
(vi) Borrowi n gs 12, 5 00
Ans. Revenue Deficit = Revenue expenditure - Revenue receipts
= , 22,2 5 0 crore - , 17,7 5 0 crore
= , 4, 5 00 crore
Fiscal Deficit = Revenue expenditure + Capita l expenditure - Revenue
receipts - Capita l receipts (net of borrowing)
= Borrowings
= , 12, 5 00 crore
Primary Deficit = Fisca l deficit - I nterest payments
= , 12, 5 00 crore - , 5 ,000 crore
= , 7, 5 00 crore
Revenue deficit = , 4, 5 00 crore.
Fiscal deficit = , 12, 5 00 crore.
Primary deficit = , 7, 5 00 crore.
16. Find borrowing by the government if payment of interest is estimated to be of , 15,000 crore which
is 25% of primary deficit.
Ans. H ere, i nterest payment = 2 5 % of primary deficit. So that,
Primary deficit = °°1
25
x 1 5 ,000 = , 60,000 crore
We know,
Primary Deficit = Fisca l deficit - I nterest payment
O r, Fiscal Deficit = Primary deficit + I nterest payment
= , 60,000 crore + , 1 5 ,000 crore
= , 7 5 ,000 crore
Borrowing = Fisca l Deficit = , 7 5 ,000 crore
Borrowi n g by the government = , 7 5 ,000 crore.
17. Revenue deficit is estimated to be , 20,000 crore, and borrowing is estimated to be , 15,000 crore.
If expenditu re on interest payment is estimated to be 50% of the revenue deficit, find fiscal deficit
and primary deficit.
Ans. Fiscal Deficit = Borrowing = , 1 5 ,000 crore
I nterest Payment = 5 0% of Revenue deficit
= 5 0% of , 20,000 crore
= , 10,000 crore
Primary Deficit = Fisca l deficit - I nterest payment
= , 1 5 ,000 crore - , 10,000 crore
= , 5 ,000 crore
Fiscal deficit = , 1 5 ,000 crore.
Primary deficit = , 5 ,000 crore.

18. Comment on the following statements as true or false, with a reason.
(i) Construction of school-building is a revenue expenditure of the government.
(ii) Gift tax is a capital receipt.
(iii) Dividends on investment made by government is a revenue receipt.
Ans. (i) It is a fa lse statement. Construction of school-bui lding is a capital expenditure because it creates
an asset for the government.
(ii) It is a false statement. G ift tax is a revenue receipt, because it neither creates l i a bi l ity nor leads
to reduction i n assets of the government.
(iii) It is a true statement. Dividends on i n vestment made by government is a revenue receipt, as it
does not add to lia bility or reduction i n assets of the government.
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19. Categorise the following government receipts into revenue and capital receipts. Give reasons for
you r answer.
(i) Receipt from sale of shares of a public sector undertaking.
(ii) Borrowing from public.
(iii) P rofit of public sector undertakings.
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(iv) Income tax received by government.
Ans.
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(i) Receipt from sa le of s h a res of a public sector underta ki ng is a capita l receipt, as it causes
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reduction in assets of the government.
(ii) Borrowing from public is a capita l receipt, as it creates lia bility for the government.
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(iii) Profit of public sector underta ki ngs is a revenue receipt, because it neither creates lia bility nor
leads to reduction in assets of the government.
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(iv) I ncome tax received by government is a revenue receipt, because it neither creates lia bility nor
leads to reduction in assets of the government.
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20. Why should revenue deficit be curbed?
Ans. Revenue deficit often occurs when unproductive expenditure of the government (li ke expenditure
B
on subsidies a n d purchases relati ng to law & order a n d defence of the country) is in excess of the tax
a n d non-tax revenue receipts. Thus, it contributes to fiscal deficit with out addi ng much to the flow of
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goods a n d services in the economy. Revenue deficit compels the government to resort to borrowing
or disi nvestment. Borrowing leads to a rise in national debt. Disinvestment leads to tra nsfer of asset
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ownership from the public sector to private sector. It implies a shift in focus from social welfa re to
profit maximisation. Thus, we conclude that revenue deficit should be curbed.
Y
21. Finance Minister has announced that steps would be taken to rationalise subsidies which presently
dominate the economy of the nation.
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What is the economic value of this statement?

Ans. The statement comes in the wa ke of consistently high fisca l deficit a rising out of h igh expenditure
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of the government on subsidies. Expenditure on subsidies is mostly unproductive. Because, it just

focuses on l owering the ma rket price of certa i n goods (li ke oil a n d LPG ) . To the extent money is spent
on subsidies, it is not available for investment in strategic sectors of economy like infrastructure.
Rationalising the subsidies mea ns provision of subsidies only for below poverty li ne populati o n . The
government has already i n itiated this process by withdrawi ng subsidy on petrol and diesel.
22. How has the decline in the price of crude oil in the international market helped the government to
reduce fiscal deficit?
Ans. I n dia imports crude oil to meet the bulk of domestic dema nd for petrol a n d diesel. A substa nti a l fa l l
in crude oil prices i n t h e international ma rket h a s prompted t h e government t o increase excise duty
on petrol a n d diesel without passing the benefit of it to the consumers. It has raised tax revenue of
the government. Accordi ngly, fisca l deficit has reduced.

4. Ana lysis & Eva l uation
1. How can the government impact allocation of resou rces through its budgetary policy?
Ans. Fol lowing observations high light how the government can impact a l location of resources through its
budgetary policy:
(i) The government can offer subsidies on such goods (l i ke coarse cloth) the prod uction of which is
essenti a l for poorer sections of the society. So that, the resources are shifted from the production
of 'goods for the rich' to the production of 'goods for the poor'.
(ii) The government can grant 'tax h o l i d ay' (exemption from tax payments) to induce investment in
the prod uction of essenti a l goods l i ke 'life saving drugs'. So that the resources are shifted from
the prod uction of non-essentia l drugs to the life-saving drugs.
(iii) The government can impact a l location of resources by shifting its own investments from
inefficient to efficient units of production. Also, a l location of resources would be impacted when
the government increases investment on the production of public goods.
(iv) H igh taxation can be imposed on such goods (like cigarettes and liquor), the prod uction of which
is harmful to the society. Accordingly, the resources would shift to the production of socia l ly
useful production a ctivities.
(v) The government can ma ke l arger budgetary a l locations for its 'Support Price Policy' in favour of
food crops. This would shift resources from non-food crops to food crops. This would ma ke the
country self-sufficient in food grain production.
2. Do you a pprove of disinvestment a s an a ppropriate policy of financing budgeta ry d eficit?
Ans. Disinvestment occurs when the government chooses to sel l its sta ke in public sector or joint sector
enterprises. This leads to 'privatisation'. Presently, this seems to be the only effective remedy available
with the government to finance the deficit. However, the government should be careful a bout two points:
(i) It should unload s hares of only inefficient enterprises . Otherwise, it would not only be lower ing
its asset holding, but a lso closing a regular source of income, and
(ii) Money received through disinvestment should not be used for purpose of po l itica l popularity
(to garner votes) . Instead, it should be used as productive investment.
3 . Su bsidy on diesel oil is a wasteful expenditu re by the government. Write one point in support of this
observation and one against it.
Ans. It is a wasteful expenditure:
Because the benefit of subsidy (on diesel oil) is unduly reaped by a richer section of the society who
get cheaper oil to run their l uxury cars.
It is not a wasteful expenditure:
Because, farmers need to be given d i esel at the l ow price. So that, the cost of farming does not rise
and farming rema ins a profita ble occupation.
4. Do you agree with the view that demonetisation of 500 and 1,000 rupee notes would help the
government in lowering its fiscal deficit?
Ans. It is true that demonetisation would help the government to lower its fisca l d eficit. Because of
demonetisation, shadow economy (bl ack money economy) wil l shrink. Unaccounted output would
now be accounted as a part of G D P. This would increase revenue receipts of the government by way
of direct and ind irect taxation. Accord ingly, fisca l d eficit must reduce.

(With Answers o r Reference to t h e Text for Answers)
1. Borrowi ng in government budget i s : (choose the correct a lternative) [CBSE Delhi 2015]
(a) revenue d eficit (b) fisca l deficit
(c) primary deficit (d ) d eficit in taxes
[(b)]

2. The non-tax revenue in the fol lowing is: (choose the correct a lternative) [CBSE Delhi 2015]
(a) export duty (b) import duty
(c) dividends (d) excise
[(c)]
3. Explain the role the government can play t h rough the budget in influencing a l location of resources .
4. P rima ry deficit in a government budget is : (choose the correct a lternative) [CBSE (Al) 2015]
(a) Revenue expenditure - Revenue receipts
(b) Tota l expenditure - Tota l receipts
(c) Revenue deficit - Interest payments
low
(d) Fisca l deficit - Interest payments
[(d)]
5. Direct tax is ca l l ed di rect because it is col lected di rectly from: (choose the correct a lternative)
[CBSE (Al) 2015]
ee
(a) the producers on goods produced (b) the sel l e rs on goods sold
(c) the buyers of goods
rF (d) the income ea rners
Fr
[(d)]
6. Explain how the government can use the budgeta ry pol i cy in reducing inequa lities in incomes.
or
Or [CBSE (Al) 201 5]
Explain how the government can use the budgeta ry policy in reducing inequa lity of income in the
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economy. [CBSE 201 9 (58/4/1)]
[ Page 293]
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7. P rima ry deficit in a government budget equa ls: (choose the co rrect a lternative) [CBSE (F) 2015]
oo
(a) interest payments (b) interest payments l ess borrowings
B
(c) borrowings l ess interest payments (d) none of the a bove

re
[(c)]
8. Which one of these is a revenue expenditure? [CBSE (F) 2015]
ou
(a) Purchase of s h a res (b) Loans advanced

ad
(c) Subsidies (d) Expenditure on acquisition of land

Y
[(c)]
9. Explain the role of government budget in fighting inflationa ry and deflationa ry tendencies.
nd
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[ Page 293] [CBSE (F) 2015]

Fi
10. Fisca l deficit equa ls: (choose the correct a lternative) [CBSE Delhi 201 6]
(a) interest payments (b) borrowings
(c) interest payments less borrowing (d) borrowings less interest payments
[(b)]
11. What is revenue expenditure? [CBSE Delhi 201 6]
[ Page 300]
12. What a re revenue receipts in a government budget? [CBSE Delhi 201 6; (A l) 201 6]
[ Page 294, 295]
13. What is revenue deficit in government budget? [CBSE Delhi 201 6]
Or
What is revenue deficit? [CBSE Delhi 201 7]

Or
Defi ne revenue deficit. [CBSE {A l) 201 7]
[Page 304]
14. What is government budget? Explain how taxes a n d subsidies ca n be used to influence a l l ocation of
resources. [CBSE Delhi 201 6]
Or
What i s government budget? Expla i n t h e role o f government budget in i nfluencing a l l ocation of
resources in the economy. [CBSE {F} 201 6]
[Page 292]
15. Defi ne revenue receipts in a government budget. Explain how government budget ca n be used to
achieve price sta bi lity in the economy. [CBSE Delhi 201 6]
Or
What a re revenue receipts? Explain t h e ro le o f government budget in bri nging sta bi lity i n the
economy.
[Page 293-295] [CBSE {F} 201 6]
16. Prima ry deficit equa ls: (choose the correct a lternative) [CBSE {Al) 201 6]
(a) borrowings (b) i nterest payments
(c) borrowings less i nterest payments (d) borrowi ngs a n d interest payments both
[(c)]
17. What a re capita l receipts in a government budget? [CBSE {Al) 201 6]
Or
What a re capita l receipts? [CBSE {F} 201 7]
[Page 298, 299]
18. Defi ne fisca l deficit. [CBSE {Al) 201 6]
Or
What is fisca l deficit? [CBSE Delhi 201 7]
Or
What is mea nt by fisca l deficit? [CBSE 2019 {58/1/1)]
[Page 305]
19. What is the difference between revenue expenditure a nd capita l expenditure? Expl a i n how taxes
a nd government expenditure ca n be used to influence distri bution of income in the society.
[Page 293, 303] [CBSE {Al} 201 6]
20. What is the difference between direct tax a n d indirect tax? Explain the ro le of government budget in
influencing a l location of resources. [CBSE (Al} 201 6]
[Page 292, 297]
21. Disi nvestment by government mea ns: (choose the correct a lternatives) [CBSE (F) 201 6]
(a) selling of its fixed capita l assets (b) sel l i ng of s h a res of public enterprises held by it
(c) selling of its bui l di n gs (d) a l l the a bove
[(b) J
22. What is capita l expenditure? [CBSE (F) 201 6]
[Page 301]
23. What is prima ry deficit? [CBSE Delhi 201 7; (F) 201 6]
Or
What is mea nt by prima ry deficit? [CBSE 2019 (58/1/1)]
[Page 306]

24. Explain the basis of cl assifying taxes into direct and ind irect tax. G i ve examples. [CBSE Delhi 201 7]
[Page 296, 297]
25. Explain how government budget can be used to influence distribution of income. [CBSE Delhi 201 7]
[Page 293]
26. Define government budget. [CBSE {Al) 201 7]
[Page 292]
27. Distinguish between d irect taxes and ind irect taxes. Give an example of each . [CBSE {A l) 201 7]
[Page 297]
28. Explain how government budget can be helpful in bringing economic sta bilisation in the economy.
[Page 293] [CBSE {Al) 201 7]
low
29. Giving reasons, classify the fol lowing into revenue receipts and capita l receipts :
(i) Recovery of loans.
(ii) Profits of public sector underta kings.
(iii) Borrowings. [CBSE {F) 201 7]
ee
[Page 462]
30.
rF
Explain how can government budget be useful in influencing a l location of resources in an economy.
Fr
[Page 292] [CBSE {F) 201 7]
31. What is government budget? Explain its major components. [CBSE 2018]
or
[Page 292, 294-302]
32. Explain (a) a l location of resources, and (b) economic sta bi lity as objectives of government budget.
sf
u
[Page 292, 293] [CBSE 2018]
k
33. Define the term 'tax'. [CBSE 2019 {58/1/1)]
Yo
oo
[Page 295]
34. H ow are capita l receipts different from revenue receipts? Discuss briefly. [CBSE 2019 {58/1/1)]
B
[Page 300]
re
35. H ow are capita l expend iture d ifferent from revenue expenditure? Discuss briefly.
[Page 303] [CBSE 2019 {58/1/2)]
ou
ad
36. (a) H ow are tax receipts d ifferent from non-tax receipts? Discuss briefly.
Y
(b) State any two items of revenue expend iture in a government budget. [CBSE 2019 {58/1/3)]
[Page 295, 297, 300, 301]
nd
Primary d eficit in a government budget wil l be zero, when _____ . (Choose the correct
Re
37.
a lternative) [CBSE 2019 {58/2/1)]
Fi
(a) revenue d eficit is zero (b) net interest payments are zero
(c) fisca l deficit is zero (d ) fisca l deficit is equa l to interest payment
[(d)]
38. What do you mean by a d irect tax? [CBSE 2019 (58/2/1)]
[Page 296, 297]
39. What do you mean by an indirect tax? [CBSE 2019 {58/2/1)]
[Page 297]
40. Classify the fol l owing statements as revenue receipts or capita l receipts. Give va l i d reasons in support
of your answer.
(i) Financia l help from a multinationa l corporation for victims in a flood affected area .
(ii) Sale of s hares of a Public Sector Und erta king (PSU) to a pr ivate company, Y Ltd .

(iii) Dividends pa id to the G over nment by the State Ba n k of I n dia .
(iv) Borrowi n gs from I nter nati o n a l Monetary Fund (I M F) . [CBSE 2019 (58/2/1)]
[Page 463]
41. (a) Disti nguish between revenue receipts a n d capita l receipts of the gover nment.
(b) Do 'disinvestment' and 'loan proceeds from a broad' constitute revenue receipts of the
gover nment? Give reason . [CBSE 2019 (58/3'/1)]
[Page 294, 295, 299, 300]
42. Given the fol l owing data estimate the va lues of (a) Revenue Deficit, a n d (b) Fisca l Deficit:
Items tr in crore)
(i) Tax revenue 1,000
(ii) Non-tax revenue 150
(iii) N et borrowings by gover nment 780
(iv) Disinvestment proceeds so
(v) Revenue expenditure 1,500
(vi) Capita l expenditure 480
[Page 463] [CBSE 2019 (58/3/1)]
43 . Dividends received from Public Sector U n derta kings (PSUs) are a part of the gover nment's
. (Choose the correct a lter native) [C8SE 2019 (58/4/1))
(a) non-tax revenue receipts (b) tax receipts
(c) capita l receipts (d) capita l expenditure
[(a)]
44. State a ny two examples of non-tax revenue receipts of the government. [C8SE 2019 (58/4/1))
Or
State a ny two examples of non-tax revenue. [CBSE 2019 (58/5/1)]
[Page 297, 298]
45. Suppose you are a member of the "Advisory Committee to the F i n a nce Minister of I n dia". The
Fina nce M i nister is concerned a bout the risi ng Revenue Deficit in the budget.
Suggest a ny one measure to co ntrol the rising Revenue Deficit of the gover nment.
[Page 305] [CBSE 2019 (58/4/1)]
46. Discuss briefly the role of the gover nment budget in influencing "a l location of resources" in the
economy. [C8SE 2019 (58/4/1))
[Page 292]
47. Which of the fol l owing is a capita l receipt in the gover nment budget? [CBSE 2019 (58/5/1)]
(a) I ncome tax
(b) I nterest receipt
(c) Sale of shares of a Public Sector U n derta king (PS U ) to X Limited (Private Compa ny)
(d) Dividends from a Public Sector U n derta king (PSU)
[(c)]
48. If i n an economy, the estimated receipts of the gover nment during a year are lesser t h a n the
estimated expenditure, the budget would be ca lled budget.
(Fi l l up the bl a n k) [CBSE 2019 (58/5/1)]
[deficit]

49. State whether the fol l owing statements a re true or fa lse. Suppo rt your a n swer with reason .
(a) Taxation i s a n effective too l t o reduce t h e i nequa lities o f income.
(b) Revenue deficit increases when government fails to recover loans forwa rded to different
nations. [CBSE 2019 (58/5/1)]
[(a) True. To correct inequality of income, the government pursues the policy of progressive taxati o n .
Progressive taxation i n I n dia focuses on the equita ble distri bution o f disposable income. H igher
rate of taxation on h igher i ncomes a nd lower rate of taxation on lower i ncomes reduces the gulf
between disposable income of the rich and the poor.
(b) Fa lse. Recovery of loans is a capita l receipt because it l eads to reduction i n assets. It does not
affect the revenue receipts.]
low
6. N C E RT Questions (Wit h H i nts to Answers)
1. Disti nguish between revenue expenditure a n d capita l expenditure.

[ H i nt : Revenue expenditure is that expenditure of the government which does not either create assets
for the government or causes a reduction in l i a bil ities of the government. Example: Expenditure on
ee
interest payments. Capita l expenditure is that expenditure of the government which either creates
rF
assets for the government or causes a reduction in government l i a bil ity. Example: Expenditure on
Fr
purchase of s h a res.]
2. "The fisca l deficit gives the borrowing requ i rement of the government." E lucidate.
or
[ H i nt : Fisca l deficit refers to excess of government expenditure over its receipts, exclusive of
borrowings . Thus, fisca l deficit poi nts to borrowing requi rement of the government to cope with
sf
u
its expenditures of the yea r. Higher borrowing implies h igher burden of repayment of loans a nd
of i nterest on the future generations. As this burden mounts up, yea r after yea r, resource-base
k
Yo
of the future generations tends to s h ri n k. This wi l l defi nitely reta rd the process of future growth,
oo
pa rticula rly when borrowi ngs by the government a re used for non-productive purposes.]
3 . Give the relationship between the revenue deficit a n d the fisca l deficit.
B
[ H int : When current account expenditure is a l l owed to mount up (without a propo rtionate rise in
re
current a ccount receipts), revenue deficit tends to rise. The rising revenue deficit is reflected as a
fisca l deficit (un l ess the government resorts to disi n vestment) . And when fisca l deficit is high, owing
ou
to high revenue deficit (implying high consumption expenditure) N OT owing to h igh investment
ad
expenditure, G D P growth receives a set-back. A set-back in G D P growth ra ises unempl oyment. Slow
Y
G D P growth a n d high unemployment lead to: (i) a cut i n government revenue receipts, a nd (ii) a rise
in government welfa re expenditure. Implying a rise in revenue deficit. Thus, there is a vicious ci rcle
nd
where revenue deficit a n d fisca l deficit sta rt feeding each other a n d the economy is driven to a state
Re
of stagnation.]
Fi
7. M isce l l a neous Questions a n d Reference to t h e Text for Answers

1. What is government budget? State its ma i n obj ectives . [Page 292, 293]
2. Give mea ning of revenue receipts a n d capita l receipts with a n example of each. [Page 294-299]
3. Disti nguish between revenue receipt a n d capita l receipt a n d give two examples of each.
[Page 294-300]
4. State the basis of classifying government receipts i nto revenue receipts a n d capita l receipts. G i ve a n
example o f each. [Page 294-299]
5. Disti nguish between tax revenue receipts a n d non-tax revenue receipts . [Page 295-298]

6. Give mea n i ng of revenue expenditure a n d capita l expenditure i n a government budget with a n
example o f each. [Page 300, 301 ]
7. Disti nguish between revenue expenditure a n d capita l expenditure. G i ve two examples of each.
[Page 300, 301, 303]
8. State the basis of classifyi ng government expenditure i nto revenue expenditure a n d capita l
expenditure. G i ve a n exampl e of each. [Page 300, 301 ]
9. Defi ne a tax. Give two examples each of direct taxes a n d indirect taxes. [Page 295-297]
10. What a re pla n a n d non-pl a n expend itures in a government budget? Give a n example of each .
[Page 301, 302]
11. What is the d ifference between pla n a n d non-pl a n expenditure? [Page 301, 302]
12. Disti nguish between ba l a nced budget a n d surplus budget. [Page 304, 309, 310]
13. What is revenue deficit? What a re its implications?
Or
Explain the mea ning a n d implications of revenue d eficit i n a government budget. [Page 304, 305]
14. What is fisca l deficit? What a re its implications? [Page 305, 306]
15. Disti nguish between fisca l deficit a n d revenue deficit. What d oes fisca l d eficit i n d icate?
[Page 304, 305, 307]
Add-on Questions with Hints
16. Giving reason, categories the fol l owing i nto revenue receipts a n d capita l receipts :
[Capita l receipts, because it reduces assets of the government.]
(ii) Corporation tax.
[ Revenue receipts, because it neither creates l i a bil ity nor reduces assets of the government.]
(iii) Dividends on investments made by government.
[ Revenue receipts, because it neither creates l i a bil ity nor reduces assets of the government.]
(iv) Sale of a public secto r underta ki ng.
[Capita l receipts, because it reduces assets of the government.]
17. Giving reason, categories the fol l owing i nto revenue expend iture and capita l expend iture :
(i) Subsidies.
[ Revenue expend iture, because it neither reduces liability nor creates assets of the government.]
(ii) G ra nts given to state governments.
[ Revenue expend iture, because it neither reduces liability nor creates assets of the government.]
(iii) Repayment of loans.
[Capita l expend iture, because it reduces liability of the government.]
(iv) Construction of school buildings.
[Capita l expend iture, because it adds to the assets of the government.]
18. Which one of the fol l owing is capita l expenditure of the government?
(i) Payment of interest.
(ii) Pu rchase of a bui l d i ng.
(iii) Pu rchase of machinery.
(iv) Loa ns gra nted to a state government.
[Purchase of a building; Purchase of mach i n e ry; Loa ns gra nted to a state government.]

B. Questions of 6 ma rks each
1. Defi ne government budget. What a re the o bjectives of a budget? [Page 292, 293]
2. Bri ng out the difference between revenue budget a n d capita l budget. G i ve the items of revenue as
wel l as capita l receipts a n d expenditure of the government. [Page 294-303]
3. Disti nguish between ba la nced budget a n d u n ba l a nced budget. Is ba l a nced budget a n achievement
of the government? [Page 309-3 1 1 ]
4. Disti nguish between progressive a n d regressive taxation in terms o f t h e i r effect o n the r i c h a n d t h e
poor. [Page 296, 332]
5. Is proportionate taxation a progressive tax or a regressive tax? G i ve an i l l ustration in support of your
a nswer. [Page 296, 332]
low
6. In an econ omy where additional tax revenue of the government is equa l to additi o n a l expenditure
by the government, would there be a ny impact on nati o n a l in come? Expl a i n with a n i l lustrati o n .
[ H i nt : Additi o n a l expenditure by the government (say of � 6 crore) would cause a multiplier effect
in the economy, simi l a r to the i n vestment mul tiplier. Assuming multiplier to be 2, additi o n a l i ncome
generated in the economy woul d be (2 x � 6 crore) = � 12 crore.
ee
Additi o n a l tax revenue by the government of � 6 crore does not cause reduction in expenditure by
rF
� 6 crore. Expenditure is reduced by 0.5 x (- � 6 crore) = - � 3 crore (on the assumption that M PC = 0.5).
Fr
Accordi ngly, multiplier being 2, the i n verse multiplier effect would be to the tune of 2 x (- � 3 crore)
= - � 6 crore.
The net effect would be an increase in i ncome by � 6 crore (= � 12 crore - � 6 crore) . ]
or
7. Ba la nced budget i s recommended as a useful policy i n strument when the economy is close t o t h e
sf
u
level o f ful l empl oyment. H ow?
[ H i nt: Ba l a n ced budget causes a modest increase in the level of AD. Because : expenditure by the
k
Yo
government raises AD by the same amount, while tax receipts reduce AD by 'M PC times' the tax
oo
receipts. A modest increase in AD would push the economy towa rds the point of ful l employment
when it is ma rgi n a l ly away from this poi nt.
B
N ote : Ba la nced budget (additi o n a l revenue bei n g equa l to additi o n a l expenditure) is a good strategy
re
during periods of modest recession when aggregate dema nd needs a modest rise.]
8. Defi ne fisca l pol icy. State the pri ncipa l objectives of fisca l policy.
ou
ad
[ H i nt : Fisca l pol i cy refers to revenue a n d expenditure policy of the government or budgeta ry pol i cy
of the government. Pri ncipa l objectives of fisca l policy a re the same as the principa l objectives of the
Y
government budget. ]
nd
DOs and DON'Ts

Re
Fi
1. Financing the fiscal deficit should not be confused as the sol ution to the problem of fi scal deficit.
Financing the fiscal deficit and solution to the problem of fisca l deficit a re different propositions. Fisca l
deficit may be fi n a n ced through borrow i n g . But this is n ot the sol ution to the problem. The sol ution to
the problem of fiscal deficit is to be fou n d in terms of: (i) lowering the govern ment expenditure, and
(i i) rai s i n g the government revenue. However, it is not so easy to lower government expenditure in a
country l i ke I nd i a where a sizea ble percentage of pop u l ation belongs to BPL category. BPL popu lation
deeply depends on the government for food, shelter, clothing and education. Likewise (i n I ndia), it is
n ot so easy for the government to increase its revenue. Taxation is the pri ncipal source of revenue.
But when the bulk of population l i ves on low i n comes, high rate of di rect taxation (income and wealth
tax) wou l d only lead to h i g h rate of tax evasion or u n bearable hard s h i p on the marg i n a l fam i l ies. Also,
h i g h rate of indirect taxation (l i ke excise duty) wou ld i ncrease the cost of production and lower the
inducement to i nvest.

The permanent sol ution to the problem of h i g h fiscal deficit is to be fou n d i n economic expansion:
GDP l evel a n d d i s posable i ncome of the peo p l e shou l d rise. Higher level of GDP would automat i ca l ly
generate h i gher reve n u e for the government Also at h i gher l evel of inco me, govern ment expenditure
on p u b l i c welfa re wou l d automat i ca l ly s h ri n k. A rise i n reve n u e a n d a fa l l i n expend iture would b r i n g
fiscal discipline.
2. Do not ever j u m p to the conclusion that b a l a nced b u d g et i s a n ach ievement of the govern ment A step
towa rd s ba l a nced b u d g et i m p l ies a step towards fi scal d i s c i p l i n e in the country. It i s essenti a l when
the economy i s passing thro u g h the phase of i nflati onary s p i ra l . But when the economy i s batt l i n g the
p roblem of excess capac ity (underem p l oyment of resou rces), the g overn ment i s expected to i ntervene
thro u g h h i g h i n vestment expenditure. It i s h i g h i nvestment expenditure that wou l d ra ise the l evel of AD
and correct the pro b l em of u n derem p l oyment Of cou rse, i nvestment expen d i t u re may lead to deficit
budget But this i s what i s req u i red to combat the p rob lem of u n de rem p l oyment
..,..__. • Sign ificance or I mportance of Public Expenditure

(with reference to the Indian Economy)
Fol low i n g observations h i g h l i g ht the s i g n ificance of p u b l i c expenditure with
reference to the I n d ian economy:
(i) Public expend itu re accelerates the pace of G D P g rowth. H i gher rate of
G D P growth is achieved through (a) investment expenditure in public sector
enterprises, (b) capital g rants by the govern ment for the p u rchase of capital
eq u i pment, (c) subsid ies for the p u rchase of i n p uts, a n d (d) p u rchase of
fa rm output at the m i n i m u m support price.
(i i) Public expend itu re promotes eq u a l ity in the d i stri bution of i ncome and
wea lth. This i s achieved by offeri ng o l d-age pen sions, as well as by
provi d i n g free food, education, a n d hea lth services to the Below Poverty
Line Pop u l ation.
(i i i) Public expend iture plays a s i g n ificant role i n restori ng economic sta b i l ity.
Particula rly, when the economy is batt l i n g economic recession. The
government expend itu re (consumption expen diture as wel l a s investment
expenditure) ra ises the level of AD. O n ly when AD is ra ised that the vicious
c i rcle of economic recession i s broken.
(iv) Public expend iture gen erates i nvestment-friendly envi ronment i n the
economy. The govern ment spends money on infrastructu ra l development
It constructs roads, da ms, bridges. It i ntrod uces faster and conven ient
means of tra n sportation. Such fac i l ities promote inducement to investment
Briefly, p u b l i c expen d iture is i n d i s pensable in any welfa re state l i ke I nd i a . It not
only promotes G D P g rowth, but a l so promotes social welfare.
• Public Goods vs. Private Goods
Publ ic Goods
Public goods are the goods which are meant for col lective use by a l l sections of
the society. Example: Law a n d order, defence a n d public a d m i n i stration. These
goods have two characteri stics: (i) non-riva l rous, and (ii) non-exc l u d a b i l ity.

(i) Non-rivalrous: These goods a re non-riva l rous i n the sense that the use
of a p u b l i c good by one i ndivi d u a l does not reduce its ava i l a b i l ity for the
other. Example: Pa rks, national defence, when used by one ind ividual are
not red uced for the other.
(ii) Non-excludability: These goods a re non-exclus ive i n the sense that the
use of a p u b l i c good by those i n d ividuals who pay for it does not exclude
others from u s i n g it who do not pay for it Exam ple: Street l i g ht may be a
paid uti l ity service. But those who do not pay can not be excl uded from the
use/benefit of it These goods, therefore, h ave the problem of free-riders':
even those who do not pay for them conti n ue to use them.
low
Private Goods
The oppos ite of a p u b l i c good is a private good. A private good is riva l rous and
excludable. Personal car of an i n d ividual is an exa m p l e of a private good . It
does not ca rry the cha racteristics of (i) non-riva l rous, and (ii) non-excludabil ity.
Beca use, this parti c u l a r car when p u rchased by me reduces the ava i l a b i l ity of
ee
ca rs by one u n it, a n d secondly, s i n ce I have paid for it, others obviously have
rF
Fr
no ri g ht to use it
• Free Rider Problem
or
A free rider is a person who enjoys the benefits of goods and services without
sf
contri buti ng to the fu l l cost or partia l cost of provid i n g them . Consumers
u
can ta ke advantage of public goods without contri buting sufficiently to their
k
creation. Th is is cal led the free rider p roblem. The free rider problem is usually
Yo
oo
more a cute i n the case of p u b l i c good s. The free rider p roblem exi sts when
people enjoy the benefits of government p rovided goods i n dependent of
B
whether they pay for them. If too m a ny consumers decide to 'free ride', private
re
costs exceed private benefits a n d the i ncentive to provide the good or service
th rough the ma rket disa ppears. The ma rket, thus, fa i l s to provide a good or
ou
service for which there i s a need .

ad
Y
• Progressive and Regressive Nature of Taxation is Different from

Progressive and Regressive Rates of Taxation
nd
Progressive Rate: The rate of taxation i ncreases with increase in i ncome.

Re
Regressive Rate: The rate of taxation decreases with i ncrease i n income.

Fi
Proportionate Rate: The rate of taxation rema i n s constant with increase or

decrease in i ncome.
Progressive Tax: A tax which (i n terms of n atu re/effect) cau ses greater rea l
burden on the r i c h compared t o t h e poor.
Regressive Tax: A tax which (in terms of natu re/effect) ca uses g reater rea l
burden on the poor compared t o t h e rich.
This i m p l i es that even a proportionate tax is a regressive tax.
Ill

h ·. / ., CHAPTER: 11
·///,;
. h'l EXCHANGE
/ RATE
•
•
•
•
Foreign Exchange and Foreign Exchange Rate
Flexible and Fixed Exchange Rate
Managed Floating
Components of Demand for Foreign Exchange
,,
• Components of Supply of Foreign Exchange
• Foreign Exchange Market
I. FOREIGN EXCHANGE AND

FOREIGN EXCHANGE RATE
Foreign exchange refers to foreign currency. The stock of foreign
exchange with a country (say India) refers to the stock of all foreign
currencies with the RBI at a point of time. The standard practice is
to measure the entire stock in terms of US dollars, by converting the
value of all currencies into US dollars.
The rate at which domestic currency can be exchanged for a foreign
currency is known as foreign exchange rate. It is the price paid in
domestic currency for buying a unit of the foreign currency. Example:
If 50 rupees are to be paid to buy one US dollar, then the exchange
rate is:
$ 1 : � 50
Thus, exchange rate expresses the ratio of exchange between the
currencies of two countries. It is the price of a currency expressed
in terms of another currency. It is also called 'external value of the
domestic currency'.
• In the words of Crowther, "The rate of exchange measures number of units of one currency which
is exchanged in the foreign market for one unit of another."
333
2. FLEXIBLE AND FIXED EXCHANGE RATE
Exchange rate is broadly classified as: (i) flexible exchange rate, and
(ii) fixed exchange rate. Following is a brief description of both these
types:
Flexible Exchange Rate

Flexible rate of exchange (also called floating rate of exchange) is
that rate which is determined by the supply-demand forces in the
foreign exchange market. It is also called 'free exchange rate' as it
low
is determined by the free play of supply and demand forces in the
international money market.
The exchange rate at which demand for foreign currency is equal to its
supply is called Par Rate of Exchange or Equilibrium Rate of Exchange.
ee
Determination of Flexible Exchange Rate
rF
Fr
Demand for and supply of foreign exchange are the two basic
determinants of flexible exchange rate. Following is a brief description
or
of both these determinants:
sf
u
Demand for Foreign Exchange
Other things remaining constant, demand for foreign exchange is
k
Yo
oo
inversely related to the price of foreign exchange (or the rate of
foreign exchange). Thus, higher the rate of foreign exchange, lower
B
the demand for foreign exchange, and vice versa. Diagrammatically,

re
demand for foreign exchange is indicated by a downward sloping

curve as in Fig. 1.
ou
ad
Demand for Foreign Exchange

Y
y
nd
Re
Q) �
0\
C
ro
=Oro
Fi
..c 0
u V1
Li'.i ::i
R, (� so : 1 US $)
.Q1
Q)
aJ Q)
0 §
� er:
0 C
Q) .!:2
...., --0
�§
0�----M�---�N--+X
(100) (200)
Demand for Foreign Exchange (US$) (million dollars)

Fig. 1 shows that higher the exchange rate, lower the demand for
foreign exchange. Thus, when exchange rate is � 50 for one US
dollar (R 1 ), the demand for US dollars is 200 million dollars (N).
When the exchange rate rises to �70 : 1 US $ (R2 ), the demand
shrinks to 100 million dollars (M).
Supply of Foreign Exchange
Other things remaining constant, supply of foreign exchange is
positively related to the rate of foreign exchange. Thus, higher the
rate of foreign exchange, higher the supply of foreign exchange, and
vice versa.
Diagrammatically, supply of foreign exchange is indicated by an
upward sloping curve, as in Fig. 2.
Supply of Foreign Exchange
y
OL._____M_,_______.N__+X
(100) (200)
Supply of Foreign Exchange (US $) (million dollars)
Fig. 2 shows that higher the exchange rate, greater the supply of foreign
exchange. Thus, when exchange rate is �50 for one US dollar (R 1 ),
supply = 100 million dollars (M). When the exchange rate rises to
�70 for one US dollar (R2 ), supply expands to 200 million dollars (N).
Equilibrium Rate of Exchange

Or
Par Rate of Exchange
Equilibrium rate of exchange or par rate of exchange occurs
when: supply of foreign exchange = demand for foreign exchange.
Diagrammatically, equilibrium rate of exchange corresponds to point
where supply and demand curves in the foreign exchange market
intersect each other. Fig. 3 depicts this situation.
Foreign Exchange Rate 335

Determination of Equilibrium Exchange Rate
y
Equilibrium Exchange Rate= OR
QJ
Equilibrium Quantity
g1 R1 t-r------,r of Foreign Currency= 00
ro
-5wX R
o R2 f-L-------;,----"'"
ro
er:
low
O..______._.._---'------
M Q x
Supply/Demand (Foreign Currency)
• Se : Supply of foreign currency. It is positively related

to the rate of exchange.
ee
• DF : Demand for foreign currency. It is negatively
related to the rate of exchange.
• E
rF
: Point of equilibrium rate of exchange where
Fr
supply and demand curves intersect each other.
• OQ: Equilibrium quantity where supply and demand
for foreign exchange are equal.
or
In Fig. 3, supply and demand are measured on the X-axis, and exchange
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rate on the Y-axis. DF is the demand curve and S F is the supply curve
of foreign currency. Both these curves intersect at point E. It is an
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equilibrium point and OR is the equilibrium rate of exchange. If the
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rate of exchange rises to OR 1 then supply of foreign currency (ON)

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will exceed its demand (OM) by an amount equivalent to MN. Supply

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being more than demand, rate of exchange will come down to OR.
On the contrary, if the rate of exchange falls to OR2 then demand
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for foreign currency (ON) will be more than its supply (OM) by MN.
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Demand being more than supply, rate of exchange will again rise to
OR. Rate of exchange will ultimately be determined at a point where
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demand for and supply of foreign currency are equal.

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Impact of Change (Increase/Decrease)

in Demand and Supply
Increase in demand for a foreign currency occurs when more of it is
demanded at its existing price (exchange rate). Decrease in demand
for a foreign currency occurs when less of it is demanded at its existing
price (exchange rate). Likewise, increase in supply of a foreign currency
occurs when more of it is supplied at its existing price (exchange
rate). Decrease in supply of a foreign currency occurs when less of

it is supplied at its existing price (exchange rate). Let us examine the
impact of these four situations on the equilibrium exchange rate. As
a reference, let us consider the exchange rate between US dollar and
Indian rupee.
Situation 1: Impact of Increase in Demand for a Foreign Currency

(US$): Depreciation of Domestic Currency
Increase in demand is reflected by a shift in demand curve to the
right, as in Fig 4.
Impact of Increase in Demand for Foreign Currency

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Assumed Exchange Rate:

OR : 1 US $ = t 60
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O> OR 1 : 1 US $ = t 70
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<U
-5X R11----.....,.,..---=
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] R f---_:_------;:,c
<U
cc:
O -----'---'------x
'--
Q 01
Demand and Supply of US $
• D · The initial demand curve for US $.
• D1 · A forward shift in demand curve for US$.
Consequently:
-Price of US$ (exchange rate) rises from OR to OR1•
-Domestic currency depreciates in relation to US $.
Demand curve shifts from D to D 1 . This causes a rise in the equilibrium

exchange rate from OR to OR 1 . Now one US $ is available for� 70,
instead of� 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 currency depreciation (or depreciation of
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the domestic currency).
Currency depreciation refers to a situation when domestic currency (rupee) depreciates (or loses
its value) in relation to a foreign currency (say US dollar). So that, you need more rupees to buy a
dollar. Example: If US $ exchanges fort 70, instead oft 60 earlier, the domestic currency (Indian
rupee) shows depreciation.

Situation 2: Impact of Decrease in Demand for a Foreign Currency
(US$): Appreciation of Domestic Currency
Decrease in demand is reflected by a shift in demand curve to the left,
as in Fig 5.
Impact of Decrease in Demand for Foreign Currency

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QJ OR: 1 US$ =�60
OR1: 1 US$ = � 50
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R1
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QJ
D
--
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O �----�-�-----x
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01 Q
or
• D Initial demand curve for US $.
• 01 Backward/downward shift in demand curve for US $.
Consequently:
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-Price of US$ (exchange rate) falls from OR to OR1•
-Domestic currency appreciates in relation to US $.
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Demand curve shifts from D to D 1 . This causes a fall in the equilibrium
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exchange rate from OR to OR 1 . Now one US $ is available for� 50,

instead of� 60 earlier. Thus, other things remaining constant, decrease
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in demand for foreign currency leads to a fall in exchange rate. This is

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described as a situation of currency appreciation (or appreciation of

the domestic currency).
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Currency appreciation refers to a situation when domestic currency (rupee) appreciates (or gains
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its value) in relation to a foreign currency (say US dollar) So that, you need less rupees to buy a dollar
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Example: If US $ exchanges for� 50, instead of� 60 earlier, the domestic currency (Indian rupee)
shows appreciation.
Situation 3: Impact of Increase in Supply of Foreign Currency

(US $): Appreciation of Domestic Currency
Increase in supply is reflected by a shift in supply curve to the right,
as in Fig 6.

Impact of Increase in Supply of Foreign Currency
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g' R 1---,-------�IC Assumed Exchange Rate:

-§ R11---'-----�-t--�
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OR: 1 US$ =�60
OR 1 : 1 US$ = � 50
4-
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er:
s
D
�-----��------x
0 0 01
Demand and Supply of US$
• S Initial supply curve for US$.
• S1 Shift in supply curve to the right (increase in supply).
Consequently:
-Price of US$ (exchange rate) falls from OR to OR 1 •
-Domestic currency appreciates in relation to US$.
Supply curve shifts from S to 5 1 . This causes a fall in the equilibrium

exchange rate from OR to OR 1 . Now one US $ is available for � 50,
instead of� 60 earlier. Again, this is a situation of currency appreciation
(or appreciation of the domestic currency).
Situation 4: Impact of Decrease in Supply of Foreign Currency

{US $): Depreciation of Domestic Currency
Decrease in supply is reflected by a shift in supply curve to the left,
as in Fig. 7.
Impact of Decrease in Supply of Foreign Currency
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OR : 1 US$ =�60
OR 1 : 1 US $ = � 70
o�-----��------
01 0 x
• S · Initial supply curve for US$.
• S1 : Shift in supply curve to the left (decrease in supply).
Consequently:
-Price of US$ (exchange rate) rises from OR to OR 1 •
-Domestic currency depreciates in relation to US$.

Su pply cu rve sh ifts from S to S 1 . Th is cau ses a rise i n the eq u i l ibrium
exchange rate from O R to O R 1 . Now, one U S $ is avai lable for � 70,
i nstead of � 60 earl ier. Th is is a situation of cu rrency depreciation (or
depreciation of the domestic cu rrency) .
Bri efly, exchange rate rises when demand for fo reign cu rrency rises
o r when su pply of foreign cu rrency fal l s . It l ead s to depreciation of
the domestic cu rrency. On the oth er hand , exchange rate fal l s when
demand for foreign cu rrency fal l s or when supply of foreign cu rrency
rises. It leads to appreci ation of domestic cu rrency.
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Appreciation and Depreciation of Domestic Currency-The Difference
F@C U S Appreciation of
Domestic Currency
Depreciation of
Domestic Currency
Z ON E (i) It is a situation of a fall in exchange (i) It is a situation of a rise in exchange
rate. rate.
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(ii) Less rupees are needed to buy one US $. (ii) More rupees are needed to buy one US $.
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(iii) Cause: (iii) Cause:
Increase in supply of foreign exchange. Increase in demand for foreign exchange.
or or
or
Decrease in demand for foreign Decrease in supply of foreign exchange.
exchange.
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(iv) Example: Exchange rate falls from (iv) Example: Exchange rate rises from
( I US $ : '{ 6 0) to ( I US $ : '{ 50). (I US $ : '{ 60) to (I US $ : '{ 70).
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Q. 1. How does appreciation and depreciation of the domestic currency affect exports a n d i m ports of the
domestic economy?
Ans. Appreciation of the domestic currency impl ies (i) less ru pees are req u i red to buy a dollar. Accord i ngly,
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i mports a re likely to increase, and (ii) more dollars a re req uired to buy a rupee. Accord ingly, exports
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a re likely to fall.
Depreciation of the domestic currency i m plies (i) more ru pees a re req u i red to b uy a dollar.
Accordi ngly, i m ports a re l i kely to fa ll, a n d ( i i) less dollars are required to buy a rupee. Accordingly,
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exports are like to rise.

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Q. 2. Explain why supply of a foreign cu rrency rises in response to a rise in its excha nge rate.
Ans. Rise in excha nge rate implies appreciati o n of foreign cu rrency in relation to domestic cu rrency. It
ca uses a rise in supply of foreign cu rrency owi ng to the fol l owing situations:
(i) Appreciation of foreign cu rrency induces F D I (foreign d i rect i nvestment) from rest of the
worl d . Beca use, now one unit of the foreign cu rrency converts i nto more u n its of the domestic
cu rrency. Accord ingly, supply of foreign cu rrency increases.
(ii) Appreciation of foreign cu rre ncy i m p l ies depreciati o n of the domestic currency. It induces
exports from the domestic economy. I m plying that the s u pply of foreign cu rrency i ncreases.
( i i i ) Appreciation of foreign currency induces FIi (foreign institutional investment-i nvestment related
to purchase of shares) in the domestic economy. Beca use, now purchasing power of the foreign
currency rises in the domestic economy. This leads to increase in supply of foreign cu rrency.

(iv) Appreciation of foreign cu rrency i ncreases d i rect p u rchases by the n o n-residents i n the
domestic eco n omy. Aga in, beca use of the rise i n p u rchasing power of the foreign currency in
the domesti c m a rket. This a l so ca uses i ncrease i n s u pply of foreign currency.
(v) Appreciation of foreign cu rrency increases re m itta n ces from a b road. Beca use, a u n it of foreign
cu rrency converts i nto m ore u n its of the domestic cu rrency. Accord i ngly, s u p p l y of foreign
cu rrency rises.
Q. 3 . Why d oes the demand for foreign cu rrency fa l l when its p rice rises?
Ans. A rise in the p rice of foreign cu rrency i m p lies that more u n its of the domestic cu rrency (say ru pees)
a re needed to buy a unit of foreign currency (say US $). It leads to a fa l l in demand for foreign
currency, owi n g to the fol lowing reason s :
( i ) With a rise i n the p rice o f foreign cu rrency, i m ports t e n d t o fa ll, l e a d i n g t o a fa l l i n demand for
foreign cu rrency.
( i i ) A rise i n p ri ce of foreign cu rrency m a kes trave l l i ng to rest of the world more expensive.
Accord i ngly, demand for foreign cu rrency fa lls.
(iii) I nvestment i n rest of the world becomes more expensive, leading to a fal l i n demand for foreign
currency.
( iv) Opportun ity cost of holding foreign currency ( i n terms of domestic cu rrency) tends to rise.
Accord i ngly, demand for foreign currency tends to s h ri nk.
Fixed Exch ange Rate

Exchange rate is said to be fixed when it is set and maintained by the
government at a particular level. The government may set it at a level
higher or lower than the equilibrium exchange rate as determined by
the market forces of supply and demand.
When Exchange Rate is set higher than the Equilibrium

Exchange Rate
Fig. 8 illustrates the situation when exchange rate is set higher than
the equilibrium exchange rate.
Exchange Rate higher than the Equilibrium Exchange Rate

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O�------�L------• X
S u pply a n d Demand (US $)

In Fig. 8, S F shows the supply of US dollars and DF shows the demand
for US dollars.
OR is the equilibrium exchange rate : 1 US $ is exchanged for �50.
OR 1 is the exchange rate as set by the government. Here, 1 US $ is
exchanged for �60.
Thus, the value of the domestic currency {Indian rupee) has been
deliberately lowered by the government. This is called 'devaluation'.
Devaluation of the currency is different from Depreciation of the
currency. The difference is as under:
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Depreciation of the (domestic) currency occurs when the value of
the (domestic) currency reduces in the international money market,
because of the market forces of supply and demand. The government
plays no role whatsoever.
Devaluation of the (domestic) currency occurs when the value of
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the domestic currency is deliberately reduced by the government by
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raising the exchange rate. The market forces of supply and demand
play no role whatsoever.
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F@C U S Depreciation vs. Devaluation
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of the (domestic) currency occurs when the value of the domestic
ZO N E
Depreciation
currency reduces in the international money market, because of the market forces of
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supply and demand. The government plays no role whatsoever.
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Devaluation of the (domestic) currency occurs when the value of the domestic
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currency is deliberately reduced by the government by raising the exchange rate. The
market forces of supply and demand play no role whatsoever.
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Implications of Devaluation
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Devaluation leads to excess supply of foreign currency in the

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international money market (in a state of equilibrium).

In Fig. 8, excess supply (S F > DF) = PO. This would lead to a fall in
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the exchange rate. In which situation the very purpose of devaluation

would be lost. It, therefore, becomes essential for the government
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to absorb the excess supply by way of its own purchase of the

foreign currency in the international money market. Accordingly, the
government-reserves of forex (foreign exchange) must rise. {It may be
noted that in India, RBI is engaged in the sale and purchase of foreign
currency in the international money market.)
When Exchange Rate is set lower than the
Equilibrium Exchange Rate
Fig. 9 illustrates the situation when exchange rate is set lower than the
equilibrium exchange rate.

Exchange Rate lower than the Eq uilibriu m Exchange Rate
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V,
�
0
� o
ru v,
cc =i (� 50 :
g ;,; R 1-------�.C:
(� 40 : �-...------i----..:
� �o_ R I i----
..c
� �
W C
ru
o '-------�L------ x
Supply and Demand (US $)
In Fig. 9, OR is the equilibrium exchange rate: 1 US $ is exchanged

for �50.
OR1 is the exchange rate as fixed by the government. Here, 1 US $ is
exchanged for �40.
Thus, the value of the domestic currency (Indian rupee) has been
del i berately raised by the government. This is cal led ' Revaluation'.
Revaluation of the currency is different from Appreciation of the
currency. The difference is as under:
Appreciation of the (domestic) currency occurs when the val ue of the
(domestic) currency rises in the international money market, because
of the market forces of supply and demand. The government plays no
role whatsoever.
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.
Appreciation vs. Revaluation
F®C U S
ZO N E
Appreciation of the (domestic) currency occurs when the value of the domestic
currency rises in the international money market, because of the market forces of supply
and demand. The government plays no role whatsoever.
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.
Implications of Revaluation
Revaluation leads to excess demand for foreign currency in the
international money market. The RBI must fulfil this excess demand
by releasing supplies from its reserves of forex.

In case supplies are not released from the reserves of forex, there
may emerge a black market for the sale and purchase of dollars. The
buyers may have to pay a premium for the purchase of dollars over
and above the price fixed by the government.
Less Developed Countries often Devalue their Currency

Less developed countries often devalue their currency: domestic currency is made cheaper in
relation to the foreign currency This is because of the three principal reasons:
(i) Devaluation (implying a planned fall in the value of the domestic currency) is expected to
raise the demand for the domestically produced goods and services. Accordingly, exports are
expected to rise.
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(ii) Rise in exports (owing to devaluation) is expected to increase the supply of foreign exchange
into the domestic economy This facilitates import of essential goods from rest of the world.
(iii) A fall in the value of domestic currency induces private foreign investment Because, for
every dollar, the investors are going to get more rupees, after devaluation. This is expected to
promote GDP growth.
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Gold Standard System of Exchange Rate-
An Old Variant of Fixed Exchange Rate System
or
Gold standard system of exchange rate is an old variant of fixed
exchange rate system.
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According to this system {prevalent in most countries prior to 1920s),
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gold was taken as the common unit of parity between currencies of
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different countries. Each country was to define value of its currency in
terms of gold. Accordingly, value of one currency in terms of the other
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currency was fixed considering gold value of each currency.

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I llustration
If UK £ (Pound) = 4 g of gold and US $ (Dollar) = 2 g of gold, then
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1 UK £ = 2 US $. Exchange rate or exchange ratio between UK £ and

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US $ = 1 : 2. Two US dollars would exchange for 1 UK pound. This

system of exchange was also known as Mint Par Valu e of Exchange or
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Mint Parity. Mint value of a currency implied gold value of that currency.
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Bretton Woods System of Exchange Rate

Or
Adjustable Peg System of Exchange Rate
Bretton Woods System Bretton Woods System (even when it was a fixed system of exchange
is na med after U n ited rate) allowed some adj ustments. So, it was called 'adjustable peg
Nations Moneta ry
Financial Conference system of exchange rate'. According to this system,
held at Bretton Woods ( i ) Different currencies were pegged ( or related) to one currency,
(U SA) i n 1 944 which led
to the esta b l ish ment that is US dollar.
of I M F ( I nternational
Monetary Fund).
(ii) US dollar was assigned gold value at a fixed price.

(iii) Value of one currency in terms of US dollar ultimately implied
value of that currency in terms of gold.
(iv) Gold continued to be the ultimate unit of parity between any
two currencies.
(v) Adjustment in the parity value of a currency was possible but
only if allowed by IMF {International Monetary Fund).
Even this system was abandoned in 1977. It was replaced by a flexible
system of exchange rate.
Fixed and Flexible Exchange Rate- Key Differences
Fixed Exchange Rate Flexible Exchange Rate
(i) Fixed exchange rate is determined by the (i) Flexible exchange rate is determined by
government. the forces of supply and demand in the
international money market.
(ii) Changes in the fixed rate of exchange are (ii) Changes in the flexible rate of exchange are
planned and introduced by the government, or linked to changes in the market forces of
the Central Bank of the country (RBI in India). supply and demand.
(iii) As set and maintained by the government, the (iii) As determined by the forces of supply and
fixed rate of exchange leads to: (a) devaluation demand, flexible rate of exchange leads to.
(when the value of the domestic currency is (a) depreciation of the domestic currency
lowered by the government), or (b) revaluation (when the exchange rate rises), and
(when the value of the domestic currency is (b) appreciation of the domestic currency
raised by the government). (when the exchange rate falls).
(iv) To maintain the fixed rate of exchange at a (iv) Flexible exchange rate does not require any
particular level, the government needs to keep large stock of foreign exchange, as its /eve/ is
a large stock of foreign exchange. set by the market forces of supply and demand.
(v) Degree of speculation is very low in the system (v) Degree of speculation is very high in the
of fixed exchange rate. It arises only when system of flexible exchange rate. It is because
people expect some change in the government of the uncertainty of market forces of supply
policy and demand.
t>TS
Q. Why was gold standard system of exchange rate a ba ndoned (discontin ued)?
Ans. This was beca use this system req uired lots of reserves of gold. This raised the demand for gold. But,
the supply of gold was extremely sca rce in relation to its demand.
3. MANAG E D FLOAT I N G
Even when exchange rate is determined by the forces of supply and
demand, at times the Central Bank (RBI) intervenes to manage the
exchange rate so that it does not slip out of the desired limits. It is
called managed floating. It may be defined as under:
Managed floating is a system of floating exchange rate in which there
is occasional intervention by the central bank to influence the float or
manage the float. It is also called 'Dirty Floating'.

How does the central bank exercises its influence on the 'float' or
market exchange rate?
It is 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 releases the supply of US $ in
the foreign exchange market. 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
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central bank increases its demand for US $ in the foreign exchange
market. Other things remaining constant, higher demand for US $
would raise the price of US $, as desired. This would lead to depreciation
of the domestic currency.
Briefly, managed floating is an exercise of sale and purchase of foreign
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curren cy by the central bank , so that the exchange rate is managed
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within the desired limits.
F@C US Managed floating is a tool employed by the central bank to restore the value of the
or
country's currency (in relation to other currencies) within the desired limits, even when
Z ONE exchange rate is determined by the market forces of demand and supply.
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In fact, managed floating may be called as the mixture of both flexible and fixed
exchange rate systems. It comprises the element of flexible exchange rate system as the
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exchange rate is primarily determined by the forces of supply and demand. Likewise, it
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comprises the element of fixed exchange rate system as the exchange rate is moderated
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(or managed) by way of intervention by the RBI.

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4. COM PO N E NTS O F DEMAN D FOR FOREIG N

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EXC HANG E (FORE I G N CU RRENCY)

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OR
WHY IS FOREIG N EXC HANG E DEMAN D E D ?
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Foreign exchange is demanded for various purposes. Basically, it is

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demanded for making payments to rest of the world. Each type of

payment constitutes a component of demand for foreign exchange.
Broadly, following are the constituents of demand for foreign exchange:
(1 ) Repayment of International Loans : International loans are raised
in terms of foreign currency. Accordingly, foreign currency is
required for the repayment of these loans. In less developed
countries like India, this is an important component of demand
for foreign exchange.
(2) Investment in Rest of the World : Investment in rest of the
world is an important business activity. We need currency of the

country in which investment is to be made. Thus, US dollars are
needed/demanded if investment is to be made in USA.
(3 ) I mports: We import goods (like cellphones and TVs) and
services (like of banking and insurance) from rest of the world.
It requires foreign exchange. Because payments for imports are
made in foreign exchange only.
(4) Di rect Purchases Abroad : Foreign exchange is needed to make
direct purchases (of goods and services) abroad. Because, people
from our country visit other countries of the world as tourists.
They also go abroad for studies or for medical treatment. This
involves direct purchases abroad.
(5) Grants and Donations: Grants and donations (unilateral
payments) to rest of the world also contribute to the demand
for foreign exchange. Grants and donations to a country are
often made in terms of the currency of that country (or in terms
of some internationally accepted currency like US dollars).
(6) Payment of I ncomes: Demand for foreign exchange in the
domestic economy also arises for the payment of factor incomes
(rent, interest, profit/dividend and wages) which are repatriated
(sent) abroad. It is like factor income to rest of the world.
(7) Speculative Trad i ng: 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.
Together, these components of demand add up to aggregate demand
for foreign exchange.
5. CO M PONEN TS O F SU PPLY O F FO REIGN

EXCHANGE (FO REIGN CU R RENCY)
OR
SOU RCES O F FO REIGN EXCHANGE
Supply of foreign exchange depends on the following sources. Each
source constitutes a component of supply of foreign exchange. A
country receives foreign exchange through the following sources of
supply:
(1 ) Exports: Export of goods and services is an important source
of supply (inflow) of foreign exchange from rest of the world.
Thus, export of goods and services from India to US would
mean supply of foreign exchange to India (in terms of receipts
for exports).

(2) Investments from Rest of the World : Investments from rest of
the world (including FIi and FDI) is another important source of
supply of foreign exchange. Lots of foreign exchange flows from
developed countries to underdeveloped countries through this
channel of economic activity.
(3) Di rect Purchases by Rest of the World : Direct purchases by the
residents of rest of the world also contribute to the flow of foreign
exchange from rest of the world to the domestic economy.
(4) Loans from Rest of the World : It refers to borrowings from rest of
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the world. A loan from UK would mean flow of UK £ from UK to
India. It contributes to the supply of foreign exchange to India.
(5) Grants and Donations from Rest of the World : Grants and
donations from rest of the world are also a source of supply
of foreign exchange. A significant amount of foreign exchange
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flows from rich to the poor countries of the world by way of
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grants and donations.
(6) Income Recei pts: Foreign exchange also flows from rest of the
world to the domestic economy by way of income receipts. These
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receipts refer to receipts of factor incomes from rest of the world.
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(7) Remittances by the Non-residents: Remittances by NRls are an
important source of supply /receipt of foreign exchange from rest
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of the world. Such remittances are indeed a significant component
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of supply of foreign exchange in developing economies like India.

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Together these components of supply add up to aggregate supply of

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foreign exchange.
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Q. 1. State a ny two factors that expla in extension of demand for a foreign currency i n response to a fa ll i n
its price.
Ans. (i) When foreign currency (say US $ ) becomes chea per (in relation to the domestic currency), we
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get more dollars per unit of our cu rrency. Accordingly, i m ports become lucrative. This raises
demand for foreign cu rrency.
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(ii) When foreign currency becomes chea per, domestic i nvestors will be ind uced to make g reater
i nvestment i n rest of the world. Accordi ngly, demand for foreign cu rrency rises.
Q. 2. State any two factors that explain contraction of s u pply of a foreign currency when its price in terms
of the domestic currency falls.
Ans. ( i ) When foreign cu rrency becomes chea per (in relation to domestic currency), p u rchasi ng power of
the foreign currency in the domestic ma rket tends to fal l . This leads to a fa ll in foreign demand for
the domestic goods. I m plyi ng fa l l in o u r exports. Accord i ngly, supply of foreign cu rrency red uces.
( i i ) When foreign currency becomes cheaper (in relation to domestic currency), less ru pees are
ava i l a ble for a US dollar. Accord i ngly, foreigners are less inclined to m a ke FOi ( Foreign Direct
I nvestment). This reduces the supply of foreign cu rrency.

6. FO RE I G N EXC HAN G E MARKET
Foreign exchange market refers to the market for national currencies
of different countries in the world. It is a centre of trade for different
currencies. Buyers and sellers in foreign exchange market wish to buy or
sell foreign exchange.
Fu nctions
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 ) Cred it 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) Hedgi ng Fu nction: It implies protection against risk related to
variations in foreign exchange rate. Exchange rate is locked for
future supplies of foreign exchange.
Operati on of Fore ign Exchange Market

Foreign exchange market operates either as
(1) Spot Market (Current Market), or as
(2) Forward Market.
(1} Spot Market (Current Market}

Spot market for foreign exchange is that market which handles only
spot transactions or current transactions.
Its princi pal characteristics are that:
(i) In terms of 'period of transaction', spot market is of 'daily
nature'. It does not trade in future deliveries.
(ii) The rate of exchange which is determined in the spot market is
known as spot rate of exchange. The spot rate of exchange (or
current rate of exchange) is that rate which prevails at the time
when transactions are made.
(2) Forward Market

Forward market for foreign exchange is that market which handles
such transactions of foreign exchange that are meant for future
delivery. Such transactions are signed today but are to materialise (or
are to be honoured) on some future date.

Principal characteristics of forward market are that:
(i) It only caters to forward transactions; it does not deal with spot
transactions in foreign exchange.
(ii) It defines (or determines) forward exchange rate-the exchange
rate at which forward transactions are to be honoured.
Why are Forward Transactions Contracted?
Forward transactions are contracted for two reasons:
(i) To avoid the risk of any adverse change in exchange rate, and
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(ii) To make speculative gains.
Spot Market and Forward Market-The Difference
Spot Market Forward Market
(i ) It hand les cu rrent tra nsactions. (i) It hand les transactions meant for future
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del ivery.
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( i i ) Rate of excha nge determined in ( i i ) Rate of excha nge dete rmined i n this
this market is ca l l ed spot rate of ma rket is ca l led fo rwa rd excha nge
excha nge. rate o r co ntracted excha nge rate.
or
( i i i ) It does not a l l ows 'hedging'. (iii) It a l l ows 'hedging'.
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'Hedgi ng' means avoi d i ng the risk of an adve rse cha nge in excha nge rate by sign ing
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foreign excha nge transactions for future delive ry.
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F®C U S Spot exchange rate (also known as current rate of exchange) is that rate of exchange
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which prevails in the market at the time when transactions are made. It relates only to
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spot transactions in the international money market.

Forward exchange rate is that exchange rate at which forward transactions
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are to be honoured. It has nothing to do with spot transactions in the international

money market. In fact, forward exchange rate is a sort of 'contracted' exchange rate
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to be applicable for the transactions which are signed today but are to be honoured
sometimes in the future.
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nd
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Power Points & Revision Wi ndow •-----------
Exchange Rate refe rs to t h e price of o n e cu rre n cy i n re lation to oth e r cu rrencies i n t h e i nternati o n a l
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m o n ey ma rket (or i nternati o n a l excha nge ma rket) . [Example: If < 50 a re to be pa id to buy
one US dol l a r, excha nge rate betwee n t h e two cu rre n cies = 50 : 1 . )
Systems: ( i ) Flexi b l e excha nge rate syste m, ( i i ) Fixed excha nge rate system .
Flexible Exchange Rate is a float rate o f excha nge, d eterm i ned by t h e su p p ly of a n d d e m a n d for d iffe re nt
cu rre n c i es.
W h e n , owing to t h e free p lay of t h e forces of s u p p l y a n d d e m a nd, excha nge
rate ha ppens to rise, it is ca l led 'de p reciation' of the ( d o mestic) cu rre n cy. On the
oth e r h a n d, when excha nge rate happens to fa l l , it is ca l led 'a p p reciatio n of the
( d o m estic) cu rre n cy.
1
Equili brium Exchange Rate occ u rs w h e n :
Su pply o f foreign cu rre ncy/fo reign excha nge = D e m a n d for foreign cu rre n cy/fo re ign excha nge
Demand for Foreign Currency/Foreign Exchange depends upon: (i) Repayment of i nternational loa ns,
(ii) I nvestment in rest of the world, (iii) I m ports, (iv) Direct purchases a b road, (v) G ra nts a n d d o nati ons,
(vi ) Payment of i n com es, (vi i ) Specu lative t ra d i ng.
Supply of Foreign Currency/Foreign Exchange d e pends u po n : (i) Exports, ( i i ) I nvest m e nts fro m rest of the
world, ( i i i ) D i rect p u rchases by rest of t h e world, ( iv) Loa ns from rest of the world, (v) G ra nts a n d donations
fro m rest of t h e wo rld, (vi) I ncom e recei pts, (vi i ) Rem itta nces by t h e n on-resi d e nts.
Fixed Exchange Rate System: Excha nge rate is set and m a i nta i n e d by the gove rn m e nt at a particu l a r
l eve l . Ma rket forces o f su pply a n d d e m a n d have n o rol e t o play. W h e n t h e
excha nge rate is ra ised b y t h e govern m e nt, i t is ca lled 'deval uation' o f the
( d o m estic) cu rre n cy. W h e n it is l owered, it is ca lled 'reva l u ation' of the
( d o m estic) cu rre n cy.
Determination: Fixed excha nge rate is d eterm i ned by t h e gove rn m e nt of t h e co untry.
Managed Floating, a lso ca l l e d Di rty Floati ng, is a syste m of floating excha nge rate (where excha nge rate is
d eterm i ned by t h e forces of d e m a n d a n d s u p ply) but occasi o n a l ly, t h e float is m a n aged
by the centra l ba n k of the co untry by way of sa l e and p u rchase of foreign excha nge i n
t h e i nternati o n a l m o n ey ma rket. Ma naged floating is a n atte m pt t o kee p the excha nge
1
rate with i n the desired l i m its.
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Foreign Exchange Market refers to the ma rket for nati o n a l cu rre n cies of d iffe rent co u ntries of the worl d .
! Functions: ( i ) Tra nsfe r fu nction, ( i i ) Cred it fu n ction, ( i i i ) Hedging fu n cti o n .
Spot Market d e a l s w i t h cu rrent sa l e a n d p u rchase o f foreign excha nge . It d eterm i nes spot rate of
excha nge .
Forward Market d e a l s with such sale a n d p u rchase of foreign excha nge wh ich a re co ntracted today but
a re i m pl e m e nted so m eti m es i n t h e futu re. It d eterm i nes forwa rd rate of excha nge.

rEX E RC I S Ej
1 . Objective Type Questions (Re m e m bering & U ndersta n d i n g based Questions)
A . M u lt i p l e Choice Questions
1. Price of one cu rrency in relation to other cu rrencies in the international exchange market is known as:
(a) eq u i l i b ri u m rate (b) fixed excha nge rate
(c) excha nge rate (d) fl exi ble excha nge rate
low
2. Accord ing to Adj usta ble Peg System (or Bretton Woods System ) of Excha nge Rate:
(a) diffe rent cu rrencies were pegged to one cu rre ncy ( U S d o l l a r)
(b) US d o l l a r was assigned gol d va l u e at a fixed price
(c) pa rity between two cu rrencies was d etermi ned by the q uantity of gold contai ned i n them
(d) all of these
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3 . U nder which system, gold was taken as the common u n it of pa rity between cu rrencies of d ifferent
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cou ntries in circu lation?
(a) Bretton Woods System of Excha nge Rate (b) Gold Sta n d a rd System of Excha nge Rate
(c) Flexi ble Excha nge Rate System (d) M a naged Fl oati ng System of Excha nge Rate
or
4. Out of the fol lowing, which is the most rigid excha nge rate system, w h ich does not a l low a ny
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adjustment i n the excha nge rate ?
(a) Flexi ble Excha nge Rate System (b) Gold Sta n d a rd System of Excha nge Rate
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(c) Bretton Woods System of Excha nge Rate (d) None of these
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5 . The rate which is determ i n ed by the government is known as:
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(a) fl exi b l e excha nge rate (b) fixed excha nge rate
(c) fl oating excha nge rate (d) none of these
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6. The excha nge rate at which demand for foreign cu rrency becomes equal to its supply, is ca l led:
(a) eq u a l rate of excha nge (b) m i nt pa rity
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ad
(c) eq u i l i b ri u m excha nge rate (d) a l l of these

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7 . What is the re lation s h i p between demand for foreign excha nge a n d excha nge rate?
(a) I nverse (b) Di rect
nd
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(c) One to one (d) N o relationsh i p

8. When s u pply of foreign excha nge increases, t h e eq u i l i b ri u m excha nge rate wi l l :
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( a ) rise (b) fa l l
(c) not cha nge (d) either rise or fa l l
9 . Demand for foreign cu rrency depends u pon :
(a) repaym ent of i nternational loans
(b) i nvestment i n rest of the world
(c) d i rect foreign i nvestment i n the domestic economy
(d) both (a) a n d ( b )
1 0 . D u e t o depreciation o f foreign cu rrency, t h e s u p ply o f foreign cu rre ncy i n domestic economy wi l l :
( a ) increase (b) not cha nge
(c) either i ncrease or decrease (d) d ecrease

11. Di rect foreign i nvestment is a sou rce of:
(a) d e m a n d fo r fo reign excha nge (b) s u p p ly of foreign excha nge
(c) both (a) a n d ( b ) (d) none o f these
12. When the excha nge rate rises due to m a naged floati ng, it is ca lled:
(a) d eva l uation (b) a p p reciation
(c) d e p reciation (d) reva l u ation
13. Which of the fol lowing fu nctions a re performed i n a foreign excha nge ma rket?
(a) Tra nsfe r fu nction (b) Credit fu nction
(c) H edging fu nction (d) All of these
14. Hedging is possible i n :
( a ) spot market (b) fo rwa rd market
(c) managed floati ng system (d) none of these
15. Spot ma rket is that ma rket w here:
(a) only cu rrent tra nsactions a re hand led
(b) forwa rd rate of excha nge is d etermi ned
(c) i n stant rate of excha nge is d etermi ned
(d) both (a) and (c)
16. Forwa rd ma rket is that ma rket w h i c h :
(a) hand les tra nsactions of foreign excha nge meant for futu re del ivery
(b) hand les cu rre nt tra nsactions
(c) hand les cu rre nt as we l l as futu re tra nsactions
(d) none of these
17. IH 120 a re req u i red to buy $ 1, instead oH 100 earlier:
(a) domestic cu rrency has a p p reciated (b) domestic currency has depreciated
(c) ru pee va l u e of i m port b i l l w i l l increase (d) both (b) a n d (c)
18. Eq u i l i bri u m excha nge rate occ u rs whe n :
(a) s u p p ly o f foreign excha nge > demand for foreign excha nge
(b) s u p ply of foreign excha nge = demand for foreign excha nge
(c) s u p ply of foreign excha nge < demand for foreign excha nge
(d) both (a) a n d (b)
1 9 . D i rty floatin g is related to:
(a) fixed system of excha nge rate (b) flexi ble system of excha nge rate
(c) both of these (d) none of these
Answers
1. (c) 2 . (d) 3 . (b) 4. ( b ) 5 . (b) 6. (c) 7. (a) 8. (b) 9. (d) 1 0 . (d)
11. (b) 12. (c) 13. (d) 14. (b) 15. (d) 16. (a) 17. (d) 18. ( b ) 19. ( b )
B. F i l l i n the B l a n ks
1. Foreign excha nge refers to cu rrency. ( domestic/foreign)
2. excha nge rate is a lso ca lled free excha nge rate. ( Fixed/Flexi ble)

3 . Decrease i n d e m a n d for foreign cu rrency leads to a i n excha nge rate. (fa l l/rise)
4. is a n exercise of sale and p u rchase of foreign cu rre ncy by the centra l ba n k.
( M a n aged floati ng/floati ng excha nge rate)
5 . Demand for foreign excha nge is related to the rate of foreign excha nge .
( positively/negative ly)
6. of domestic currency is a situation of a rise i n excha nge rate.
(Ap preciation/Dep reciati o n )
7. leads to a rise i n s u p ply of foreign cu rrency. ( Deva l u ation/Reva l u atio n )
8. Di rect p u rchases by rest of the world is a n i m porta nt sou rce of of/for foreign
excha nge . (su p ply/d e m a n d )
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9. excha nge rate is d etermi ned by the free play of s u p ply a n d d e m a n d fo rces i n the
i nternati o n a l m oney market. ( Fixed/Flexi ble)
1 0 . Cu rre ncy a p p reciation refers to a situation when domestic cu rrency its va l u e in
relation to a foreign cu rrency. ( l oses/ga ins)
ee
Answers
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Fr
1. foreign 2 . Flexi ble 3 . fa l l 4. M a naged floati ng
5 . negatively 6. Depreciation 7. Deva l uation 8. s u pply 9. Flexible 10. ga ins
or
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C. True or Fa lse
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State whether the fol lowi ng statements are True or False:
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1 . Rise in excha nge rate i m p l ies a p p reciation of foreign cu rre ncy in relation to domestic
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cu rrency. (Tru e/Fa lse)

2 . M i nt va l u e of a cu rre ncy i m p l ied paper va l u e of that cu rrency. (True/Fa lse)
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3 . I n case of depreciation of the domestic cu rrency, exports a re l i kely to rise. (True/Fa lse)
ou
ad
4. Bretton woods system of excha nge rate was rep laced by a d i rty floati ng system
of excha nge rate. (Tru e/Fa lse)
Y
5 . When foreign cu rre ncy beco mes cheaper ( i n relation to domestic cu rrency),
less ru pees a re ava i l a b l e for a US d o l l a r. (Tru e/Fa lse)
nd
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6. Spot market is of d a i ly nature. (True/Fa lse)

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7. M a n aged floati ng com p rises o n ly the element of fixed excha nge rate system . (Tru e/Fa lse)
8. Buye rs a n d se l l e rs i n foreign excha nge ma rket wish to buy or sel l foreign excha nge. (True/Fa lse)
9. Excha nge rate is the price of a cu rre ncy expressed i n terms of go l d . (Tru e/Fa lse)
10. Forward excha nge rate is that excha nge rate a t w h i c h cu rre nt tra nsactions
a re to be honoured . (Tru e/Fa lse)
Answers
1. True 2 . Fa lse 3 . True 4. Fa lse 5 . Tru e 6. Tru e 7 . False 8. True 9. Fa lse 10. Fa lse

D. M a tch i n g t he Correct State me nts
I . From the set of statements given in Column I and Column 11, choose the correct pair of statements:
Col umn I Column I I
(a) S u p p l y cu rve o f foreign excha nge ( i ) Downwa rd sloping cu rve
( b) Depreci ation of the domesti c cu rre ncy ( i i ) Va lue of the domestic cu rrency is deliberately
red uced by the government
(c) Repaym ent of i nternati ona l loans (iii) A so u rce of su pply of foreign excha nge
(d) Exports fro m I n dia to US ( iv) Demand for fore ign excha nge from I n dia
(e) Appreciation of domestic cu rre ncy (v) Government plays no role wh atsoever
Answer
(e) Appreciation of domestic currency-(v) Government plays no role whatsoever
I I . Identify the correct sequence of alternatives given in Column II by matching them with respective
items in Column I:
Column I Column I I
(a) Excha nge rate ( i ) Supply of fo reign excha nge = Demand for
foreign excha nge
(b) Gold sta ndard system of excha nge rate ( i i ) Domestic cu rrency loses its va l u e in re lation to
a foreign curre ncy
(c) F ixed excha nge rate ( i i i ) Exte rnal va l u e of the domestic cu rrency
(d) Par rate of excha nge (iv) Dete rm ined by the gove rnment
(e) Cu rrency d e p reciation (v) An o ld va riant of fixed excha nge rate system
Answers
( a ) - ( i i i ), ( b ) - ( v ), ( c ) - ( iv ), ( d ) - ( i ), ( e ) - ( i i )
E . 'Very S h o rt A nswe r' O bj ecti ve Type Q u est i o n s

1. Defi n e foreign excha nge rate.
Ans. The rate at which one cu rre ncy excha nges for the other cu rre ncy in the i nternational money ma rket
is known as foreign excha nge rate.
2 . What is fixed excha nge rate?
Ans. Fixed rate of excha nge is a rate which is set a n d m a i nta ined by the govern ment of a cou ntry.
3 . Defi n e flexible excha nge rate.
Ans. Flexi b l e rate of excha nge is that rate which is determi ned by the demand for a n d s u p ply of foreign
excha nge in the i nte rnational money market.
4. What is 'float' rate of excha nge?
Ans. Float rate of excha nge refe rs to flexible rate of excha nge as d etermi ned by the d e m a n d and s u p ply
forces of foreign excha nge in the i nternational m oney market.
5 . What do you mea n by managed floating?
Ans. Managed floati ng refers to managing the float rate of excha nge by the centra l ba n k ( R B I ) by way of sa l e
and purchase o f foreign excha nge i n t h e i nternational money ma rket. It is a l s o ca l led 'Di rty Floati ng'.

6. At what point eq u i l ibriu m rate of excha nge is determ i ned?
Ans. Eq u i l i b r i u m excha nge rate is d etermi ned at the point where demand for foreign cu rrency a n d s u p ply
of foreign cu rrency a re eq u a l to each othe r.
7. What is m ea nt by cu rrency a p p reciation?
Ans. Cu rre ncy a p p reciation refe rs to a rise i n the va l u e of domestic cu rre ncy i n relation to a foreign
cu rrency. Exa m ple: 50 ru pees a re req u i red to buy one US d o l l a r, i n stead of 60 ru pees earlier.
8. What is m ea nt by cu rrency depreciation?
Ans. Cu rre ncy d e p reciation refers to a fa l l i n the va l u e of domestic cu rrency i n re lation to a foreign
cu rrency. Exa m ple: 60 ru pees a re req u i red to buy one US d o l l a r, i n stead of 50 ru pees earlier.
9. What is m ea nt by cu rrency deva luation?
low
Ans. Cu rre ncy deva l u ation refers to fa l l i n the va l u e of the domestic cu rrency i n re lation to a foreign
cu rrency as p l a n ned by the gove rn ment. It is not re lated to the s u p p ly-de m a n d forces i n the
i nternational m oney market.
10. What is m ea nt by cu rrency reva l uation?
Ans. Cu rre ncy reva l u ation refers to rise i n the va l u e of the domestic cu rre ncy i n relation to a foreign
cu rrency as p l a n ned by the gove rn ment. It is not re lated to the s u p p ly-de m a n d forces i n the
ee
i nternational m oney market.
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Fr
11. What is foreign excha nge ma rket?
Ans. Foreign excha nge ma rket is that ma rket which hand les s u p ply a n d demand (and therefo re, trade) of
the cu rrencies of d ifferent cou ntries.
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12. What is spot ma rket?
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Ans. Spot ma rket in foreign excha nge is that ma rket which cove rs sale a n d p u rchase of foreign excha nge
of the d a i ly natu re. This is a lso ca lled cu rre nt ma rket of fo reign excha nge .
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13. Define forwa rd ma rket.
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Ans. Forwa rd market i n foreign excha nge is that market which covers such busi ness deals (of sale and
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purchase) of foreign excha nge which a re contracted today but a re honoured someti mes i n the future.
14. What is spot excha nge rate?
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Ans. Spot excha nge rate is that excha nge rate which p reva i l s in the ma rket when tra nsactions a re made.
15. What is forwa rd excha nge rate?
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ad
Ans. Forward excha nge rate is that excha nge rate at which forwa rd tra nsactions a re to be honoured . It is
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a sort of 'contracted' excha nge rate to be a p p l ica ble for the tra nsactions which a re signed today but
a re to be honoured someti mes in the future.
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16. What is hedging?

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Ans. Hedging mea ns protection aga i nst the risk related to variations in foreign excha nge rate. Excha nge
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rate is locked for futu re s u p p l ies of foreign excha nge.

17. What a re forwa rd tra nsactions?
Ans. Transactions that a re signed today but wi l l material ise on some futu re date a re ca l led forward transactions.
2. Reaso n - based Questions (Com prehension of the S u bject-matter)
Read the fol lowi ng statements ca refu l l y. Write Tru e or Fa lse with a reaso n .
1. Flexible excha nge rate depends upon supply and demand pa ra m eters of foreign excha nge i n the
foreign excha nge ma rket.
Ans. True. Flexi ble excha nge rate is d etermi ned by the d e m a n d for a n d s u p ply of foreign excha nge i n the
foreign excha nge ma rket.

2 . I n the eve nt of depreciation of the cou ntry's cu rrency, its exports tend to i ncrease w h i l e i m ports
tend to decrease.
Ans. True. Beca use due to depreciation, va l u e of d o mestic cu rrency d ecreases i n relation to the foreign
cu rrency. Accord i ngly, goods become cheaper i n the domestic economy which encou rages exports,
a n d goods become costlier in the foreign market which d isco u rages i m ports.
3 . Forwa rd rate of excha nge is a contractual rate of excha nge.
Ans. True. Forwa rd rate of excha nge is a contractual rate of excha nge . Beca use it is a contract signed
today, to be h o n o u red someti mes in the fut u re .
4. Fixed excha nge rate is determi ned b y t h e forces o f d e m a n d a n d su pply i n t h e i nternati o n a l money
ma rket.
Ans. Fa lse. Fixed excha nge rate is not determi ned by the fo rces of d e m a n d a n d s u p ply in the i nternational
m oney ma rket. I nstead, it is set a n d m a i nta ined by the government of a cou ntry.
5 . Speculative p u rchases of foreign excha nge by the domestic i nvestors i n the i nternational money
ma rket does not i m pact the float rate of excha nge.
Ans. Fa lse. Spec u lative p u rchases of fo reign excha nge by the d o mestic i nvesto rs in the i nternational
m oney market is a n i m porta nt component of d e m a n d for foreign exchange, a n d therefo re, i m pacts
the fl oat rate of excha nge.
6. The rising demand for foreign goods i m plies h igher demand for foreign excha nge.
Ans. True. The rising d e m a n d for foreign good s i m p l ies greater i m ports and hence h igher d e m a n d fo r
foreign excha nge.
7. Flexible excha nge rate is determ i n ed by the WTO.
Ans. Fa lse. Flexi b l e excha nge rate is d etermi ned by the forces of s u p p ly a n d d e m a n d i n the i nternational
m oney ma rket.
8. Forwa rd m a rket i n foreign excha nge is that m a rket which deals with sale a n d p u rchase of foreign
excha nge for cu rrent tra nsactions.
Ans. Fa lse. Forwa rd ma rket in foreign excha nge is that ma rket which deals with sale and p u rchase of
foreign excha nge for futu re del ivery.
9. Appreciation of the I n d i a n cu rrency occurs when more ru pees a re to be paid for a US $ .
Ans. Fa lse. I n case of a p p reciation, the va l u e of domestic cu rre ncy i ncreases i n relation to the va l u e of
othe r cu rre ncy a n d he nce less ru pees a re to be paid for a US $ .
10. G reater flow of foreign excha nge from rest of the world a l ways ind icates higher level of development
of the domestic economy.
Ans. Fa lse. Beca use greater flow of foreign excha nge may be occu rring on acco u nt of borrowings from
rest of the worl d .

1. The m a rket price of US dollar has increased considera bly lea d i ng to rise in rupee va l u e of i m ports
of essentia l goods. What ca n the R B I do to correct the situation?
Ans. The centra l ba n k ca n sel l its reserves of US d o l l a rs i n the money ma rket to red u ce the pressu re of
d e m a n d for d o l l a rs. In case s u p p ly a l igns with dema nd, the price of d o l l a r will fa l l i n terms of the
I n d i a n ru pee.
2 . If US dollar becomes costlier i n terms of the I nd i a n rupee, it is good as wel l as bad for the domestic
growth. H ow?
Ans. ( i ) It is good beca use p u rchasing powe r of US d o l l a r i n the I n d i a n ma rket i ncreases. Acco rd ingly,
d e m a n d for the domestic goods is expected to rise. I m plying a rise i n exports a n d the refore, a
rise i n G D P.

( i i ) It is bad beca use i m ports of essential ca pita l goods (critica l for growth) become expe nsive. It
i nflates CAD (cu rre nt acco u nt d eficit) and borrowi ngs from rest of the wor l d .
3 . Distinguish between d eva l uation and depreciation o f domestic cu rrency.
Ans. Deva l uation is the fa l l i n the va l u e of d o mestic cu rre ncy i n relation to foreign cu rre ncy as p l a n ned
by the gove rn ment i n a situation when excha nge rate is not d etermi ned by the forces of s u p p ly a n d
d e m a n d b u t is fixed b y the govern ment o f d ifferent cou ntries. Depreciation, on the othe r hand, is
the fa l l i n the va l u e of domestic cu rre ncy i n relation to foreign cu rre ncy i n a situation when excha nge
rate is d etermi ned by the forces of s u p p ly a n d d e m a n d in the i nternational money ma rket. Both
depreciation and deva l u ation resu lt in fa l l in the va l u e of domestic cu rre ncy in terms of foreign
cu rrency. H owever, w h i l e deva l u ation causes a desired fa l l i n the va l u e of rupee (so that the exports
a re boosted), d e p reciation may ca use u ndesired fa l l as wel l . And, in the event of an u ndesired fa l l i n
low
t h e va l u e o f domestic cu rrency, i m po rt b i l l o f t h e government may become enormously h igh, leading
to a rise i n cu rre nt acco u nt d eficit (CAD) a n d fisca l d eficit to u n m a nagea b l e l i m its.
4. H ow is appreciation of domestic cu rrency l i kely to affect exports and i m ports of domestic economy?
Ans. Appreciation of the domestic cu rre ncy i m p l ies that the va l u e of domestic cu rre ncy rises in relation to
a foreign cu rrency (say d o l l a r) . N ow, less ru pees a re req u i red to buy a d o l l a r. Th is means that a d o l l a r
ee
ca n b u y lesser a m o u nt o f goods i n t h e domestic economy. Accord i ngly, exports o f t h e cou ntry a re
l i kely to fa l l .
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Fr
S i m i l a rly, less ru pees a re now req u i red t o b u y goods worth o n e d o l l a r i n t h e US ma rket. Acco rd ingly,
i m ports a re l i kely to rise.
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5 . When foreign excha nge rate i n a cou ntry is on the rise, what i m pact is it l i kely to have on exports
a n d i m ports and how?
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Ans. A u n it of the domestic cu rrency wi l l now buy less goods from rest of the world w h i l e a u n it of foreign
cu rrency ca n now buy more goods i n the domestic economy. Goods produced in the domestic
k
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economy become cheaper to the buyers a b road w h i l e foreign goods become relatively expensive to
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the domestic buye rs . As a resu lt, exports a re expected to rise and i m ports a re expected to fa l l .
B
6. H ow i s depreciation o f I n d i a n ru pee l i kely t o affect Indian exports? Expl a i n .

A n s . Depreciation o f the domestic cu rrency i m p l ies that the domestic cu rrency ( ru pee) loses its va l u e i n
re
relation t o a foreign cu rrency (say US d o l l a r) . N ow, more ru pees a re req u i red t o b u y a d o l l a r, o r a

d o l l a r ca n now buy more goods i n the domestic economy. Accord ingly, exports a re expected to rise .
ou
ad

Y
1. W i l l you a lways appreciate a rise in excha nge rate as a means to boost our exports?
nd
Ans. No. Beca use a rise in excha nge rate may not a lways lead to a rise in o u r export earni ngs. A rise i n
Re
excha nge rate is beneficial o n ly w h e n elasticity o f d e m a n d fo r o u r exports is greate r t h a n u n ity.

Fi
Beca use, it is o n ly then that the tota l expend itu re on o u r exports wi l l rise i n response to a fa l l i n
p rices o f domestic goods i n terms o f t h e foreign cu rrency. I n othe r words, a fa l l i n prices o f domestic
goods (in terms of the foreign cu rre ncy) yields greate r reve n u e o n ly when the elasticity of d e m a n d
for o u r exports is greater than u n ity.
2. Com ment on the statement that increase in i nterest rate in the domestic economy leads to a n
a p p reciation o f domestic cu rrency.
Ans. The statement is true. I n case domestic i nterest rate rises a n d is h igher than the i nterest rate i n rest
of the world, the foreigners wi l l be i n d uced to sh ift their fu nds to the domestic economy. G reate r
flow of fu nds from a b road w i l l ra ise the d e m a n d for I n d i a n cu rrency. ( Beca use, foreign cu rrency m u st
be co nve rted i nto I n d i a n cu rre ncy for pu rpose of i nvestment.) I m plying a rise i n d e m a n d for the
I n d i a n cu rrency, leading to its a p p reciation i n relation to the foreign cu rrency.

3 . H ow does decrease i n FD I i n I nd i a act as a su pply shock of foreign excha nge?
Ans. Decrease in FDI leads to a decrease in s u p p ly of foreign excha nge, for reasons other than cha nge i n
excha nge rate. It is a s u p ply shock that causes a backwa rd s h ift o f s u p ply cu rve o f foreign excha nge
for the I nd i a n eco nomy. Conseq u e ntly, eq u i l i b ri u m excha nge rate wi l l rise. M o re ru pees a re to be
paid for buyi ng a u n it of foreign cu rrency.
4. Ca n you th i n k of a situation when CAD ( Cu rrent Accou nt Deficit ) i n I nd i a has i m p roved even when
excha nge rate has rem a i ned a l m ost consta nt?
Ans. It is in the latte r h a lf of the yea r 2014 that CAD in I nd ia has i m p roved even when excha nge rate ( U S $
i n relation to I n d i a n rupee) has rem a i ned a l most consta nt. It has h a p pe n ed i n the wa ke of a d rastic fa l l
i n t h e price o f crude o i l i n the i nternati o n a l ma rket : t h e p rice s l i pping from US $ 1 10 t o US $ 4 5 per
barre l .
5 . H ow do t h e deficit B o P a n d surplus B o P i m pact t h e excha nge rate?
Ans. (i) Deficit Bala nce of Payments : If the ba la nce of payme nts of a cou ntry s h ows d eficit, d e m a n d fo r
fo reign cu rre ncy wi l l i ncrease. Accord i ngly, excha nge rate is expected to rise. Domestic cu rrency
wi l l d e p reciate i n re lation to fo reign cu rrency.
(ii) Surplus Bala nce of Payments : If the bala nce of payments of a cou ntry shows su rplus, ava i l a b i l ity
of fo reign cu rre ncy w i l l increase. Accord i ngly, excha nge rate is expected to fa l l . Domestic
cu rrency wi l l a p p reciate i n relation to foreign cu rrency.

(With A n swers o r Reference to the Text for Answers)
1. Othe r thi ngs rem a i n i ng u ncha nged, when i n a cou ntry the price of foreign cu rre ncy rises, nati o n a l
i ncome is: (choose the correct a lternative) [CBSE Delhi 2015]
(a) l i kely to rise (b) l i kely to fa l l
(c) l i kely t o rise a n d fa l l both (d) not affected
[(d)
N ote : Rise o r fa l l i n the p rice of foreign cu rre ncy has no d i rect i m pact on nati o n a l i ncome of a
cou ntry. Excha nge rate ( p rice of fo reign cu rrency) cha nges eve ryday a n d seve ra l ti mes i n a day. It
does not mean that nati o n a l i nco me wou l d cha nge accord i ngly.
I n d i rect I m pact: When excha nge rate rises, foreign cu rre ncy becomes expensive . I m po rts te nd to
fa l l a n d exports tend to rise. Accord ingly, AD tends to rise. A rise i n AD may lead to a rise i n nati o n a l
i ncome.]
2 . Othe r thi ngs rem a i n i ng the same, when i n a cou ntry the ma rket price of foreign cu rrency fa l l s,
nati o n a l i ncome is l i kely: (choose the correct a lternative) [CBSE {Al} 2015]
(a) to rise (b) to fa l l
(c) t o rise or t o fa l l ( d ) to rem a i n u naffected
[(d)
N ote: Rise or fa l l in the p rice of foreign cu rre ncy has no d i rect i m pact on nati o n a l i ncome of a
cou ntry. Excha nge rate ( p rice of fo reign cu rrency) cha nges eve ryday a n d seve ra l ti mes i n a day. It
does not mean that nati o n a l i nco me wou l d cha nge accord i ngly.
I n d i rect I m pact: When excha nge rate fa l ls, foreign cu rrency becomes cheaper. I m ports tend to rise
and exports tend to fa l l . Accord i ngly, AD tends to fa l l . A fa l l i n AD may lead to a fa l l i n nati o n a l
i ncome.]

3 . What a re fixed a n d flexible excha nge rates? [CBSE {Al) 2015]
[Page 334, 341]
4. Exp l a i n the mea n i ng of managed floati ng excha nge rate. [CBSE {A l) 2015]
Or
Discuss briefly the concept of m a naged floati ng syste m of foreign excha nge rate d etermi nati o n .
[Page 345, 346] [CBSE 2019 {58/2/1)]
5. Othe r thi ngs re m a i n i ng the same, when foreign cu rre ncy becomes cheaper, the effect on nati o n a l
i ncome is l i kely t o be: (choose the correct a lternative) [CBSE {F) 2015]
(a) positive ( b ) negative
(c) positive a n d negative both ( d ) no effect
low
[(d); See N ote, Q. 2 a bove.]
6. Why d oes the d e m a n d fo r fo reign cu rre ncy fa l l a n d s u p ply rises when its price rises? Expla i n .
[Page 340, 341] [CBSE Delhi 201 7]
7. What is mea nt by d e p reciation of domestic cu rrency? [CBSE (Al) 201 7]
[Page 342]
ee
8. Exp l a i n the d i sti nction between the flexible excha nge rate and the managed floati ng excha nge rate.
rF
Fr
[Page 334, 345, 346] [CBSE {F) 201 7]
9. Exp l a i n by givi ng exa m p l es, the d i sti nction between d e p reciation a n d d eva l u atio n of domestic
cu rrency. [CBSE {F) 201 7]
or
[Page 342]
sf
u
10. Discuss briefly the mea n i ng of:
(a) Fixed excha nge rate .
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(b) Flexi b l e excha nge rate.
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(c) M a n aged floati ng excha nge rate. [CBSE 201 8]
B
[Page 334, 341, 345, 346]

re
11. " I n d i a n Ru pee (�) p l u nged to a l l ti me low of � 74.48 aga i n st the US Dol l a r ( $ ) ."
- The Economic Times
ou
I n the l ight of the a bove report, d iscuss the i m pact of the situation on I nd i a n i m ports.
ad
[Page 337, 340] [CBSE 2019 {58/1/1)]

Y
12. (a) Disti nguish betwee n a p p reciation of home cu rre ncy a n d d e p reciation of home cu rrency.
(b) State a ny one sou rce of s u p ply of foreign cu rrency for a country. [CBSE 2019 {58/2/2)]
nd
Re
[Page 340, 347, 348]

13. Discuss briefly the concept of flexible excha nge rate system of foreign excha nge rate
Fi
d etermi nati o n . [CBSE 2019 (58/2/3)]

[Page 334-336]
14. N a m e a ny two sources of d e m a n d for foreign excha nge by households i n an eco nomy.
[Page 346, 347] [CBSE 2019 (58/3/1)]
15. I n rece nt ti mes the I nd i a n Ru pee (�) d e p reciated to a n a l l ti me l ow aga i n st the US d o l l a r ( $ ) . Discuss
its i m pact on I n d ia's i m ports. [CBSE 2019 (58/3/1)]
[Page 337, 340]
16. State a ny two factors responsible for i nflow of foreign cu rrency. [CBSE 2019 {58/4/1)]
[Page 347, 348]

17. Disti nguish between d e p reciation of a cu rre ncy a n d deva l u ation of a cu rrency. [CBSE 2019 {58/4/1)]
[Page 342]
18. State the mea n i ng of fixed foreign excha nge rate. [CBSE 2019 {58/5/1)]
[Page 341]
6. NCERT Questions (With H i nts to Answers)

1. Disti nguish betwee n the n o m i n a l excha nge rate a n d the rea l excha nge rate . If you we re to decide
whether to buy domestic goods or foreign goods, which rate wou l d be more releva nt? Exp l a i n .
[ H i nt: N o m i n a l excha nge rate is that type o f excha nge rate w h i c h d oes not acco u nt for cha nges i n t h e
p rice l evel w h i l e measuring ave rage strength o f one cu rre ncy i n relation t o the others . Rea l excha nge
rate is that type of excha nge rate which accou nts for changes in the p rice l eve l across d iffe rent
cou ntries of the world. It is an excha nge rate that is based u pon constant p rices. To buy domestic
goods or foreign goods at a point of ti me, n o m i n a l excha nge rate is more re leva nt.]
2 . H ow is the excha nge rate d etermi ned u n d e r a flexible excha nge rate regime?
[ H int: Flexi ble rate of excha nge is d etermi ned by the fo rces of s u p ply a n d d e m a n d i n the i nternati o n a l
m oney market. W h i l e d e m a n d for foreign excha nge is i nve rsely related t o its o w n price, su pply of
foreign excha nge is positive ly related to its own price . ]
3 . Diffe re ntiate betwee n deva l uation a n d d e p reciati o n .
[ H i nt: Deva l u ation is the fa l l i n the va l u e o f domestic cu rre ncy i n re lation t o foreign currency as
p l a n ned by the government i n a situation when excha nge rate is not d etermi ned by the forces of
s u p p ly a n d demand but is fixed by the govern ment of d iffere nt cou ntries. Depreciation, on the other
hand, is the fa l l i n the va l u e of domestic currency i n relation to foreign cu rrency i n a situation when
excha nge rate is d etermi ned by the fo rces of s u p ply a n d demand i n the i nte rnati o n a l money market.]
4. Wou l d the centra l ba n k need to i nte rven e in a ma naged floati ng system ? Exp l a i n why.
[ H int: M a naged floating refers to a situation when the centra l ba n k i nterve nes to ma nage the
excha nge rate with i n the desi red ra nge. Thus, the R B I wou l d se l l d o l l a rs i n the i nternational money
ma rket to ra ise its su pply a n d lower its excha nge va l u e . This wou l d lead to reva l u ation of the I n d i a n
cu rrency. On t h e othe r h a n d , I n d i a n cu rrency wou l d be deva l ued w h e n t h e R B I buys US d o l l a rs to
ra ise its d e m a n d (and there by its excha nge va l u e ) in the i nternational money ma rket.]
5 . Are the concepts of demand for d o mestic goods a n d domestic demand for goods the same?
[ H i nt: 'De m a n d for d o mestic goods' a n d 'domestic demand for goods' a re d ifferent concepts.
Demand for domestic goods incl udes d e m a n d for goods by the domestic con s u mers and by the
foreigners . Domestic d e m a n d for goods incl udes (i) d e m a n d for goods prod uced domestica l ly, a n d
( i i ) d e m a n d for goods prod uced a b road .
Demand for domestic goods = C + I + G + X - M .
Domestic d e m a n d for goods = C + I + G .
S o that, Demand for domestic goods = Domestic d e m a n d for goods + ( X - M ) .]
7. M isce l l a neous Q uestions and Reference to the Text for Answers
A . Questions of 3 & 4 marks each

1. What is meant by foreign excha nge rate? G ive t h ree reasons why people desire to hold foreign
excha nge . [Page 333, 346, 34 7)
2 . H ow is foreign excha nge rate d etermi ned? Use d iagra m . [Page 335, 336)

3 . What is Bretton Woods Syste m of excha nge? [Page 344, 345]
4. Write a short note on flexible excha nge rate syste m . [Page 334]
5. When d e m a n d for a foreign cu rre ncy increases, rate of excha nge fa l l s . Exp l a i n, how? [Page 334, 335]
6. State fou r sou rces each of d e m a n d for a n d s u p ply of foreign excha nge.
Or
G ive t h ree sources each of d e m a n d for and s u p ply of foreign excha nge. [Page 346-348]
7. Why d oes a rise i n foreign excha nge rate ca use a rise i n its s u p p ly? [Page 340, 341 ]
8. Defi n e foreign excha nge rate. Why d oes the d e m a n d fo r foreign excha nge rise when its price fa lls?
[Page 333, 348]
low
9. Exp l a i n the effects of an increase in s u p ply of foreign cu rrency on excha nge rate? [Page 338, 339]
10. Exp l a i n the principal cha racte ristics of fo rwa rd market in foreign excha nge . [Page 350]
11. State the d ifference between spot excha nge rate a n d forwa rd excha nge rate . [Page 350]
B. Questions of 6 marks each
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1. What do you mea n by excha nge rate? Exp l a i n the m a i n factors which d ete r m i n e excha nge rate.
rF
Fr
[Page 333, 346-348]
2. H ow is eq u i l i bri u m rate of excha nge d etermined? Expla i n with the h e l p of a d iagra m . [Page 335, 336]
or
3 . H ow is Bretton Woods System d iffe rent from Gold Sta n d a rd System of excha nge rate?
[Page 344, 345]
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4. Diffe re ntiate betwee n s pot ma rket a n d forwa rd ma rket. [Page 350]
5. What d etermi nes the s u p p ly of foreign excha nge in a cou ntry? [Page 347, 348]
k
Yo
oo
6. What is pa rity va lue?
[ Hint: I n the context of excha nge rate i n foreign excha nge market, pa rity va lue refers to the va lue of one
B
cu rrency i n terms of the othe r for a give n basket of goods a n d services. If a US d o l l a r buys 50 ti mes
the goods and services i n I n d ia, com p a red to a ru pee, the pa rity va l u e of a d o l l a r s h o u l d be 50 : 1.
re
Accord ingly, the excha nge rate betwee n ru pee and a d o l l a r ought to be t 50 : $ 1 . Any cha nge i n the
pa rity va l u e wou l d i m ply a corresponding cha nge i n the excha nge rate.]
ou
ad
7. Exp l a i n the concept of hedging i n the context of i nternati o n a l money ma rket.

Y
[Hint: Hedging refers to 'risk ma nagement'. It is an i m portant concept in the co ntext of forwa rd
ma rket for fo reign excha nge. I n such a market, contracts (for the s u p p ly a n d d e m a n d ) of foreign
nd
excha nge a re made at one p o i nt of ti m e and these a re to be h o n o u red someti mes in the fut u re .
Re
W h i l e m a ki n g such contra cts, the buye rs a re m a naging the r i s k o f r i s e i n price o f fo reign excha nge,
Fi
w h i l e the se l l e rs a re ma naging the risk of fa l l in the price of fo reign excha nge in the n e a r fut u re .
T h i s is w h a t hedging m e a n s . It is gu a rd i ng aga i nst the r i s k o f cha nge i n excha nge rate i n the n e a r
futu re .]

DOs and DON'Ts
1. You must u nderstand it: I f a d o l l a r becomes expen sive i n terms of rupees, it should not be ta ke n a s
a situation w h e n t h e I n d i a n Govern ment h a s t o print more notes t o b u y t h e d o l l ars. I n stead, it i s a
situation when a d o l l a r c a n buy more goods a n d services i n the I n d i a n m a rket Thus, what we i n fact
lose is not more ru pees for a d o l l a r, but more goods a n d services for a d o l l a r.
2. H edg ing i s done when we lock the exc h a n g e rate fo r future tra nsacti ons. But t h i s s h o u l d n ot be
i nterpreted a s a mea n s to m a ke g a i n s . H ed g i n g i s only a means to p rotect u s fro m the risk of a poss i b l e
r i s e i n exchange rate i n the near futu re. B u t , the excha nge rate m a y even fa l l . I n such a situation,
hedg i n g (at the current rate of exchange) may c a u se losses .
3. Eq u i l i b r i u m exchange rate i s a c h i eved when s u p p l y of a foreign c u rrency i s eq u a l to demand for a
foreign cu rrency. But, it i s i m porta nt to remember that the equ i l i b r i u m exc h a n g e rate (a s determ i n ed
by the free p l ay of s u p p ly-demand forces) becomes red u n d a nt (pract i c a l l y i rrel evant) beca use of
m a n a ged fl oat i n g or d i rty float i n g . D i rty floating a i m s at i nfl u e n c i n g the s u p p ly-d e m a n d forces . To that
extent, m a rket rate of exchange fa i l s to be a n eq u i l i brium rate of exc h a nge. The d ivergence between
the m a rket rate of exchange and equ i l i b ri u m rate of exchange i m p l ies that exports and i m ports in the
g l o b a l economy a re not ent i rely d eterm i ned by the free p l ay of the m a rket forces.
• Key Merits and Demerits of Fixed and Flexible System of Exchange Rate
Fixed Exchange Rate
Merits
(i) Market Stability: Sta b i l ity of the market is key merit of fixed exchange
rate. It p romotes i nvestment across nation s.
(i i) Stable Macroeconomic Policies: G iven the fixed exchange rate, the
centra l bank can frame its moneta ry pol icy and the govern ment can fra me
its fi scal pol icy, i n dependent of the external shocks relati n g to fl uctuations
in exchange rate.
(ii i) Devaluation-A Key Tool to expand Foreign Market for the Domestic
Producers: Fixed exchange rate system a l lows deva l uation of the
cu rren cy. It is a planned fa l l in the va lue of the domestic cu rren cy. It helps
expand foreign ma rket for the domestic prod ucers.
Demerits
(i) Reserves of Forex: To m a i nta i n the rate of exchange at the des i red level,
the govern ment n eed to keep a l a rge stock of foreign exchange. Th is is the
pri ncipal demerit of the fixed exchange rate system .
(i i) Inefficient Al location of Resources: Exchange rate fixed by the government
often deviates from the equ i l i bri u m exchange rate (i n a free market
economy). To that extent, al location of resources may not be efficient
(ii i) Small Size of Forex Market: When the rate of exchange is fixed, foreign
exchange does not emerge a s a trad ing com mod ity. Accord i n g ly, size
of the forex market rem a i n s sma l l . This acts as a h u rdle i n the global
economic growth.

(iv) Speculative Attack on a Currency: There are speculative attacks on a
cu rrency. Thus, if ru pee is expected to be deval ued i n relation to US dollar,
the investors would start buyi ng dollars (to be converted i nto rupees after
deval uation) . Such speculative attacks often force the government to
reset the rate of exchange.
Flexible Exchange Rate
Merits:
(i) Large Reserves of Forex not required : Flexible system of exchange rate
does not req u i re large reserves of foreign exchange with the government.
low
Market forces of supply and demand automatica l ly d rive the rate of
exchange to the poi nt of eq u i l i brium.
(ii) Efficient Allocation o f 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
ee
trading commodity, the size of forex market tends to be large. This induces
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economic g rowth across a l l parts of the world.
(iv) I nternational Mobility of Liquidity: Since large reserves of forex are not
req u i red, flexible exchange rate tends to promote i nternational mobil ity of
or
liquid ity. This is good for the less developed countries (l i ke I n d ia), where
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foreign investment is a sign ificant determ inant of G D P g rowth.
Demerits
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(i) Marginalisation of Weak Currencies: Flexible exchange rate system leads
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to marginal isation of weak currencies i n the i nternational money market.

B
Weak currencies (of sma l l economies) often suffer huge depreciation i n

relation t o strong currencies (of b i g econom ies) . According ly, g a i n s of
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i nternational trade accrue more to the large econom ies than the smal l
economies.
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(ii) Uncertainty of the Market: There is a high deg ree of uncertainty i n the
Y
market. Owing to the freq uently chang ing rate of exchange, it becomes
d ifficult to form ulate a stable monetary pol i cy in the domestic economy.
nd
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(iii) External Shocks: Flexible exchange rate system exposes the domestic
economy to external shocks. Example: As and when US dollar appreciates
Fi
(in relation to I ndian rupee), the burden of import payments tends to rise,
even when the i nternational price of the goods is constant. Because
payments are to be made in terms of dollars, and (after a rise i n exchange
rate) larger amount of the I ndian cu rrency is needed to pay the same
amount of dollars.
Ill

h ·. / ., CHAPTER: 12
///�
. h 'l/
O F PAY M ENTS
•
•
•
BoP (or BoP Accounts): Meaning
Componen ts/Structure of BoP Account:
Current Accoun t, Capital Account and Official Reserves Account
Equilibrium and Disequilibrium in BoP-BoP Deficit
,,
I . BOP (OR BOP ACCOU NTS): M EAN I N G
Balance of payments (BoP) is a statement of accounts showing all
monetary transactions (or economic transactions) of a country with
the rest of the world during a period of time, generally one year.
These transactions may be made by the individuals, firms and the
government of a country. Broadly, the monetary transactions relate
to: (i) export and import of goods. In the BoP language, it is called
'merchandise' or 'visible trade' (simply because goods are visible when
they cross the borders. Goods can be seen), (ii) export and import
of services. It is called 'invisible trade' (simply because services are
not visible when they cross the borders. Services cannot be seen),
(iii) international sale and purchase of financial assets. These assets
include stocks and bonds, and (iv) international sale and purchase of
real assets. Real assets are like plant and machinery.
There is a flow of foreign exchange into the country when we export
goods and services or when the foreigners invest in our financial or
real assets. Likewise, there is a flow of foreign exchange from our
country to rest of the world when we import goods and services
or when our residents invest in the financial or real assets of other
countries. BoP accounts record all receipts and payments of foreign
exchange. Receipts are recorded as credit items, while payments are
recorded as debit items. The BoP accounts, thus prepared, reflect
performance of our economy in relation to rest of the world.
36 5
2. COMPO N E NTS OF BOP ACCOU NT
BoP accou nts include: (i) cu rrent accou nt, ( i i ) capital accou nt, and
( i i i ) official reserves accou nt. Following is thei r brief descri ptio n :
C u rrent Acco u nt
Note Cu rrent accou nt reco rds recei pt and payment of foreign exchange on
O n l y such g oods a re acco unt of such transactions which do not i m pact asset-l iabi l ity status
treated as 'e xport' which of a cou ntry i n rel ation to rest of the worl d . Liabi l ities or assets of
a re ta n g i b l e and can be
seen crossing the borders a cou ntry ( i n relation to rest of the world) are neither rai sed nor
low
as merchand ise. Goods red uced . I n other wo rd s , cu rrent accou nt transacti ons do not give ri se
bought by the foreign
tourists i n the domestic to 'futu re clai m s'.
markets a re not treated
as 'e xport'. L i kewise Components
g oods p u rchased by the
domestic tou rists in rest of Pri ncipal items ( co m ponents) of cu rre nt acco u nt BoP are as u n der:
ee
the world a re not treated
(i) Export and Import of Goods
as ' i m port'.
rF
Fr
Export and i m port of goods is treated as 'merchand ise' or 'visible
trade'. Th i s is a visible trade becau se good s are tangi ble ( m aterial ) and
or
therefore , can be seen while crossi ng the borders. Example: Export or
i m port of cel l u lar phones can be seen w h i le crossing the borders.
sf
u
(ii) Export and Import of Services
k
Yo
Export and i m port of services is treated as ' i nvisible trade'. Th is is
oo
becau se services are not tangi ble ( m aterial ) and therefore , can not be
B
seen wh ile crossing the borders. Example: I nsurance services being

re
rendered across the borders cannot be seen as crossing the borders.

Services are further classified as: factor services and non-factor services.
ou
ad
(a) Factor Services: Factor services are those which lead to factor
Y
payments or factor i ncome. I n the BoP accou nts, monetary

transactions related to factor incomes are split as: ( i ) i nvestment
nd
income, and ( i i ) com pensation of employees. I nvestment i ncome

Re
includes i ncome on accou nt of rent, i nterest and profit.
I
Fi
In BoP Accounts
Factor Incomes = Compensation of employees
+
Investment income (= rent + interest + profit)
(b) Non-factor Services : N on-factor servi ces include al l services,

other than factor services. I n s u rance and banking services may
be cited as exam ples. Monetary transactions related to non
factor services are recorded as recei pts when these services are
exported , and as payments when these services are i m ported .

(iii) Cu rrent Transfers
Current transfers refer to 'transfers for free'. These are unilateral
transfers made by way of gifts, grants and remittances (by the
residents settled abroad). In the BoP accounts, current transfers are
treated as an element of 'invisibles'.
Im portant Observations
In the BoP accounts, current transfers are treated as an element of invisibles. So that, invisibles
in the BoP accounts include: (i) monetary transactions related to export and import of factor services,
(ii) monetary transactions related to export and import of non-factor services, and (iii) monetary
transactions related to current transfers.
I nvisibles in BoP Accounts
(1 ) Monetary transactions + (2) Monetary transactions
related to export and import of services related to current transfers
JJ
(i) Monetary transactions related to
export and import of factor services
(briefly called 'income')
+
(ii) Monetary transactions related to
export and import of non-factor services
Following is a flow chart presentation of the components of current

account BoP :
Components of Current Account BoP F®C U S

Or
Structure of Current Account BoP ZO N E
Ex port of Good s I m port of Goods
'
I nvi s i b l e s
(X)
I
(M)
t t
i
Export a n d I m port
i i
of Merc h a n d i se I n come
[incl uding a l l Non-fa ctor Services Cu rrent Tra n sfers
or
' '
components of [Sh i ppi ng, I nsurance, [Gifts, Grants and
Export a n d I m port income from factor Banki ng, etc.] Workers' Rem itta nces]
of Vis i b les services]
:J
M onetary tra nsactions Monetary transactions
on acco u n t of export on acco u nt of export U n i l ateral tra n sfers,
and i m port of and i m port of or tra n sfers
facto r services non-factor services for free
[Note: Cu rrent accou nt records all payments to rest of the world as debit
( i ndi cated by the ' - ' sign) and all rece ipts from rest of the world as
credit ( i n d i cated by the '+' sign ) . Net rece ipts refer to the difference
between recei pts and payments . ]
Balance of Payments 367

Esti mation of Balance Related to Cu rrent Accou nt
'Balance' relating to current account BoP is estimated in terms of four
parameters as under:
(i) Trade Balance/Merchandise Balance = X - M.
Trade balance is reflected as:
(a) Trade Deficit when M > X, and
(b) Trade Surplus when X > M.
(ii) Goods and Services Balance
Export �f Goods Import �f Goods
low
[ ] - [ ]
- Export of Import of
non-factor services non-factor services
= Trade balance + Balance on account of non-factor services
ee
(iii) Invisibles Balance
rF
Fr
= Balance on non-factor services
+ Balance on income (balance on factor services)
or
+ Balance on current transfers
(iv) Current Account Balance
sf
u
= Trade Balance
k
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+ Invisibles Balance
oo
It must be clearly understood that:

B
While estimating trade balance, we consider goods only.

re
While estimating goods and services balance, we consider (i) goods,

and (ii) non-factor services only.
ou
ad
While estimating invisibles balance, we consider (i) balance relating

Y
to non-factor services, (ii) balance relating to factor services (called

balance on income), and (iii) balance on current transfers.
nd
Re
Table 1 shows actual estimation of Balance relating to Current Account

BoP.
Fi
Table 1 . Estimation of Balance related to Current Account BoP

(based on data for the period 2017-1 8 , Economic Survey, 201 8-1 9)
Items US million $
Exports 3,08,970
I m ports 4,69,006
I nvisi bles ( net) 1, 1 1, 3 19
( a ) Non-factor Services 77,562
(b) I ncome -28, 681
(c) Tra nsfers 62,438

1. Trade Balance
=X-M
= 3,08,970 - 4,69,006
= ( - ) 1,60,036 Trade Deficit
2. Goods and Services Balance
= Trade balance + Balance on account of non-factor services
= (-) 1,60,036 + 77, 562
= (-) 82,474
3. Invisibles Balance
= Balance on non-factor services + Balance on income
(factor services) + Balance on transfers
= 77, 562 - 28, 681 + 62,438
= 1,11, 319
4. Current Account Balance
= Trade balance + Invisibles balance (= Net of invisibles)
= (-) 1,60,036 + 1,11, 319
= (-) 48,717
[Note: (i) Exports of goods and services are recorded as positive (+) items
as these cause flow of foreign exchange i nto the domestic
economy.
( i i ) Imports of goods and services are recorded as negative (-) items
as these cause flow of foreign exchange out of the domestic
economy.
( i i i ) All receipts on accou nt of transfers are recorded as positive (+)
items, while payments are recorded as negative (-) items.]
f>TS
Q. 1. Name three such items wh ich are not incl uded i n bala nce of trade.
Ans. Three items which are not incl uded i n bala nce of trade are:
(i) Export and i mport of services such as of shipping, insurance and banking.
(ii) I nterest and dividend payments between the countries.
( iii) Expenditu re by the tourists.
Q. 2. What is the difference between bala n ce of trade and current account balance?
Ans. Balance of trade refers to the balance occu rring on account of export and i mport of visi ble items
(goods only).
Current accou nt bala nce includes the ba lance of trade as well as ba la nce on i nvisibles.

Capital Accou nt
Capital account records receipts and payments of such transactions
which cause an impact on asset-liability status of a country in relation
to rest of the world. Liabilities or assets of a country (in relation to
rest of the world) are either raised or reduced. In other words, capital
account transactions lead to future claims.
Confusion is sometimes raised with regard to the export and import
of capital goods, like plant and machinery. Should such transactions
Export a n d i m port of
low
ca pita l g oods (plant be incl uded in the capital account? Answer is 'No'. Let it be absolutely
and m a c h i nery) is N OT clear that the export and import of all types of goods (consumer
i ncl uded in the capita l
accou nt. Export and goods or capital goods) is recorded as 'merchandise' or 'visible trade'
i m po rt of a l l types in the current account of BoP. Thus, export and import of capital
of goods (consumer
goods or capital goods has nothing to do with capital account of BoP.
ee
goods) i s recorded as
rF
Fr
'merchand ise' or 'visi b l e Components
trade' i n the cu rrent
acco u n t of BoP.
Two principal components of capital account are:
or
( 1) Borrowing, and
(2) Foreign investment.
sf
u
(1 ) Borrowi ng: Borrowing is split as:
k
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(i) External commercial borrowing, and
oo
(ii) External assistance.

B
The principal difference between the two is that while external

re
commercial borrowing is available at the market rate of interest

(in the international money market), external assistance is
ou
ad
available at the concessional rate of interest.

Y
Borrowing from rest of the world raises our liability to rest of

the world. But, note it carefully, that it is recorded as a 'credit
nd
Re
item' in the capital account of BoP. The reason is this: all receipts
of foreign exchange are recorded as credit items in the BoP
Fi
accounts. Thus, borrowing of rest of the world (or lending to

rest of the world) would be recorded as 'debit item' in the capital
account, as it causes flow of foreign exchange from our country
to rest of the world.
(2) Foreign Investment: Foreign investment is split as:
(i) Portfolio Investment, and
(ii) Foreign Direct Investment (FDI).

Portfolio Investment basically refers to foreign institutional
investment (FIi). It is investment by rest of the world in shares
and bonds of the domestic companies.
Foreign Direct Investment relates to ownership of enterprises (in
the domestic economy) by rest of the world. Example: Walmart
stores in India.
Other Components of Capital Account

Besides, borrowing and investment (which are the principal components
of capital account) there are other components, as under:
(3) NRI Deposits: In the context of the Indian economy, 'N RI deposits'
is also a significant constituent of capital account. However, here
a note of caution is essential:
Only such NRI deposits are to be considered (as a component of
capital account) which are made in the domestic economy. Thus,
non-resident Indians should make deposits in India.
It also needs to be noted that money sent by the NRls to their
families in India is to be treated as 'current transfers', and are
to be recorded in current account of BoP. Only deposits held
by NRls in the domestic economy are to be considered as a
component of capital account.
(4) Banking Capital (Other than NRI Deposits): Banking capital is
yet another component of capital account. It refers to 'foreign
assets' held by the commercial banks. Owing to drawdown of
foreign assets of the commercial banks (the commercial banks
converting their foreign assets into liquidity), inflow of foreign
exchange into the domestic economy tends to rise.
(5) Short-term Trade Credit: In the context of the Indian BoP, short
term trade credit is another important component of capital
account. It arises on account of purchases in the international
market without making immediate payment. Repayment of
short-term debt to rest of the world leads to outflow of foreign
exchange to rest of the world. Accordingly, it is recorded in the
capital account with a negative sign. Inward flow of foreign
exchange (from rest of the world), on the other hand, is recorded
with a positive sign.
Following is a flow chart presentation of the components of capital
account BoP:

F®C U S Com ponents of Capital Account BoP
ZO N E Or
Structure of Capital Account BoP
(in dicating Net Capita l Flows)
'
8 Borrowing 8 Foreign I nvestment
I
External Fil FDI
Commercial Externa l
Assistance (Foreign I n stitutional (Foreign Direct
low
Borrowing I nvestment; also cal led I nvestment)
Portfolio I nvestment)
9 Ba n king 0
N RI Ca pital Short-term
-----
Deposits (excluding Trade
ee
N R I De osits) Cred it
rF
Fr
[N ote: (i) Similar to current account, capital account records all payments
to rest of the world as debit, indicated by the ·-· sign and
or
all receipts from rest of the world as credit, indicated by the
'+' sign .
sf
u
(ii) Often , flows in the capital account are shown as ' N et Capital
k
Flows'. Net flows reflect the balance on account of capital
Yo
account transactions, which may be positive or negative.
oo
Positive balance indicates that the inward flow of foreign

B
exchange is greater than the outward flow, while the negative

balance indicates just the opposite.]
re
Esti mation of Balance Related to Capital Accou nt

ou
ad
Balance of the capital account is estimated as the net of positive

Y
and negative values. Table 2 shows the actual estimation of Capital

Account Balance in India.
nd
Re
Table 2 . Estimation of Capital Account Balance (based on data for

Fi
the period 2017-1 8 , Economic Survey, 201 8-1 9)

Items US million $-
- --------+--
External Assista nce ( n et) 2,944
External Commercial Borrowing (net) -183
Short-term Cred it 13,900
Banking Capita l ( n et) ( i ncl usive of N R I Deposits) 16, 190
Foreign I nvestment ( n et) 52,401
Other F l ows (net) 6,138
Ca pita l Acco u nt Balance 9 1, 390

It shows that d u ring the period (201 7-1 8), there has been a net inflow
of foreign exchange of US $ 91 , 390 on account of capital accou nt
BoP transactions.
Overall Balance
I n the Ind ian BoP accou nting syste m , overal l balance is estimated as the
sum total of ( i ) cu rrent account balance , (ii) capital account balance, and
(iii) errors and omissions (accou nting for statistical d i screpancies) .
Overal l Balance = Cu rrent account balance
+ Capital accou nt balance
+ Errors and om issions
Here is an illustration of the Estimation of Overall Balance (based on
data for the period 201 7-1 8, Economic Survey, 201 8-19).
Overall Balance
= Cu rrent account balance + Capital account balance + Errors
and omissions
= ( - ) 48,71 7 + 91 , 390 + 902 = 43 , 574 (US m i l l ion $ )
t t t t
Cu rre nt Ca pita l Esti mated Overa l l
acco u nt acco u nt va l u e of bala nce
bala nce bala nce e rrors a n d
om issions
Official Reserves Account

(indicati ng Reserves of Forex with the RBI)
T h e overal l balance is finally reflected i n t h e Official Reserves Accou nt
of the RB I . Because, R B I is the custod ian of forex reserves of the
cou ntry, and al l forex transactions i n the cou ntry are routed through
the RB I . If overal l balance is positive (as i n the above i l l u stratio n ) , it
causes i ncrease in official reserves; if overal l balance is negative , it
causes decrease in official reserves.
I n the above illustration, Official Reserves Account of the RBI would
show an increase of 43 , 574 U S m i l l ion $ .
Here , comes an i mportant observation which needs to be carefully noted :
Sometimes, Official Reserves Accou nt is shown as a part of the
cap ital acco unt BoP, rather than a se parate accou nt. If official reserves
are shown as a part of the capital accou nt BoP, then BoP always
balances . Because (for pu rpose of balancing BoP accou nts) , i n crease
in the official rese rves is ind icated by a negative sign , wh i le decrease
is indicated by a positive sign . Table 3 is an exam ple of I n d ia's BoP

accounts, wherein increase/decrease in official reserves is shown as
a part of the capital account BoP. Accordingly, BoP shows a perfect
balance, or the balance of BoP accounts is equal to O (zero). Table 3 is
based on the actual data relating to some major items of India's BoP.
Table 3 . Major Items of India's BoP, showing how
Balance of Payments always Balances
(201 7-1 8 , Economic Survey, 201 8-1 9)
Items US mil lion $
low
1. Exports 3,08,970
2 . I m po rts 4,69,006
3 . Tra de Bala nce (-) 1,60,036
4. I nvisibles (net) 1, 11,319
ee
5. Cu rrent Account Balance (-) 48, 717
rF
Fr
6. Ca pita l Account Balance 9 1, 390
7. Errors and Omissions 902
or
8. Overa l l Bala nce 43,574
sf
u
9 . *Official Rese rves [ I ncrease (-)/Decrease (+)] (-) 43,574
k
Yo
* Item 9 i n BoP accou nts a lways sh ows cha nge in official rese rves ( i ncrease o r
oo
decrease). It neve r s hows tota l officia l reserves. I n the p resent ta b l e, th ere is a n
i ncrease i n official rese rves as indicated b y a '-' sign. To repeat, in crease i n officia l
B
rese rves is i nd icated b y a '-' sig n, while the decrease is ind icated by a '+' sig n. This is
re
o n ly then that the BoP acco unt wou l d reflect a pe rfect bala nce (= O).
In case, Official Reserves are not shown as a part of the capital account,
ou
ad
the Official Reserves Account is separately presented and classified as

Y
"Below the Line". In such situations, the current and capital accounts
together may show a surplus or deficit BoP.
nd
Re
Thus:
BoP Surplus = Current Account Surplus + Capital Account Surplus
Fi
(When Official Reserves Account is not a part of

capital account)
BoP Deficit = Current Account Deficit + Capital Account Deficit
(When Official Reserves Account is not a part of
capital account)
BoP always balances when Official Reserves Account is a part of
capital account, and therefore: Current account balance + Capital
account balance = Zero.

3 . EQUILIBRIU M AND DISEQUILIBRIU M IN BO P
BoP eq uilibrium is struck when: Current account balance + Capital
account balance + Errors and omissions = Zero, and there is no
movement (increase or decrease) of official reserves of the central
bank. In case we ignore the element of errors and omissions, we can
say that the BoP equilibrium is stuck when:
Current account balance + Capital account balance = Zero, and there
is no movement (increase/decrease) of the official reserves.
Or
We can say that BoP is in a state of equilibrium when any negative
balance in the current account is equally counterbalanced by a
positive balance in the capital account, and there is no change in
official reserves of the central bank.
Thus, in a state of BoP equ ilibrium inward flow of foreign exchange
( on account of current account and capital account transactions) is
exactly equal to the outward flow of foreign exchange, and there is
no change in official reserves ( of foreign exchange and gold) with the
central bank of the country.
A disequilibrium in BoP occurs when the sum total of current account
balance and capital account balance is not zero; instead it is either
some positive number or some negative number. In case the sum
total of current account balance and capital account balance is some
positive number, it indicates BoP Surplus. On the other hand, if the
sum total of current account balance and capital account balance is
some negative number, it indicates BoP Deficit. Thus, we have:
(i) BoP Diseq u i l ibrium when :
Current account balance + Capital account balance is NOT equal
to zero, and it causes the movement of official reserves.
(ii) BoP Surplus when:
Current account balance + Capital account balance is some
positive number, pointing to net inward flow of foreign exchange,
and leading to an increase in official reserves.
(i i i ) BoP Deficit when :
Current account balance + Capital account balance is some
negative number, pointing to net outward flow of foreign
exchange, and leading to a decrease in official reserves.

Autonomous and Accom modati ng Items of BoP Accou nt
BoP transactions or items in BoP account are often classified as
autonomous items and accommodating items. The difference is as
under:
Autonomous items refer to such BoP transactions which are undertaken
with a view to making profits. It is due to these transactions that there
is a BoP deficit/surplus. Accommodating items, on the other hand,
refer to such transactions which are undertaken by the central bank
of a country with a view to correcting BoP imbalance and restoring
low
BoP equilibrium. It is important to note that accommodating items do
not cause any movement of goods and services across the borders.
These relate only to the movement of official reserves with a view to
correcting BoP imbalances.
ee
Often the accommodating items are not reflected as an element of
rF
BoP accounts. These are therefore called 'below the line' items, while
Fr
autonomous items are called 'above the line' items. Thus, when BoP
deficit/surplus is estimated, it is with reference to only the autonomous
or
items or autonomous transactions of BoP.
sf
u
F®Cus ____
Autonomous Items and Accommodating Items-The Difference
k
Yo
A_u_t_o_n_o_m_o
__us_ e_
lt_ m_s______A_c_c_ _
o_m_m d_
o_ ti_n_g_l_
a_ _
te_m s__
oo
ZO N E (i) Autonomous items refer to such (i) Accommodating items are

B
BoP transactions which are free from the considerations

undertaken for considerations of profit
re
of profit.
(ii) Autonomous items are the (ii) Accommodating items are
ou
ad
cause of BoP imbalance (BoP meant to restore BoP balance.

surplus or BoP deficit). or
Y
Accommodating items
are meant to correct BoP
nd
Re
imbalance.
Fi
(iii) Autonomous items may involve (iii) Accommodating items do

the movement of goods across not involve the movement of
the borders (like export and goods across the borders.
import of consumer goods or These items only involve the
capital goods). movement of official reserves
with the RBI.
(iv) Autonomous items are classified (iv) Accommodating items are
as 'a bove the line' items of BoP classified as 'below the line'
items of BoP

Signifi c ance of BoP Accounts ( or BoP Data)
Having understood the concept and composition of BoP accounts,
we can now write the significance of these accounts, in terms of the
following observations:
(1) Financial Status of the Domestic Economy: BoP accounts reveal
financial status of the domestic economy in relation to rest of
the world. Borrowing reveals dependence on rest of the world. It
points to backwardness of the domestic economy.
(2) Net Factor Income from Abroad: BoP data offers information on
net factor income from abroad. It is an important component of
national income.
(3) X - M (A Component of AD): BoP accounts show exports and
imports of a country. We know, net of exports (X - M) is an
important component of AD (aggregate demand in the domestic
economy). Rise in 'X - M' leads to a rise in AD. It directly impacts
the level of output and employment in the domestic economy
(particularly when there is unemployment due to deficiency of
AD).
(4) Market Potential: BoP accounts reflect market potential in the
domestic economy. It is reflected by the size of foreign investment.
Larger size of foreign investment points to high market potential
in the economy.
(5) Monetary and Fiscal Policies: BoP performance of a country
impacts its monetary and fiscal policies. In the event of greater
flow of foreign exchange from rest of the world, there is a pressure
of demand for the domestic currency. The RBI has to account for
it in the formulation of its monetary policy. Likewise, poor-flow
of foreign investment in the domestic economy, may point to
hard tax laws in the domestic economy. The government must
account for it in the formulation of its fiscal policy.
Briefly, BoP accounts (or BoP data) reveals financial strength of a
country in relation to rest of the world. For less developed countries
like India, it highlights the need for borrowing from rest of the world
as well as the need for foreign investment.
Balance ofPoyments 377

SOM E VITAL DIFFERENCES
1. Current Account BoP and Capital Account BoP
Current Account BoP Capital Account BoP
(1) Concept
C u rrent account records receipts a n d payments of Ca pita l acco u nt records recei pts and payme nts of
fore ign excha nge on acco u nt of such transactions fo reign excha nge on acco u nt of such tra nsactions
which do not i m pact asset- l ia b i l ity status of a which i m pact asset-liabil ity status of a cou ntry i n
cou ntry i n re lation to rest of the worl d . Thus, re lation t o rest o f the worl d . Thus, ca pital acco u nt
current account tra n sactions d o n ot give rise to tra n sactions give rise to future c l a i ms.
futu re claims.
low
(2) Composition
Cu rrent acco u nt tra nsactions include: Ca pita l acco u nt transactions include:
( i ) Export a n d i m port of goods (ca l l ed visible (i) Borrowing, Principal compon ents
]
trade), ( i i ) Foreign I nvestme nt,
(ii) Export and i m port of services (called i nvisible (iii) N R I Deposits,
ee
trade), (iv) Banking Capital, ] Oth e c com po"'""
( i i i ) Cu rrent transfers.
rF (v) Short-te rm Debt.
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(3) Significance
( i ) Cu rrent account tra nsactions revea l X - M, a n (i) Capital acco unt tra nsactions reveal borrowi ngs
or
i m portant component o f AD i n t h e domesti c fro m rest of the world. It is a reflection of
eco nomy. backwa rd ness of the domestic economy.
sf
u
( i i ) Cu rrent account tra nsactions reveal net fa ctor ( i i ) C a p ita l acco u n t tra n sa ct i o n s s h ow fo re ign
i n come from a broad, a n i m porta nt compon ent i nvestment i n the d o m est i c eco n o my. W h i l e
k
of national i ncome. it reve a l s ma rket potential o f t h e d o m estic
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econo my, it a l s o reve a l s d e p e n d ence o n rest of
oo
(iii) Beca use of their d i rect i m pact on AD, current the world fo r o u r G D P growt h .
B
acco u nt transactions i m pact the leve l of output ( i i i ) C a p ita l account t ra n sacti o n s d o n o t cause
a n d e m p l oyment i n the do mestic economy. a ny d i rect i m pact o n t h e level of output
re
and e m p l oyment i n t h e econo my. These

tra n sa ct i o n s j u st revea l a sset-l i a b i l ity status of
ou
t h e economy i n re l a t i o n to rest of t h e wo r l d .
ad
Y
2. Balance of Trade and Current Account Balance of Payments

Ba lance of Trade Current Account Balance of Payments
-
nd
Re
( i ) Bala nce of trade is that acco unt which records ( i ) C u rrent account bala nce of payments is that
i m po rts and exports of goods on ly. account which records (a) import and export
Fi
of goods, (b) im port and export of services, a n d

( c ) cu rrent transfers.
( i i ) It is the d i fference between visible exports a n d ( i i ) It is the sum tota l of trade balance a n d i nvisi b les
visi bl e i m ports. bala nce. I nvisi bles bala nce i n cl udes (a) bala nce
on non-factor servi ces, (b) bala nce on income
arising out of factor services, and (c) bala nce on
tra nsfers .
( i i i ) It i nvolves i nternational transactions relating to ( i i i ) It involves i nte rnational transactions re lating
physical goods which ca n be seen crossing the to physical goods (wh i ch ca n be seen crossi ng
borders. the bord e rs) as we l l as transactions relati ng
to services which ca nnot be seen cross ing the
bord e rs.

3. Balance of Payments and Balance of Trade
Ba lance of Payments Ba lance of Trade
( i ) Bala nce of payments is a summary statement of (i) Balance of trade is the difference between
all economic tra nsactions of a cou ntry with rest visible exports (X) and visible i m ports ( M ) .
o f world.
(ii) It records transactions related to goods as wel l ( i i ) I t records transactions related to goods only
as services.
( i i i ) It records both current account as well as (iii) It does not record capita l account transactions.
capita l account transactions.
( iv) BoP a lways balances, provided movement of (iv) It is either positive (X > M ) or negative (X < M). It
RBI reserves (official reserves) is reflected i n it. balances only when X = M.
Power Points & Revision Wi ndow -----------
j 1
Balance of Payments is a s u m m a ry statement of a l l m o n eta ry (or econom ic) tra nsacti o n s betwee n a
cou ntry a n d rest of the wo rld .
Components: ( i ) Current a ccou nt, ( i i ) Ca pita l accou nt, ( i i i ) Offic i a l reserves acco u nt.
Economic Transactions i n BoP a re broa d ly classified as: ( i ) m e rc h a n d ise, ( i i ) i nvisi b l es, and ( i i i ) tra nsactions
j
lea d i n g to c h a nge in t h e owners h i p of assets vis-a-vis rest of t h e worl d .
Current Account records recei pts a n d paym e nts o f fore ign excha nge o f a cou ntry o n a cco u nt o f s u c h
tra nsactions which d o n o t i m pact asset- l i a b i l ity status o f a cou ntry i n re la tion t o rest o f
t h e worl d .
Components: ( i ) Export a n d i m port o f goods, ( i i ) Export a n d i m port o f services [ ( a ) fa cto r
services + ( b ) n o n -fa cto r services], ( i i i ) Current tra nsfers.
Export and import of goods is ca l led m e rch a n d ise o r 'visi b l e tra de'.
Invisibles i n c l u d e : ( i ) N o n -factor services, ( i i ) Factor i n come, ( i i i ) Cu rrent tra nsfe rs.
Balance of Trade ( o r Tra d e Ba la nce) = Export of m e rcha n d ise - I m port of m e rcha n d ise.
j
Current Account Balance = Trad e bala nce + I nv i s i bles b a l a nce.
Capita l Account records recei pts a n d payme nts of fore ign excha nge of a co u ntry o n acco u nt of such
tra nsactions w h i c h i m pact asset- l ia b i l ity status of a cou ntry i n relation to rest of the
worl d .
Components: ( i ) Bo rrowi n g, ( i i ) Fore ign i nvest m ent, ( i i i ) N R I d eposits, ( iv) Ba n ki ng ca pita l ,
( v ) Short-te rm d e bt.
Borrowing i nc l u des (i) exte r n a l com m e rc i a l borrowi ng, and ( i i ) exte rnal assista nce.
Investment i n c l u des (i) FIi ( Foreign I nstituti o n a l I nvest m e nt), and (ii) FDI ( Fo reign Di rect I nvest m e nt) .
Capital Accou nt Balance sh ows net ca p i ta l flows.
Positive Balance shows that i nwa rd flow of ca p ita l is greater t h a n the outwa rd fl ow.
Negative Balance shows that i n wa rd flow of cap ita l is l ess t h a n t h e outwa rd fl ow.

BoP Equilibrium is a situation when cu rrent accou nt balance a n d ca pita l acco u nt ba la nce add u p to ze ro,
a n d there is no m ovement ( i ncrease or d ecrease) in officia l rese rves. Or, it is a situation
when recei pts and payments of a cou ntry on acco u nt of economic tra nsactions with
rest of the world a re exactly e q u a l to each other, and there is no m ovement of official
rese rves.
BoP Deficit occu rs when payme nts of a cou ntry on accou nt of economic tra nsactions with rest of
the wo rld exceed its recei pts and conseq uently, there is a decrease i n official reserves.
BoP Surplus occu rs when recei pts of a cou ntry on acco u nt of economic tra nsactions with rest of the
world exceed its paym e nts a n d conseq uently, there is i ncrease i n officia l reserves.
j
Autonomous and Accommodating Items a re the BoP tra nsactions affecti ng its eq u i l i bri u m .
low
! Autonomous Items refe r t o s u c h B o P tra nsactions which a re d etermined b y considerations of
p rofit. It is d ue to these tra nsactions that the BoP d eficit/surplus a rises. These a re ca l led 'a bove the
line item s'.
Accommodating Items refer to such BoP tra nsactions which a re n ot d etermined by considerations of
p rofit. It is d u e to these tra nsactions that the BoP deficit/surplus is corrected. These a re ca l led 'below the
ee
line items'.
rF
Fr
or
rEX E RC I S Ej sf
u
k
Yo
1 . Objective Type Q u estions (Remembering & U nd e rsta n d i n g based Questions)
oo
B
A. M u l t i p l e Choice Questions
re

1. BoP is measured as:
ou
ad
(a) d iffere nce betwee n vis i b l e ite ms of exports and i m po rts

Y
(b) d iffere nce betwee n i nvis i b l e ite ms of exports a n d i m ports

(c) d iffere nce betwee n externa l a n d i nternal fl ow of gol d
nd
(d) d iffere nce betwee n a l l recei pts o f foreign excha nge a n d payments o f foreign excha nge
Re
2. Bala nce of trade is measured as:

Fi
(a) d iffere nce betwee n i m port a n d export of goods

(b) d iffere nce betwee n i m port and export of services
(c) d iffere nce betwee n i m port and export of ca pita l
(d) d iffere nce betwee n a l l exports a n d a l l i m ports
3. In which of the fol lowing categories a re the tra nsactions of bala nce of trade recorded?
(a) Visi ble ite ms (b) I nvisi ble ite ms
(c) Ca pita l tra nsfers (d) All of these
4. Cu rrent account records tra nsactions relating to:
(a) expo rt and i m port of goods (b) non-factor and factor i n come
(c) current tra nsfe rs (d) a l l of these

5 . Which of the fol lowing items relate to BoP on ca pita l account?
(a) Foreign i nvestment (b) Loa ns
(c) NRI remitta nces (d) All of these
6. Which of the fol lowing a re not included in bala nce of trade?
(a) Payment of i nterest a n d d ividend (b) Expe n d it u re by the tou rists
(c) Borrowi ng from rest of the world (d) All of these
7. If the va lue of visible exports exceeds the va lue of visi ble im ports, the bala nce relates to:
(a) current acco u nt BoP (b) ca pita l acco u nt BoP
(c) ba l a n ce of trade (d) none of these
8. U n i latera l tra nsfers a re :
(a) one-sided payme nts (b) reci proca l payme nts
(c) factor i ncomes (d) a l l of these
9 . Surplus i n BoP occ u rs when:
(a) recei pts = payments (b) recei pts < payme nts
(c) recei pts > payments (d) both (a) a n d (c)
10. Ba la nce of payments is i n d iseq u i l i bri u m when:
(a) current acco u nt ba l a n ce + ca pita l acco u nt ba l a n ce is not eq u a l to ze ro
(b) current acco u nt ba l a n ce + ca pita l acco u nt ba l a n ce is some positive n u m be r
(c) current acco u nt ba l a n ce + ca pita l acco u nt ba l a n ce is s o m e negative n u m ber
(d) all of these
11. Diseq u i l i b ri u m i n bala nce of payments leads to :
(a) increase i n official reserves with R B I
(b) d ecrease i n officia l rese rves with R B I
(c) both (a) a n d ( b )
(d) none o f these
12. Autonomous items a re related to those tra nsactions which:
(a) a re determined by motive of profit
(b) a re not concerned with the e q u i l i bri u m status of BoP
(d) none o f these
13. Accommodating items a re those items of BoP which:
(a) a re n ot d etermined by considerations of profit
(b) a re con d itioned by the positive or negative BoP status
(c) lead to increase o r decrease i n official rese rves with RBI
(d) all of these
14. Cause of BoP i m b a l a nce relates to:
(a) autonomous ite ms (b) acco m m odating items
(c) both (a) a n d (b) (d) neither (a) nor (b)
15. Ba la nce o f tra de is a p a rt of:
(a) current acco u nt BoP (b) ca pita l acco u nt BoP
(c) official rese rves acco u nt (d) none of these
Balance ofPayments 381

16. I nvisi b les ba l a n ce refers to:
(a) Exports - I m ports
(b) Trad e balance + Ba la nce of non-factor services
(c) Ba la nce of non-factor services + Bala nce of i n come + Bala nce of tra nsfers
(d) Exports - I m ports + Bala nce of factor services
17. When b a l a n ce of paym ents bala nces:
(a) current acco u nt + ca pita l acco u nt = zero
(b) official rese rves acco u nt is a part of cu rrent accou nt
(c) official rese rves acco u nt is a part of ca pita l acco u nt
low
(d) both (a) a n d (c)
18. Exports = t 1,000 la kh, i m ports = t 1,650 la kh, ba la nce of tra de shows :
(a) s u rp l u s of t 650 l a kh (b) d eficit of t 650 lakh
(c) ba l a n ce of t 2,650 lakh (d) none of these
ee
19. If bala nce of trade is (-) t 600 crore and va l u e of exports is t 500 crore, then the va l u e of i m ports
wi l l be:
rF
Fr
(a) t 1,300 cro re (b) t 300 crore
(c) t 1, 100 cro re (d) t 1,200 crore
or
20. If bala nce of trade is showing a deficit of t 200 crore a n d va l u e of i m ports is t 900 crore, then the
va l u e of exports wou ld be:
sf
u
(a) t 200 crore (b) t 500 crore
k
(c) t 700 crore (d) t 900 crore
Yo
oo
Answers
B
1. (d) 2. (a) 3 . (a) 4. (d ) 5 . (d) 6. (d) 7. (c) 8. (a) 9. (c) 10. ( d )

re
11. (c) 12. (c) 13. (d) 14. (a ) 15. (a) 16. (c) 17. (d) 18. ( b) 19. (c) 20. (c)
ou
ad
B. Fill in the Bla n ks

Y

nd
1. records i m ports a n d exports of goods on ly. ( B a l a nce of trade/Bala nce of payme nts)
Re
2. accou nt tra nsactions d o n ot give rise t o 'futu re clai ms'. (Cu rre nt/Ca pita l )
Fi
3 . The re is a flow o f foreign excha nge i nto t h e cou ntry w h e n we goods a n d

services . (export/i m port)
4. = Com pensation of e m p l oyees + I nvestment i ncom e .
( Factor I n com es/Tra nsfe r I ncomes)
5 . Export and i m port of a l l types of goods is recorded in the acco u nt of BoP.
(current/ca pita l )
6. acco u nt ba la nce includes t h e ba l a n ce o f trade as wel l as balance on i nvisi bles.
(Cu rre nt/Ca pita l )
7. Export a n d i m port o f ca pita l goods is n ot i ncluded i n the accou nt.
(current/ca pita l )

8. ite ms refe r to such BoP tra nsactions which a re u n d e rta ke n with a view to making
p rofits. (Autonomous/Accom m odati ng)
9. When BoP is i n there is no m ovement o f official rese rves o f t h e centra l ba n k .
(eq u i l i b ri u m/d iseq u i l i bri u m )
10. B o P surplus leads t o a n/a i n official reserves. ( i n c rease/d ecrease)
Answers
1. Bala nce of trade 2 . Cu rrent 3 . export 4. Factor I ncomes 5. cu rrent
6. Cu rrent 7. ca p ita l 8. Autonomous 9. equ i l i b ri u m 10. increase
C. Tru e or Fa lse
State whether the following statements a re True or False:

1. Services a re not vis i b l e when they cross the borders. (Tru e/Fa lse)
2. I nvisi b l es i n BoP accou nts i n c l u d e moneta ry tra nsactions re lated to cu rrent tra nsfe rs. (Tru e/Fa lse)
3. Expe n d itu re by the tou rists is i nc l u ded i n ba l a n ce of trade. (Tru e/Fa lse)
4. Cu rrent accou nt records a l l payments to rest of the world as d ebit. (Tru e/Fa lse)
5. BoP a lways ba lances when official reserves account is a part of ca pita l account. (True/Fa lse )
6. F i n a ncial tra nsactions re late t o i nternational sale a n d p u rchase o f rea l assets. (Tru e/Fa lse)
7. Bala nce of payme nts records tra nsactions re lated to goods on ly. (Tru e/Fa lse )
8. Acco m modating ite ms a re meant t o restore BoP ba l a n ce. (Tru e/Fa lse )
9. I n c rease i n the officia l reserves is i n d i cated by a negative sign i n the BoP accou nts. (Tru e/Fa lse )
10. U n i l atera l tra n sfe rs made by way of gifts, gra nts a n d rem itta nces a re treated
as cu rre nt tra nsfers . (Tru e/Fa lse)
Answers
1. True 2. True 3 . Fa lse 4. True 5 . True 6. Fa lse 7. False 8. True 9. True 10. True
D. M atch i n g the Correct State ments
Column I Column I I
(a) Exte rnal com m e rc i a l borrowing (i) Ava ila ble at the con cessional rate of interest
( b) Rea l assets ( i i ) Stocks and bonds
(c) Autonomous items ( i i i ) Classified as 'below the l i ne' items of BoP
(d) Exports of goods and services ( iv) Recorded as positive items in BoP accounts
(e) Deposits held by N R l s (v) A component o f cu rrent accou nt
Answer
(d) Exports of goods a nd services - (iv) Recorded as positive items in BoP accounts

items in Column I:
Column I Column I I
(a) Tra de deficit (i) Cause of BoP i m b a l a nce
(b) Merch a n d ise ( i i ) Export of goods < I m port of goods
(c) Autonomous items ( i i i ) An element of i nvisibles
(d) C u rrent t ra nsfe rs ( iv) Foreign instituti o n a l i nvestment
(e) Portfo lio i nvestment (v) Export a n d i m port of goods
Answers
low
(a) - ( i i), ( b) - (v), (c) - ( i), (d) -( ii i), (e) - (iv)
E . 'Very Short A nswe r' Objective Type Questions
ee
1. What is meant by bala nce of payments?
rF
Ans. Bala nce of payments refers to the statement of accou nts record ing a l l economic tra nsactions of a
Fr
cou ntry with rest of the world i n a n acco u nti ng yea r.
2 . What is meant by bala nce of trade?
or
Ans. Bala nce of trade is defi ned as the diffe rence between the va l u e of i m ports and expo rts of o n ly
p hysica l goods or vis i b l e items.
sf
u
3 . Which two tra nsactions determine ba la nce of trade?
k
Ans. ( i ) Export of goods (or vis i b l e items).
Yo
oo
( i i ) I m port of goods (or vis i b l e items).
B
4. What is meant by visible items of bala nce of payments?

Ans. All such items of exports a n d i m ports which a re mate rial in natu re a re ca l led visibles. These ite ms ca n
re
be seen crossing the borders. These a re a lso ca l l ed merchand ise.

5 . Name three invisible items of ba la nce of payments.
ou
ad
Ans. (i) Export and i m port of services such as of s h i p p i ng, i n s u ra n ce and b a n k i ng.
Y
(ii) I nterest and d ividend payments between the countries.

( i i i ) Expe n d iture by the tourists.
nd
Re
6. Defi ne bala nce of payments on cu rrent acco u nt.

Ans. Bala nce of paym e nts on cu rre nt accou nt records recei pts and payme nts of foreign excha nge of a
Fi
cou ntry on acco u nt of such tra nsactions which do not i m pact asset- l i a b i l ity status of a cou ntry i n
re lation t o rest o f t h e worl d .
7. Defi ne bala nce o f payments on ca p ital accou nt.
Ans. Bala nce of paym ents on ca pita l acco u nt records recei pts and payme nts of foreign excha nge of a
cou ntry on acco u nt of such tra nsactions which i m pact asset- l i a b i l ity status of a cou ntry i n relation to
rest of the worl d .
8. N a m e two items each relating t o Cu rrent Accou nt BoP a n d Ca p ita l Acco u nt BoP.
Ans. ( i ) Cu rrent Accou nt BoP i n c l u d es :
(a) export a n d i m port o f goods (ca l led merchand ise), a n d
( b ) export a n d i m po rt o f services (ca l led i nvisi b les) .

( i i ) Ca pita l Accou nt BoP incl udes:
(a) i nternati o n a l sa l e a n d p u rchase of fi nancial assets ( l i ke stocks a n d bonds), and
( b ) i nte rnati o n a l sa l e a n d p u rchase of rea l assets ( l i ke p l a nt a n d mach i n e ry) .
9. H ow is bala nce of trade esti m ated ?
A n s . Bala nce o f Trad e = Export o f goods - I m port o f goods.
1 0 . H ow is cu rre nt acco u nt B o P esti m ated ?
A n s . Cu rrent Accou nt BoP = Trade bala nce + I nvisi bles ba la nce.
11. What is the d ifference between the va lue of exports of goods and va lue of i m ports of goods ca lled?
Ans. Bala nce of trade.
12. W h a t does a deficit i n bala nce o f trade account i n d icate ?
Ans. A d eficit i n ba l a n ce of trade accou nt i n d icates that the va l u e of i m port of goods exceeds the va l u e of
export of goods .
13. What a re a utonomous items?
Ans. Autonomous items a re those economic tra nsactions i n the cu rrent and ca pita l acco u nt that a re
underta ken for certa i n economic or profit motive. These items a re a lso known as 'a bove the line items'.
14. What a re accommodati ng items?
Ans. Accom modati ng items a re those eco n o m ic tra nsactions that a re u n d e rtake n by the R B I with a view
to correcting i m ba l a nces i n the cou ntry's BoP acco u nt. These items a re a lso known as 'below the l i n e
items'.
15. What is officia l rese rves accou nt?
Ans. It is the acco u nt i n d i cating rese rves of forex with the R B I .
2 . Rea son - based Quest i o n s (Co m p re h e n s i o n o f t h e S u bject - m a tter)
Read the fo l l owi n g statements ca refu l l y. Write Tru e or Fa lse with a rea so n.
1 . Ba la nce of payme nts always b a l a n ces.
Ans. True. But, it is only in the accou nting sense that ba la nce of payme nts a l ways balances. It is movement
of official rese rves or 'below the l i ne' items that i m pa rts ba la nce to the BoP accou nts.
2 . There is no differe nce between bala nce of trade a n d bala nce on cu rre nt accou nt of BoP.
Ans. Fa lse. Ba lance of trade i n c l u des o n ly visible items whereas cu rrent acco u nt of ba la nce of payments
i n c l u d es both vis i b l e as wel l as i nvisible items.
3 . Trade of i nvis i b l e items is a part of ca pita l acco u nt of BoP.
Ans. Fa lse. Ca pita l acco u nt records a l l such tra nsactions which ca use a cha nge i n the owners h i p of assets
between the domestic economy a n d rest of the worl d .
4. H igh rate o f i nflation i n t h e domestic economy causes 'deficit bala nce o f trade'.
Ans. True. Beca use high rate of i nflation m a kes dom estic goods costlier in relation to goods from rest of
the world. This leads to i ncrease in i m ports a n d decrease in exports. I m p lying a deficit ba lance of trade.
5 . Autonomous ite ms of trade a re u n d e rta ke n by the government with a view to restore e q u i l i b ri u m
i n ba la nce o f payments .
Ans. Fa lse. Autonomous ite ms a re not meant to restore eq u i l i b ri u m i n ba la nce of payme nts. These a re
determi ned e nti re ly by considerations of profit.
6. I m p rove ment i n excha nge rate of the country's cu rrency does not necessarily mea n i m p rovement
i n BoP status of the country.
Ans. True. I m provement i n cou ntry's excha nge rate may i n fact ca use d eficit BoP eq u i l i brium, beca use
exports may decrease and i m ports may increase.

7. Borrowing a n d lending i n the i nternational m oney m a rket is a part of cu rrent account bala nce of
payme nts .
Ans. Fa lse. Borrowi ng a n d l e n d i ng i n the i nte rnati o n a l money ma rket is a part of ca pita l acco u nt ba l a n ce
of payments.
8. Cu rrent account bala nce of payments i ncl udes export and i m port of goods on ly.
Ans. Fa lse. Cu rrent acco u nt ba la nce of paym ents i n c l u d es export a n d i m port of goods a n d se rvices, i. e., it
i n c l u d es va l u e of export a n d i m port of both visi b l e a n d i nvis i b l e items.
9. Cu rre nt accou nt surplus i n bala nce of payments occurs when export of vis i b les > i m port of
vis i b les.
Ans. Fa lse. Cu rrent acco u nt balance depends o n :
low
( i ) export a n d i m port o f vis i b l es, a n d
( i i ) export a n d i m port o f i nvisi bles.
Excess of export of visi b les ove r a n d a bove i m port of visi b l es wou l d lead to cu rrent acco u nt surplus
BoP only if ba la nce o n i nvis i bles is ze ro.
10. If bala nce of trade is i n deficit, the bala nce of payments is a lso i n deficit.
ee
Ans. Fa lse. Beca use bala nce of trade is only a part of BoP acco u nts.
rF
Fr
1 1 . Ba la nce of payme nts is b a l a nced t h rough u n i l ate ra l tra n sfers .
Ans. Fa lse. Ba la nce of payments is not balanced t h rough u n i l atera l tra n sfe rs. These tra n sfers a re o n ly a
com ponent of cu rrent acco u nt BoP. BoP is ba la nced t h rough acco m m odati ng items.
or
12. 'Above the l i n e items' i n BoP accou nts include a utonomous as wel l as acco m modatin g items.
Ans. Fa lse. 'Above the l i n e ite ms' in BoP accou nts include autonomous ite ms on ly.
sf
u
13. BoP a lways balances when accom modating items a re reflected as a p a rt of ca p ita l accou nt.
Ans. True. Beca use accom modating ite ms a re meant to restore a ba l a n ce in BoP accou nts.
k
Yo
oo
14. Foreign private loans a re not incl uded i n the BoP accou nts.
Ans. Fa lse. Fo reign private loans a re included in the ca pita l acco u nt of ba la nce of payments.
B
15. NRI de posits i n I ndi a a re a component of cu rrent account bala nce of payments.
re
Ans. Fa lse. N R I d eposits in I nd ia a re a com ponent of ca pita l acco u nt bala nce of paym e nts.
16. 'Tra nsfers to rest of the world' is a de bit com ponent of bala nce of payments on cu rre nt accou nt.
ou
ad
Ans. True. Tra nsfers to rest of the world is record ed as negative item a n d therefore, reflected in the debit
side of balance of payments on cu rrent acco u nt. This is beca use it i nvo lves the paym e nt of foreign
Y
excha nge to rest of the worl d .

1 7 . Compe nsation o f e m p l oyees from rest o f t h e world i s a credit component o f bala nce o f payme nts
nd
Re
on ca pita l accou nt.

Ans. Fa lse. Com pensation of e m p l oyees from rest of the world is a credit com ponent of ba la nce of
Fi
paym ents on cu rrent accou nt.

1. Do you t h i n k that a s u rplus in capita l acco u nt BoP reflects p rosperity of the nation?
Ans. N o, it is i n co rrect to say that surplus i n ca pita l acco u nt reflects prosperity of the nati o n . Beca use
surplus in ca pita l acco u nt balance of payments may have been achieved t h rough loans which a re a
fi nancial obligation to rest of the world.
2 . U nfavo ura b l e ba la nce on cu rrent acco u nt leads t o h igh recei pt o f foreign excha nge i n the ca p ita l
accou nt. Do you agree?
Ans. U nfavo u ra b l e ba la nce on cu rrent acco u nt l eaves us with no option other t h a n (i) borrowings from
rest of the world, or ( i i ) sel l i ng o u r assets to rest of the world. Either way, it leads to the recei pt of

foreign excha nge i n the ca pita l acco u nt. Howeve r, these recei pts a re o n ly a d d i ng to o u r l i a bi l ity to
rest of the world or red uci ng o u r owners h i p of assets vis-a-vis rest of the worl d .
3 . Bala nce o f payments a lways bala nces. Does i t mean a situation o f zero net financial obl igation for a
country?
Ans. It is o n ly in the acco u nting sense that balance of payment always bala nces. From the practica l point
of view, it s h o u l d not be i nterpreted as a situation of zero net fi nancial o b l igation for a cou ntry. A
negative ba la nce on the cu rre nt acco u nt is equated with positive ba l a n ce i n the ca pita l accou nt. But
the positive ba la nce i n ca pita l acco u nt may have been achieved t h rough loans from rest of the world.
All loans a re fi nancial o b l igations to rest of the worl d .
4. CAD ( cu rre nt acco u nt deficit ) ca n b e ma naged t h rough i m port su bstitution . D o you agree?
Ans. It is true that CAD ca n be ma naged t h rough i m port su bstitutio n . I m port su bstitution i m plies that
domestic goods a re su bstituted for the i m ported goods. Exa m ple: We ca n cut i m ports by sh ifting
from a l l opathic d rugs to ayu rvedic d rugs. This wi l l help us save foreign excha nge. Accord i ngly, CAD
ca n be ma naged .
5 . H ow a re rem itta nces by N Rls helpfu l i n tackl ing BoP deficit?
Ans. Rem itta nces by N Rls a re reflected as recei pts of foreign excha nge in the ca pita l acco u nt. If these
recei pts shoot u p, then the Bo P deficit (excess of payment of foreign excha nge ove r and a bove the
recei pts of fo reign excha nge) is red uced . Th us, rem itta nces by NRls a re h e l pfu l i n tackl ing BoP d eficit.
6. Ca lcu late the va l u e of i m ports when the bala nce of trade ( merc h a n d ise ) is (-) � 1,000 crore a n d the
va lue of exports is � 500 crore .
Ans. Bala nce of Trad e = Va l u e of exports - Va l u e of i m ports
(-) � 1,000 crore = � 500 crore - Va l u e of i m ports
Va l u e of i m ports = � 500 crore + � 1,000 cro re
= � 1,500 crore
Va l u e of i m po rts = � 1,500 crore .

7. The bala nce of trade shows a surplus of � 10,000 crore a n d the i m port of merc h a n d ise is half of the
export of merchand ise. Find the va lue of exports.
Ans. S u p pose the va l u e of exports = X
Bala nce of trade = � 10,000 crore
1 1
I m port = of ( Export) = (X)
2 2
We know, Bala nce of Trad e = Export - I m port
1
= X - - (X)
2
X
10,000 = x-2
X
10,000 -
2
X = 20,000
Exports = � 20,000 crore.
8. Ca pita l account BoP shows a deficit of � 40,000, and exports of mercha n d ise = i m port of merc h a n d ise
= � 30,000. Find the state of bala nce of the cu rrent acco u nt BoP. G ive reason i n s u p port of you r
a n swe r.
Ans. The cu rrent acco u nt ba l a n ce of paym e nts shows a surplus of � 40,000. Beca use the ove ra l l balance
of payme nts a lways ba la nces a n d when there is d eficit i n the ca pita l accou nt, there s h o u l d be surplus
i n the current acco u nt of ba la nce of payments by the e q u a l a m o u nt.

9. "Slump in oil prices."
H ow w i l l this affect I n d ia's CAD?
Ans. I n d ia is a big i m porter of o i l . A fa l l in oil prices means that I n d i a wi l l be a b l e to save foreign excha nge
even when the q u a nt u m of i m port is not red uced . Acco rd i ngly, CAD w i l l be m a n aged . This w i l l h e l p
i n i m p rovi ng I nd ia's cu rrent accou nt deficit.
10. Indian Rupee has been depreciating in the recent times.
What effect wi l l it h ave on the CAD?
Ans. As a result of d e p reciation of the ru pee, foreign goods become expensive while domestic goods
become cheaper. This s h o u l d lead to a rise in exports and fa l l in i m ports . Accord i ngly, CAD should
i m p rove. But, if we a re i m porting certa i n essentia l raw mate ria ls (the i m ports of which ca n n ot be
low
cut) o u r i m port bill may swe l l with the increase i n excha nge rate . Accord i ngly, CAD may not i m p rove .
I n fact, it may d eteriorate fu rther.
11. What is 'cu rrent accou nt deficit' i n the bala nce of payments?
Ans. Cu rrent accou nt d eficit in BoP refers to the deficit occu rring on acco u nt of:
Trad e ba la nce
ee
+ Ba la nce on i nvis i bles ( = bala nce on factor i ncome + bala nce on non-factor i ncome + bala nce on
rF
Fr
tra nsfe rs ) .
12. H ow is B o P deficit or B o P surplus esti m ated ?
A n s . BoP deficit (or su rplus) is esti mated i n terms o f a n ove ra l l BoP ba l a n ce. It is fou n d out b y com b i n i ng
or
the ba la nce related to cu rrent acco u nt BoP a n d ca pita l acco u nt BoP. Also, errors a n d om issions
( i n d icati ng statistica l d iscrepancies) a re taken acco u nt of. Thus, the ove ra l l ba la nce (deficit or surplus)
sf
u
is esti mated by specifyi ng the fol l owing equati o n :
k
Overa l l Bala nce = Cu rrent acco u nt balance + Ca pita l acco u nt ba la nce + E rrors a n d o m issions
Yo
oo
I n case overa l l bala nce is fou n d to be positive, it is ca lled BoP surplus.
I n case it is fou n d to be negative, it is ca l led BoP deficit.
B
re

ou
ad
1. H ow would you a rgue for a n d aga i nst foreign i nvestment?

Ans. (A) Arguments aga i nst Foreign I nvestment:
Y
( i ) Foreign i nvestment leads to rise i n c l a i ms by the foreigners aga i n st assets i n the domestic
economy. I m p lying conce ntration of economic power with the foreign i nvestors in the domestic
nd
Re
economy.
( i i ) G reater the foreign i nvestme nt, l a rger is the flow of i nvestment i ncome ( profits, i nte rest a n d
Fi
d ividends) o u t o f the domestic economy. I m plying a constant d ra i n o f foreign excha nge o u t of

the cou ntry.
( B) Arguments i n favour of Foreign I nvestment:
( i ) Overa l l i nvestment i n the d omestic economy is expa nded, leading to a rise i n the l eve l of output
and e m p l oyment.
(ii) If d i rect foreign i nvestment is d i rected towa rds export-orie nted i n d u stry, exports wi l l rise.
I ncrease i n exports ca uses a rise i n AD. It is l i ke a n i njection i nto the circu l a r flow of i ncome.
(iii) FDI eases p ressu re o n t h e sca rce d o m est i c resou rces. Accord i ngly, d o m est i c resou rces ca n
be re leased fo r t h e p ro d u ct i o n of s u c h goods ( p u b l i c goods) w h e re private i nvest m e nt is
l ow.

2 . H ow is ca nce l l ation of coa l b locks a l location by the S u p reme Cou rt of I nd i a l i kely to affect ou r CAD
( cu rrent account deficit ) ?
Ans. Ca nce l l ation of coa l blocks a l location is l i kely to ca use a fa l l i n s u p ply of coa l, particu l a rly for the
p rod uction of el ectricity. Si nce coa l is the core i n put for the generation of power i n I n d ia, a cut in
domestic s u p p ly is bou nd to ca use a rise i n i m ports. Our i m port bill is bound to rise. A rise i n i m port
paym ents i m p l ies a rise i n CAD, other t h i ngs re m a i n i n g consta nt.
3 . H ow do we fi n a nce the deficit on cu rrent acco u nt BoP i n case officia l reserves with the R B I a re not
moved?
Ans. We a re l eft with two a lternatives o n ly:
( i ) We borrow fro m rest of the worl d .
( i i ) W e se l l o u r assets (fi n a ncial assets l i ke stocks a n d bonds, & p hysica l assets l i ke p l a nt a n d
mach i n e ry) t o rest o f the wo rld.

(With A n swers or Reference to the Text for Answers)
1. Where wi l l sa l e of mach i n e ry to a b road be record ed in the balance of paym e nts accou nts? G ive
reasons. [CBSE Delhi 2015]
[Sa le of mach i n e ry to a b road is accou nted u n d e r trade balance or cu rrent acco u nt BoP. Beca use
sa l e/pu rchase of mach i n e ry is a part of the m e rcha n d ise, and all merch a n d ise is recorded as a trade
bala nce i n the cu rre nt acco u nt BoP.]
2 . N a m e the b road categories of tra nsactions record ed i n the 'cu r rent accou nt' of the ba la nce of
paym ents accou nts. [CBSE Delhi 2015]
[Page 366, 367]
3 . N a m e the b road categories of tra nsactions recorded i n the 'ca pita l accou nt' of the bala nce of
paym ents accou nts. [CBSE Delhi 2015]
[Page 370, 371]
4. Where is 'borrowi ngs fro m a b road' record ed i n the balance of paym ents accou nts? G ive reasons.
[CBSE {A l) 2015]
['Borrowi ngs from a b road' is record ed i n the ca pita l accou nt of the bala nce of payme nts accou nts.
It is reflected i n the ca pita l accou nt, as it i m pacts the asset- l i a b i l ity status of a cou ntry. It does not
i nvolve m ovement of goods a n d services across the bord e rs. Also, borrowing is record ed with a
+sign i n the BoP accou nts. Th is is beca use it leads to the recei pt of foreign excha nge fro m rest of the
worl d . ]
5 . G iving reaso ns, exp l a i n where cha rity t o foreign cou ntries is record ed i n t h e bala nce o f payments
accou nts. [CBSE (F) 2015]
[Cha rity to foreign cou ntries is record ed u n d e r i nvis i bles cu rrent acco u nt BoP. Beca use cha rity to
foreign cou ntries is a part of the cu rrent tra nsfers, a n d a l l cu rrent tra nsfers a re recorded as a i nvis i b l e
bala nce i n the cu rre nt acco u nt BoP.]
6. G ive the mea n i ngs of bala nce of trade a n d bala nce on cu rrent acco u nt of bala nce of payments
accou nts. [CBSE (F) 2015]
[Page 369]
7. G ive the mea n i ngs of 'a utonomous' tra nsactions and 'acco m m odati ng' tra nsactions i n the ba l a n ce
of payments accou nts. [CBSE (F) 2015]
[Page 376]

8. Foreign excha nge tra nsactions dependent o n other foreign excha nge tra nsactions a re ca l l e d : (choose
the correct a lternative) [CB.SE Delhi 20161
(a) cu rrent acco u nt tra nsactions (b) ca pita l acco u nt tra nsactions
(c) a utonomous tra nsactions (d) accom modating tra nsactions
[(d)]
9. (a) In which su b-accou nt a n d on which side of bala nce of payme nts acco u nt wi l l foreign i nvestments
in I nd ia be recorded? G ive reasons.
(b) What will be the effect of foreign i nvestments i n I nd i a on excha nge rate? Exp l a i n .
[CBSE Delhf2016J
[(a) Foreign i nvestments i n I n d i a w i l l be reco rd ed i n the ca pita l acco u nt of the ba l a n ce of payments
low
accou nt. It is refl ected in the ca pita l accou nt, as it i m pacts the asset- l i a b i l ity status of a cou ntry. It
does not i nvolve m ove ment of goods and services across the borders . Also, foreign i nvestments
in I n d i a wi l l be recorded with a +sign (cred it side) in the BoP accou nt beca use it leads to the
recei pt of foreign excha nge from rest of the world.
(b) As a resu lt of fo reign i nvestme nts i n I n d ia, s u p ply of foreign cu rrency increases. Acco rd i ngly,
ee
s u p ply cu rve sh ifts to the right. This ca uses a fa l l i n eq u i l i b ri u m excha nge rate. N ow one US d o l l a r
rF
is ava i l a b l e for l ess I n d i a n ru pees. T h i s is a situation o f a p p reciation o f t h e domestic cu rrency.]
Fr
10. Foreign excha nge tra nsactions which a re i n d e pendent of other tra nsactions i n the bala nce of
paym ents acco u nt a re ca l l e d : (choose the correct a lternative) [CBS£ (Al) 2016]
or
(a) cu rrent tra nsactions (b) ca pita l tra nsactions
(c) a utonomous tra nsactions (d) accom modating tra nsactions
sf
u
[(c)]
11. I n d i a n i nvestors lend a b road . Answer the fol l owing q u estions:
k
Yo
oo
(a) I n which su b-accou nt a n d on which side of the ba la nce of payme nts accou nt such lend i ng is
record ed? G ive reasons.
B
(b) Expla i n the i m pact of this l e n d i ng on ma rket excha nge rate. [CBSE (Al) 2016]
re
[(a) ' I n d ia ns l e n d i ng to a b road' is reco rd ed i n the ca pita l acco u nt of the ba la nce of payments
accou nt. It is refl ected in the cap ita l accou nt, as it i m pacts the asset- l i a b i l ity status of a cou ntry.
ou
It d oes not i nvolve move ment of goods a n d services across the bord e rs. Also, l e n d i ng a b road is
ad
record ed with a -sign (debit side) i n the BoP acco u nt. Th is is beca use it leads to the paym e nt of
Y
foreign excha nge to rest of the world.

(b) As a resu lt of l e n d i ng to a b road, d e m a n d for foreign cu rrency increases. Accord ingly, d e m a n d
nd
Re
cu rve sh ifts t o the right. Th is causes a r i s e i n eq u i l i bri u m excha nge rate. N ow, more I n d i a n ru pees
a re to be paid for one U S d o l l a r. This is a situation of depreciation of the domestic cu rrency.]
Fi
12. Bala nce of payme nts 'deficit' is the excess of: (choose the correct a lternative) [CBSE (F) 2016]
(a) current acco u nt payme nts over cu rrent acco u nt recei pts
(b) ca pita l acco u nt payments over ca pita l accou nt recei pts
(c) autonomous payments over a utonomous recei pts
(d) acco m m odating paym ents over a acco m m odating recei pts
[(c)]
13. I n d i a n i nvestors borrow from a b road . Answe r the fol l owing:
(a) I n which su b-accou nt a n d on which side of the bala nce of payme nts acco u nt wi l l this borrowing
be record ed? G ive reaso n .
(b) Expla i n what is t h e i m pact o f t h i s borrowing on excha nge rate. [CBSE (F) 2016}

[(a) 'Borrowing from a b road' wi l l be reco rd ed i n the ca pita l acco u nt of the bala nce of payments
acco u nt. It is reflected in the ca pita l accou nt, as it i m pacts the asset- l i a b i l ity status of a cou ntry.
It d oes not i nvolve m ovement of goods a n d services across the borders. Also, borrowing from
a b road w i l l be record ed with a +sign (cred it side) i n the BoP accou nt. This is beca use it leads to
the recei pt of foreign excha nge from rest of the world .
( b ) As a resu lt o f borrowing from a b road, s u p ply o f foreign cu rrency i ncreases. Accord i ngly, s u p ply
cu rve s h ifts to the right. This ca uses a fa l l in eq u i l i br i u m excha nge rate. N ow one US d o l l a r is
ava i l a b l e for less I nd i a n ru pees. This is a situation of a p p reciation of dom estic cu rrency.]
14. G ive the mea n i ng of ba la nce of payments. [ CBSE Delhi 201 7}
[Page 365]
15. Disti nguish (a) between cu rrent acco u nt a n d ca pita l accou nt, a n d (b) between autonomous
tra n sactions a n d acco m modati ng tra nsactions of bala nce of payme nts acco u nt. [CBS£ (Al) 201 7]
[Page 376, 378]
16. What a re non-debt creating ca pita l recei pts? G ive two exa m ples of such receipts. [CBSE (Al) 2017]
[ N o n-debt creating ca pita l recei pts a re those recei pts which do not create debt.
Exa m p les: Recovery of loa ns, disi nvestment.
Recove ry of loans ( by the government) d oes not create a ny debt for the government. It o n ly clears
debt of the borrower. Li kewise, disi nvestment by the government leads to ca pita l recei pts without
ca using a ny d e bt b u rd e n . These recei pts a rise beca use of the l i q u idation (sale) of past i nvestments.]
17. What is mea nt by trade deficit? [CBSf (F) 2017]
[Trade d eficit occ u rs when : 'export of goods' < 'im port of goods'.]
18. Defi ne "Trad e S u rp l us". H ow is it d iffe rent from "Cu rrent Accou nt S u rp l us"? [CBSE 2019 (58/1/1)]
[Trade surplus occ u rs whe n : X > M (export of goods > i m port of goods).
Cu rrent acco u nt surplus occ u rs whe n : 'export of goods as we l l as of i nvis i b l es' > 'import of goods as
we l l as of i nvisi b l es'.]
19. Defi ne "Trad e Surpl us" a n d "Trade Deficit". [CBSE 2019 (58/2/1)]
[See Q. 17 & Q. 18, above]
20. What is mea nt by "cu rre nt acco u nt su rpl us"? [ CBSE 2019 (58/2/2))
[See Q. 18, above]
2 1 . Disti nguish between 'Trad e Deficit' a n d 'Cu rrent Accou nt Deficit'. [CBSE 2019 (58/2/3)]
[See Q. 17, above
Cu rrent acco u nt deficit occu rs whe n : 'export of goods as wel l as of i nvis i b l es' < 'import of goods as
we l l as of i nvisi b l es'.]
22. Defi ne autonomous tra n sactions i n ba la nce of payments of a n eco n omy. [CBSE 2D19 (58/3/1)]
[Page 376]
23. Defi ne acco m m odati ng tra n sactions i n bala nce of payme nts of a n econo my. [CBSE 2019 (58/3/1))
[Page 376]
24. "A cou ntry with trade d eficit ca n n ot have cu rrent acco u nt surplus i n its Ba l a n ce of Payme nts." Do you
agree with the given state ment? Discuss with reason. [CBSE 2019 (58/3/1))
[ N o . Surplus in cu rrent acco u nt ca n a rise when the deficit on trade acco u nt is l ess than the surplus
on acco u nt of i nvisi b l es. I n other words, when the s u r p l u s a rising out of the excess of export of
i nvis i b l es ove r the i m port of i nvisi bles is greater than the d eficit a rising out of the excess of i m ports
over exports, we wi l l have cu rrent acco u nt surplus.]
Balance ofPayments 391

25. State on which side of ca pita l accou nt/cu rrent accou nt wi l l the fol lowi ng tra nsactions be record ed
a n d why:
( i ) I nterest on loa n received from N e p a l .
( i i ) I m port o f mobile p h ones from C h i n a . [CBSE 2019 (58/4/1)]
[(i) I nterest on loa n received from N e p a l w i l l be record ed i n the cred it side of cu rrent acco u nt as it
ca uses i nfl ow of the foreign cu rrency to the home country.
( i i ) I m port of m o b i l e phones from C h i n a wi l l be record ed i n the debit side of cu rrent accou nt as it
ca uses outflow of the foreign cu rrency t h rough visi ble i m ports.]
26. Disti nguish between a utonomous and accom modating tra nsactions of bala nce of payments
accou nt. [CBSE 201 9 (58/4/1)]
low
[ Page 376]
27. State the mea n i ng of the fol lowing:
(i) Trad e surplus.
( i i ) Acco m m odating tra nsactions. [CBSE 2019 (58/5/1)]
[ Page 376; See Q. 18, a bove]
ee
rF
Fr
1. Diffe rentiate between ba la nce of trade a n d cu rrent acco u nt bala nce.
or
[ H i nt : Ba la nce of Trade = Export of mate ria l goods - I m port of mate ria l goods.
sf
u
Cu rrent Accou nt Bala nce = Trad e bala nce + Bala nce on acco u nt of i nvisi bles. I nvis i bles i n c l u d e factor
a n d non-factor services as wel l as cu rrent tra n sfe rs.]
k
Yo
2. What a re official reserve tra nsactions? Exp l a i n their i m po rta nce i n the ba la nce of payments.
oo
[ H i nt : Tra nsactions that ca use cha nges in the official rese rves of the centra l b a n k a re known as official
B
reserve tra nsactions.

re
When cu rrent acco u nt bala nce a n d ca pita l acco u nt ba la nce is n ot equal to ze ro (and the refo re,
BoP is not in a state of ba l a n ce), there a re official rese rves tra nsactions of the centra l bank. These
ou
tra nsactions act as acco m m odating items in the ba l a n ce of payments. These a re u nderta ke n with a
ad
view to correcti ng BoP i m ba l a nce.]

Y
7. M i scel la neous Questions a nd Reference to the Text for A n swers

nd
Re
A . Questions of 3 & 4 m a rks each

Fi
1. What is mea nt by ba la nce of payments? Name its co m ponents. [Page 365, 366]
2. What is meant by vis i b l e a n d i nvis i b l e items i n the balance of payments accou nt? G ive two exa m ples
of i nvis i b l e items. [Page 366, 367]
3. State the com po n e nts of the cu rrent acco u nt of ba l a n ce of paym ents accou nt. [Page 366, 367]
4. State the com po n e nts of the ca pita l acco u nt of ba la nce of payments accou nt. [Page 3 70, 3 71 ]
5. Disti nguish betwee n cu rrent acco u nt a n d ca pita l acco u nt o f bala nce o f payme nts accou nt. I n what
acco u nt wou l d ban king ca pita l be i n c l u d ed ? [Page 3 78]
6. State the d ifference between a utonomous a n d accom modating items of bala nce of payments
accou nt. [Page 3 76]

7. Bala nce of payme nts always bala nces. Exp l a i n . [Page 3 73, 3 74]
8. What is mea nt b y ba la nce o f payments d eficit? Expla i n . [Page 3 75, 388, Q. 12]
B. Questions of 6 marks each

1. What is balance of payments accou nt? N a m e th ree components each of its cu rrent acco u nt a n d
ca pita l accou nt.
Or
List th ree ite ms each of cu rrent accou nt and ca pita l acco u nt of the ba l a n ce of payme nts accou nt.
[Page 365-3 71 ]
2 . H ow is balance of trade d iffe rent from ba l a n ce of payme nts? State the items not i nc l u ded i n balance
of trade. [Page 369, 3 79]
3. Is i m p rovement in excha nge rate of the cou ntry's cu rrency always beneficia l for BoP?
[Hint: I m p rovement i n the excha nge rate of a cou ntry's cu rrency (say I n d i a n ru pee vis-a-vis US d o l l a r)
i m p l ies that less ru pees a re to be paid for a d o l l a r than before. It poi nts to the relative strength of the
I n d i a n ru pee i n the i nte rnational ma rket. H owever, for a d eveloping cou ntry l i ke India it is not always
desi red . It wou ld mean that one US d o l l a r now ca n buy l ess I n d i a n goods for a d o l l a r than before,
which m ight ca use a cut US d e m a n d for the I n d i a n goods. Accord i ngly, o u r exports may s l i d e d own,
a d d i ng to BoP deficit.]
4. Is rising rese rve of I n d i a's foreign excha nge a sign of rising p rod uction activity i n the economy?
[Hint: N ot necessari ly. Rese rves of foreign excha nge in I n d ia te nd to rise l a rgely on acco u nt
of bo rrowi ngs, F D I a n d F I i . As rega rds the rol e of borrowi ngs, prod uction activity is expected to
acce lerate o n ly if borrowi ngs a re not related to u n p roductive use ( i m p lying cons u m pti o n ) . F I i relates
to i nvestment in s h a res a n d bonds, a n d therefore, is not d i rectly related to prod uction activity. F D I of
cou rse is d i rectly re lated to prod uction activity. If foreign excha nge rese rves b u i l d up on accou nt of
FDI, prod uction activity is expected to accelerate .]
5 . H ow does bala nce of payments refl ect s u p p ly, d e m a n d status of foreign excha nge for a cou ntry?
[ Hint: U nfavo u ra b l e bala nce of payme nts status of a cou ntry shows o u r greater fi nancial obl igations
to rest of the world than o u r fi nancial claims aga i n st rest of the world. It a lso refl ects a situation of
l ow forex reserves of the cou ntry. Together these facts i m ply that: ( i ) ava i l a b i l ity of forex reserves is
l ow, a n d ( i i ) d e m a n d for forex rese rves is high. Th is pushes up d e m a n d for forex in the i nternational
ma rket. Accord i ngly, the p rice of 'forex' or the rate at which the cou ntry ca n buy foreign excha nge
tends to rise.]

DOs and DON'Ts
1. It m u st b e borne i n m i n d that, a s a m atter of convention, (i) a l l c u rrent tran sfers between a country a n d
rest of t h e worl d a re recorded a s i nv i s i bles i n the c u rrent account B o P, a n d ( i i ) a l l d i rect purchases by
n on-res ident tou ri sts in the d omestic economy a n d a l l d i rect p u rc h a ses by the res ident tou r i sts i n rest
of the world a re recorded as i nvisi bles i n the cu rrent accou nt BoP Thus, cha rity (g ra nts) to rest of the
world (or from rest of the world) i s to be recorded a s a component of i nvisib les i n the c u rrent accou nt
BoP.
2. Never lose s i g ht of the basic pri n c i p l e i n BoP accou nti n g th at. all recei pts of fore i g n exchange (by way
of i n comes, revenue, tran sfers or borrow i n g s) a re recorded a s pos itive (+) items, w h i l e a l l payments
low
of fo re i g n exc h a n g e a re record ed as negative (-) items. The b a l a nce i s esti m ated a s the d i fference
between rec e i pts (+ items) and payments (- items).
3. Export a n d i m port of g o o d s i n c l u d es a l l types of goods, whether the se a re consum e r goods ( l i ke b read
and butter) or cap ita l goods ( l i ke p l a nt a n d machinery) . B a l a n ce on accou nt of export and i m port of
goods i s ca l led Tra d e B a l a nce. I t i s a n el ement of c u rrent accou nt BoP Never consider the export and
i m port of capital goods (like pl ant and mach i nery) as an element of capital account BoP.
ee
4.
rF
Monetary transactions relating to capital account BoP do not involve the movement of goods and
Fr
services from one country to the other. These tra n sactions a ri se s i mply beca use (i) the ownersh i p
o f phys i c a l a s sets i s tra nsferred b y o n e cou ntry t o t h e other (w ithout mov i n g these assets fro m one
cou ntry to the other), (ii) the owners h i p of fi na n c i a l assets (stocks a n d bonds) i s tra n sferred by one
or
cou ntry to the other, ( i i i) fore i g n exc h a n g e i s tra n sferred from one cou ntry to the other by way of loa ns/
sf
borrow i n g s . Thus, goods do n ot move across the borders. On ly the foreign exchange moves from one
u
country to the other on account of change i n ownership of assets.
k
Yo
5. Remember that a n account i n g equ i l i b ri u m i n BoP does not necessarily poi nt to a g ood economic
oo
hea lth of a n econ omy. I t may em erge s i m ply beca use high CAD (cu rrent accou nt deficit) h a s been
tackled through high borrow i n g s from rest of the worl d . H i g h borrow i n g s (reflected a s recei pts of
B
foreign exchange in BoP accou nts) a re i n d eed a reflect ion of poor performance of the economy both
re
i n the domest i c a s w e l l a s g l obal m a rkets.

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• What Causes Disequi l i brium in BoP?

nd
Diseq u i l i bri u m in BoP is cau sed by a n u m ber of factors, b roadly categori sed
Re
as (i) econom i c factors, (i i) pol iti ca l factors, a n d (ii i) soc i al factors . Fol l owing
Fi
a re the deta i l s:
(i) Economic Factors
(a) H u ge development expend itu re by the govern ment owing to which there
are l a rge scale i m ports. It may cause a 'deficit BoP d i seq u i l i b ri u m'.
(b) Bu si n ess cyc les i n terms of recession, depression, recovery and boom. A
period of boom may witness l a rge scale exports of a cou ntry. Accord i ngly,
a 'surplus Bo P d i seq u i l ibrium' may occu r.
(c) H i g h rate of i n flation i n the domesti c market, compel l i n g l a rge scale
i m ports of essential good s. This causes 'deficit BoP d iseq u i l i briu m'.

(d) Development of i m port su bstitutes, beca use of which i m ports are reduced
and surp l u s BoP may emerge in place of deficit BoP.
(e) Change i n the cost structu re of tra d i n g partners, beca use of technolog ical
and ma nageri a l i n n ovations. Favourable change i n cost structure wou ld
encourage exports a n d lead to 'surp l u s BoP d iseq u i l i bri um'.
(ii) Political Factors
(a) Pol iti cal i nsta bi l ity owi n g to which i nflow of d i rect foreign i nvestment a n d
portfolio i n vestment from abroad m a y shrink. It causes deficit on capita l
accou nt BoP
(b) Popu l i sm po l i cies of the government l i ke h u ge cuts i n i m port duty. This
encourages i mports beca use of which cu rrent accou nt deficit may swe l l .
(iii) Social Factors
(a) Change i n tastes a n d preferences, owing to which pattern of demand (i n the
i nternational market) may change. A favourable change may encourage
exports, w h i l e an u nfavoura b l e shift may cause a rise in i m ports. A rise
i n exports leads to cu rrent account surplus. A rise in i m ports leads to a
current account deficit.
(b) Cross-border prej u d i ces, which someti mes force the cou ntries (l i ke, I n d i a
and Pa kista n) t o s h i ft t o expens ive sources o f i m ports a n d less profitable
areas of exports . Such s ituations often d rive a n economy towards the
state of deficit BoP d i seq u i l ibri u m .
• Balance of Payments (BoP) :
Accounting Sense and Operational Sense
Let us understa n d the concept of bala nce of payments in 'accou nti ng sense'
a n d 'operational sen se' throu gh the fol lowi n g i l l u stration. Ca refu l l y exa m i ne
the data given i n the fo l lowi ng table
Balance of Payments
I- Assets (Credits) t crore Lia bilities (Debits) t crore
·-
1. Export of goods 550 1 . I m po rt of goods 800
2. Export of services (banki ng, 150 2 . I mport of services (banking, so
shipping, insura nce, tourism, etc.) shipping, insurance, tourism, etc.)
3. Tra nsfe r payments fro m rest of 100 3. Tra nsfer payme nts to rest of 80
the world (gifts, aid, etc.) the world (gifts, aid, etc.)
4. Capita l receipts ( loans, sale of 200 4. Ca pita l payments (loans to 70
assets to fo reigners, recei pt of fore igners, buying of assets
capita l ) from foreigners, payment o f
ca pita l t o fo reigners)
Tota l Receipts 1,000�- Total Payments
- -
1,000
The a bove table shows that in the accounti ng sense bala nce of payments
bala nces, beca use total receipts (cred its) a re eq u a l to tota l payments (debits),
i. e., � 1 ,000 crore. But in the operational sense, the a n a lys i s of the table reveals
the fol lowing facts:

• Balance of Trade (the difference between the va l u e of tota l exports a n d i mports)
is negative.
Bala nce of Trade = Export of goods - I m port of goods
= < 550 crore - < 800 crore
= (-) < 250 crore
• Balance of Payments on Cu rrent Account shows a deficit of < 1 30 crore.

Bala nce of Payments on Cu rrent Accou nt
= Tra de Ba l a nce (Export of goods - I m port of goods) + I nvisi bles
Bala nce [Ba l a nce on non-factor services (ba nking, shipping,
low
etc .) + Bala nce on cu rrent tra nsfers]
= (< 550 crore - < 800 crore) + [(< 1 50 crore - < 50 crore)
+ (< 1 00 crore - < 80 crore)]

= (-) < 250 crore + < 1 00 crore + < 20 crore
= (-) < 1 30 crore
ee
• Balance of Payments on Capital Account shows a surp l u s of < 1 30 crore.
rF
Fr
Bala nce of Payments on Capital Accou nt
= Ca pita l Recei pts - Capital Payments
or
= < 200 crore - < 70 crore
= < 1 30 crore
sf
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• Overall Balance of Payments Balances (< 1 ,000 crore of recei pts = < 1 ,000 crore
k
of payments) beca use the surpl us bala nce of < 1 30 crore on capital accou nt
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compensates deficit ba lance of <1 30 crore on cu rrent accou nt.
• From where has the < 1 3 0 crore surplus on capital accou nt emerged?
B
I n fact < 1 30 crore may have been received through foreign loa n s . I n that case,
re
the surp l u s of capita l account act u a l ly refl ects our i n debted n ess, not a sound
fi n a ncial statu s.
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nd
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Fi

N U M E R I CA LS :
SO LV E D AN D U N SO LV E D
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B u
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NATIONAL INCOME AND RELATED AGGREGATES
Numericals related to Nominal GDP
1. If Real GDP is< 200 and price index (with base = 100) is 110, calculate Nominal GDP. [CBSE Delhi 2015]
Nominal GDP
Sol. Real GDP= x 100
Price Index
Real GDP x Price Index
Or, Nominal GDP=--------
100
200 X 110
= = 220
100
Ans. Nominal GDP = < 220.
2. If the Real GDP is< 500 and price index (base = 100) is 125, calculate the Nominal GDP.
[CBSE (Al) 2015]
Nominal GDP
Sol. Real GDP= x 100
Price Index
Nominal GDP
500 = X 100
!��
125
Nominal GDP= 500 x = 625
Ans. Nominal GDP = < 625.

3. If the Real Gross Domestic Product is< 250 and the price index (base = 100) is 120, calculate the
Nominal Gross Domestic Product. [CBSE (F) 2015]
Nominal GDP
Sol. Real GDP= X 100
Price Index
Real GDP x Price Index
Or, Nominal GDP=--------
100
250 X 120
= = 300
100
Ans. Nominal gross domestic product < 300.
=
4. Assuming real income to be< 200 crore and price index to be 135, calculate nominal income.
[CBSE (Al) 2016]
= Nominal Income
Sol. Real Income x 100
Price Index
399
. 11 ncome Real Income x Price Index
Or, Nomina =
100
200 X 135
= = 2 70
100
Ans. Nominal income = � 270 crore.
5. If real income is� 400 and price index is 105, calculate nominal income. [CBSE (Al) 2016]
Nominal Income
Sol. Real Income = x 100
Price Index
Real Income x Price Index
Or, Nominal Income = ---------
100
low
400 X 10 5
= = 4 20
100
Ans. Nominal income = � 420.
6. Given real income to be 400 and price index be 100, calculate nominal income. [CBSE (F) 2016]
Nominal Income
Sol. Real Income = x 10 0
ee
Price Index
rF
Real Income x Price Index
Fr
Or, Nominal Income = ---------
100
400 X 100
= 400
or
=
100
Ans. Nominal income = 400 .
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Numericals related to Real GDP
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7. If the Nominal GDP is t 1,200 and price index (with base = 100) is 120, calculate Real GDP.
[CBSE Delhi 2015]
B
Nominal GDP
Sol. Real GDP = x 100
re
Price Index
1, 200
= X 100 = 1 000
ou
12 0
ad
Ans. Real GDP=� 1,00 0.

Y
8. If the Nominal GDP is 600 and price index (base= 100) is 120, calculate the Real GDP. [CBSE (Al) 2015]
Nominal GDP
nd

Re
Price Index
600 X
100 = 5 00
Fi
=
12 0
Ans. Real GDP = 500.
9. If the Nominal Gross Domestic Product = � 4,400 and the price index (base = 100) = 110, calculate
the Real Gross Domestic Product. [CBSE (F) 2015]
Nominal GDP
Price Index
4 , 400 X 100 = 4 000
=
110
Ans. Real gross domestic product=� 4 , 000 .

10. If nominal income is< 500 and price index is 125, calculate real income. [CBSE (Al) 2016]
Nominal Income
Price Index
500
= X 100= 400
12 5
Ans. Real income = < 400.
11. Given nominal income to be< 375 and price index 125, calculate real income. [CBSE (F) 2016]
_ Nominal Income
S0 I · Rea 11 ncome - x 100
Price Index
375
= X 100= 300
12 5
12. If nominal income is< 600 and price index is 100, find real income. [CBSE (F) 2016]
Nominal Income
Price Index
600
= X 100= 600
100
Numericals related to Price Index

13. If the Real GDP is< 300 and Nominal GDP is< 330, calculate price index (base = 100).
[CBSE Delhi 2015]
Nominal GDP
Sol. Real GDP =----- x 100
Price Index
Nominal GDP
Or, Price Index =----- x 100
Real GDP
330
= X 100= 110
300
Ans. Price index = 110.
14. If the Real GDP is< 400 and Nominal GDP is< 450, calculate the price index (base = 100).
[CBSE (Al) 2015]
Nominal GDP
Price Index
450
400 = X 100
Price Index
. 450
Price Index = x 100 = 112 . 5
400
Ans. Price index = 112.5.
15. If the Real Gross Domestic Product is < 200 and the Nominal Gross Domestic Product is < 2 10,
calculate the price index (base = 100). [CBSE (F) 2015]
Nominal GDP
Sol. Real GDP = X 100
Price Index
Nominal GDP
Or, Price Index = x 100
Real GDP
2 10
= X 100= 105
200
Ans. Price index = 105 .
Solved Numericals 401

METHODS OF CALCULATING NATIONAL INCOME
Numericals related to Value Added/Product Method
1. Calculate Value Added by firm A and firm B, given the following information:
Items (< in lakh)
(i) Purchases by firm A from abroad 60
(ii) Sales by firm B 180
(iii) Purchases by firm A from firm B 100
(iv) Domestic sales by firm A 220
(v) Exports by firm A 60
low
(vi) Excess of opening stock over closing stock of firm A 20
(vii) Excess of closing stock over opening stock of firm B 30
(viii) Purchases by firm B from firm A 100
Sol. Value Added by Firm A
= Domestic sales+ Exports - Excess of opening stock over closing stock - Purchases from firm B
ee
- Purchases from abroad
rF
Fr
= < 220 lakh+ < 60 lakh-< 20 lakh-< 100 lakh-< 60 lakh
= < 100 lakh
Value Added by Firm B
or
= Sales+ Excess of closing stock over opening stock- Purchases from firm A
sf
u
= < 180 lakh+ < 30 lakh-< 100 lakh
= < 110 lakh
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Ans. Value added by firm A=< 100 lakh.
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Value added by firm B = < 110 lakh.
B
2. Find Gross Value Added by firm A, given the following information:

Items (< )
re
(i) Purchase of factor inputs by firm A 5,00,000

(ii) Purchase of non-factor inputs by firm A 2,00,000
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ad
(iii) Sales by firm A to other firms in the domestic economy 10,00,000

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(iv) Import of raw material by firm A from rest of the world 50,000
(v) Excess of its opening stock over closing stock 1,00,000
nd
Sol. Gross Value Added by Firm A

Re
= Sales by firm A- Purchase of non-factor inputs- Excess of opening stock over closing stock
Fi
= < 10, 00,000-< 2, 00,000-< 1, 00,000

= < 7, 00,000
Ans. Gross value added by firm A=< 7, 00,000.
[Note: It is assumed that purchases of non-factor inputs include purchases from the domestic market
as well as from abroad.]
3. Calculate 'Value of Output' from the following data:
Items (< in lakh)
(i) Net value added at factor cost 100
(ii) Intermediate consumption 75
(iii) Excise duty 20

(iv) Subsidy s
(v) Depreciation 10
Sol. Net Value Added at Factor Cost
= Value of output- Intermediate consumption - Depreciation- Excise duty+ Subsidy
Or, Value of Output
= Net value added at factor cost+ Intermediate consumption+ Depreciation+ Excise duty- Subsidy
= < 100 lakh+ < 75 lakh+ < 10 lakh+ < 20 lakh- < 5 lakh
= < 2 00 lakh
Ans. Value of output = < 200 lakh.
4. Calculate 'Intermediate Consumption' from the following data:
Items (< in lakh)
(i) Value of output 200
(ii) Net value add ed at factor cost 80
(iii) Sales tax 15
(iv) Subsidy s
(v) Depreciation 20
= Value of output- Intermediate consumption - Depreciation - Indirect tax+ Subsidy
Or, Intermediate Consumption
= Value of output- Net value added at factor cost- Depreciation - Indirect tax+ Subsidy
= < 2 00 lakh-< 80 lakh-< 20 lakh-< 15 lakh+ < 5 lakh
= < 90 lakh
Ans. Intermediate consumption = < 90 lakh.
5. Calculate 'Sales' from the following data:
Items (< in lakh)
(ii) Intermediate consumption 200
(iii) Indirect tax 20
(iv) Depreciation 30
(v) Change in stocks (-) so
= Sales+ Change in stocks- Intermediate consumption- Depreciation - Indirect tax
Or, Sales= Netvalueadded at factor cost-Change in stocks+ Intermediate consumption+ Depreciation
+ Indirect taxes
= < 300 lakh- (-) < SO lakh+ < 200 lakh+ < 30 lakh+ < 20 lakh
= < 300 lakh+ < SO lakh + < 2 00 lakh+ < 30 lakh+ < 20 lakh
= < 600 lakh
Ans. Sales = < 600 lakh.
6. From the following data, calculate 'Gross Value Added at Factor Cost':
Items (< in crore)
(i) Sales 8,000
(ii) Change in stock 100

(iii) Subsidies 200
(iv) Consumption of fixed capital 300
(v) Intermediate consumption 5 ,500
(vi) Rent 500
Sol. Gross Value Added at Factor Cost
= Sales+ Change in stock- Intermediate consumption + Subsidies
= < 8, 000 crore+ < 100 crore-< 5 , 5 00 crore+ < 200 crore
= < 2,800 crore
Ans. Gross value added at factor cost= < 2 ,800 crore.
7. Calculate 'Sales' f rom the following data:
low
Items (< in lakh)
(i) Intermediate costs 700
(ii) Consumption offixed capital 80
(iii) Change in stock (-) 50
ee
(iv) Subsidy 60
(v) Net value added at factor cost
rF 1,300
Fr
(vi) Exports 50
or
= Sales+ Change in stock- Intermediate costs- Consumption of fixed capital + Subsidy
Or, Sales
sf
u
= Net value added at factor cost - Change in stock+ Intermediate costs+ Consumption of fixed
k
capital - Subsidy
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= < 1, 300 lakh- (- ) < 50 lakh+ < 700 lakh+ < 80 lakh-< 60 lakh
= < 1, 300 lakh+ < 50 lakh+ < 700 lakh+ < 80 lakh-< 60 lakh
B
= < 2 , 070 lakh

re
Ans. Sales= < 2,070 lakh.

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Items (< in lakh)

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(ii) Sales 600
nd
(iii) Indirect tax 20

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Fi
(v) Change in stock (-) 50

= Sales+ Change in stock- Intermediate consumption - Depreciation- Indirect tax
Or, Intermediate Consumption
= Sales - Net value added at factor cost+ Change in stock- Depreciation - Indirect tax
= < 600 lakh-< 300 lakh+ (- ) < 50 lakh -< 30 lakh -< 20 lakh
= < 600 lakh-< 300 lakh-< 50 lakh-< 30 lakh-< 20 lakh
= < 2 00 lakh
Ans. Intermediate consumption= < 2 00 lakh.

9. From the following data, find 'Net Value Added at Market Price':
Items
(i) Output sold (units) 700
(ii) Price per unit of output (�) 15
(iii) Goods and Service tax (�) 1,200
(iv) Import duty (�) 500
(v) Net change in stocks (�) (-) 800
(vi) Depreciation (�) 500
(vii) Intermediate consumption (�) 6,200
Sol. Net Value Added at Market Price
= Sales ( Output sold x Price per unit of output )+ Net change in stocks - Intermediate consumption
- Depreciation
= ( 7 QQ X � 15 ) + (-) � 8QQ- � 6,2QQ- � SQQ
= � 10,500- � 800- � 6,200- � 500
= � 3,000
Ans. Net value added at market price = � 3,000.
10. From the following data, find 'Change in Stock':
Items (� in lakh)
(i) Intermediate consumption 10,000
(ii) Net value added at factor cost 17 ,600
(iii) Sales 30,000
(iv) Net indirect taxes 400
(v) Import duty 1,000
(vi) Consumption affixed capital 3,000
= Sales + Change in stock - Intermediate consumption - Consumption of fixed capital - Net
indirect taxes
Or, Change in Stock
= Net value added at factor cost - Sales + Intermediate consumption + Consumption of fixed
capital + Net indirect taxes
= � 17 ,600 lakh - � 30,000 lakh + � 10,000 lakh + � 3,000 lakh + � 400 lakh
= � 1,000 lakh
Ans. Change in stock = � 1,000 lakh.
11. Find 'Net Value Added at Factor Cost':
Items (� in lakh)
(i) Sales 100
(ii) Closing stock 20
(iii) Excise 15
(iv) Opening stock 10
(v) Depreciation 12
(vi) Intermediate consumption so
[CBSE Sample Paper 2013]

*Sol. Net Value Added at Factor Cost
= Sales+ Closing stock- Opening stock- Intermediate consumption- Depreciation - Excise
= � 100 lakh+� 20 lakh-� 10 lakh-� SO lakh-� 12 lakh-� 15 lakh
= � 33 lakh
Ans. Net value added at factor cost=� 33 lakh.
* Item (vi) ( in the answer) seems to be missing from the CBSE question. It is 'intermediate consumption
= � SO lakh' .
12. Find Net Value Added at Factor Cost:
Items (� in lakh)
( i) Durable use producer goods with a life span of 10 years 10
low
(ii) Single use producer goods s
(iii) Sales 20
(iv) Unsold output produced during the year 2
(v) Taxes on production 1
[CBSE Delhi 2016]
ee
rF
Fr
= Sales+ Change in stock- Single use producer goods- Depreciation - Taxes on production
= � 2 0 lakh +� 2 lakh-� 5 lakh-� 1 lakh-� 1 lakh
or
= � 15 lakh
Ans. Net value added at factor cost=� 15 lakh.
sf
u
Value of durable use producer goods _
. ti. on= ------------ �_l_O_l_ak_h_ ""
[Note: Annua I Deprec1a -= = , l lakh.]
Life span of producer goods 10
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13. Find Net Value Added at Market Price:
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Items (� in lakh)
B
(i) Fixed capital good with a life span of 5 years 15

(ii) Raw materials 6
re
(iii) Sales 25
(iv) Net change in stock (-) 2
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ad
(v) Taxes on production 1

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[CBSE Delhi 2016]

Sol. Net Value Added at Market Price
nd
Re
= Sales+ Net change in stock- Raw materials - Depreciation

= � 2 5 lakh + (- ) � 2 lakh-� 6 lakh-� 3 lakh
Fi
= � 25 lakh-� 2 lakh-� 6 lakh-� 3 lakh

= � 14 lakh
Ans. Net value added at market price=� 14 lakh.
value of fixed capital goods � 15 lakh
[Note: Annual Depreciation= _ =� 3 lakh.J
Life span of fixed capital goods s
14. Find Gross Value Added at Market P rice:
Items (� in lakh)
(i) Depreciation 20
(ii) Domestic sales 200
( iii) Net change in stocks (-) 10

(iv) Exports 10
(v) Single use producer goods 120
[CBSE Delhi 2016]
Sol. Gross Value Added at Market Price
= Domestic sales+ Net change in stocks- Single use producer goods+ Exports
= < 2 00 lakh + (- ) < 10 lakh-< 120 lakh + < 10 lakh
= < 2 00 lakh-< 10 lakh-< 120 lakh + < 10 lakh
= < 80 lakh
Ans. Gross value added at market price = < 80 lakh.
15. In an economy, following transactions took place. Calculate Val ue of Output and Value Added by
firm B:
(i) Firm A sold to firm B goods of < 80 crore; to firm C < 50 crore; to household < 30 crore and
goods of value< 10 crore remains unsold .
(ii) Firm B sold to firm C goods of < 70 crore; to fi rm D < 40 crore; goods of value< 30 crore were
exported and goods of value < 5 crore was sold to government. [CBSE Sample Paper 2019]
Sol. Value of Output of Firm B Sales to firm C+ Sales to firm D+ Exports+ Sales to the government
=
= < 70 crore+ < 40 crore+ < 30 crore+ < 5 crore
= < 145 crore
Value Added by Firm B Value of output of firm B - Purchases from firm A

=
= < 145 crore-< 80 crore = < 65 crore
Ans. Value of output of firm B = < 145 crore.

Value added by firm B = < 65 crore.
Numericals related to Income Method

16. From the following data, calculate 'National Income':
Items (< in crore)
(i) Compensation of employees 800
(ii) Rent 200
(iii) Wages and salaries 750
(iv) Net exports (-) 30
(v) Net factor income from abroad (-) 20
(vi) Profit 300
(vii) Interest 100
(viii) Depreciation so
(ix) Remittances from abroad 80
(x) Taxes on profits 60
Sol. National Income ( NNP Fcl
= Compensation of employees+ Rent+ Profit+ Interest+ Net factor income from abroad [Income
Method]
= < 800 crore+ < 200 crore+ < 300 crore+ < 100 crore+ (- ) < 20 crore
= < 800 crore+ < 200 crore+ < 300 crore+ < 100 crore- < 20 crore
= < 1, 380 crore
Ans. National income = < 1, 380 crore.

17. Calculate 'Net Domestic Product at Factor Cost' from the following:
Items (� in crore)
(i) Dividends 100
(ii) Contribution to social security schemes by employers 200
(iii) Undistributed profits 20
(iv) Rent 100
(v) Interest paid by the production units 130
(vi) Corporation tax 50
(vii) Wages and salaries 1, 000
(viii) Net factor income from abroad 10
low
Sol. Net Domestic Product at Factor Cost ( NDP F cl
= Wages and salaries + Contribution to social security schemes by employers + Rent + Interest
+ Dividends+ Undistributed profits+ Corporation tax
= � 1, 000 crore+ � 200 crore+ � 100 crore+ � 130 crore+ � 100 crore+ � 20 crore+ � 50 crore
= � 1, 600 crore
ee
Ans. Net domestic product at factor cost= � 1, 600 crore.
rF
18. Find 'Wages and Salaries' from the following data:
Fr
(i) Royalty 50
or
(ii) Rent 100
(iii) Interest 400
sf
u
(iv) Net indirect tax 70
k
(v) Net national product at market price 1, 700
Yo
oo
(vi) Profit 300
(vii) Net factor income to abroad (-) 20
B
(viii) Consumption of fi xed capital 120

re
(ix) Social security contribution by employers 60

(x) Social security contribution by employees 40
ou
ad
Sol. Net National Product at Market Price

= Wages and salaries + Social security contribution by employers + Rent + Royalty + Interest
Y
+ Profit+ Net indirect tax- Net factor income to abroad

Or, Wages and Salaries
nd
Re
= Net national product at market price- Social security contribution by employers- Rent- Royalty
- Interest- Profit- Net indirect tax+ Net factor income to abroad
Fi
= � 1, 700 crore- � 60 crore- � 100 crore - � 50 crore- � 400 crore- � 300 crore- � 70 crore
+ (-) � 20 crore
= � 1, 700 crore- � 60 crore - � 100 crore - � 50 crore- � 400 crore - � 300 crore- � 70 crore
- � 2 0 crore
= � 700 crore
Ans. Wages and salaries = � 700 crore.
19. From the following data, calculate 'Operating Surplus' :
(i) Net indirect tax 300
(ii) Gross domestic product at market price 3, 120

(iii) Employees contribution to social security schemes 200
(iv) Compensation of employees 1,600
(v) Rent 2 00
(vi) Interest 150
(vii) Net factor income from abroad (-) 20
(viii) Depreciation 200
Sol. Gross domestic product at market price
= Compensation of employees+ Operating surplus+ Depreciation + Net indirect tax
Or, Operating Surplus
Gross domestic product at market price- Compensation of employees- Depreciation- Net
indirect tax
t 3, 120 crore- t 1, 600 crore- t 2 00 crore - t 300 crore
t 1, 020 crore
Ans. Operati ng surplus = t 1, 020 crore.
20. Calculate 'National Income' from the following data:
(i) Net exports (-) 300
(ii) Compensation of employees 6, 000
(iii) Rent 400
(iv) Dividend 200
(v) Consumption of fixed capital 300
(vi) Change in stock 50
(vii) Profits 800
(viii) Net factor income to abroad (-) 80
(ix) Net indirect taxes 600
(x) Interest 500
Sol. National Income
= Compensation of employees+ Rent+ Interest+ Profits - Net factor income to abroad
= � 6, 000 crore+ � 400 crore+ � 500 crore+ � 800 crore- (-) � 80 crore
= � 6, 000 crore+ � 400 crore+ � 500 crore+ � 800 crore + � 80 crore
= � 7,780 crore
Ans. National income = � 7,780 crore.
21. From the following data, calculate 'Mixed Income of Self-employed':
(i) Profit 500
(ii) Rent 200
(iii) Consumption of fixed capital 100
(iv) Com pensation of em ployees 1,000
(v) National income 2,700
(vi) Corporation tax 200
{vii) Net retained earnings of private enterprises 150
(viii) Net factor income from abroad (-) 50
(ix) Interest 250
(x) Net indirect taxes 160

= Compensation of employees+ Operating surplus ( Rent+ Interest+ Profit) + Mixed income of
self-employed+ Net factor income from abroad
Or, Mixed Income of Self-employed
= National Income- Compensation of employees- Operating surplus ( Profit+ Rent+ Interest)
- Net factor income from abroad
= � 2,700 crore- � 1,000 crore- (� 200 crore+ � 250 crore+ � 500 crore) - (- ) � 50 crore
= � 2,700 crore- � 1,000 crore- � 950 crore+ � 50 crore
= � 800 crore
Ans. Mixed income of self-employed = � 800 crore.
low
22. Calculate 'Gross National Product at Market P rice' :
(i) Rent 100
(ii) Net current transfers to rest of the world 30
(iii) Social security contributions by employers 47
ee
(iv) Mixed income 600
(v) Gross domestic capital formation
rF 140
Fr
(vi) Royalty 20
(vii) Interest 110
or
(viii) Compensation of employees 500
(ix) Net domestic capital formation 120
sf
u
(x) Net factor income from abroad (-) 10
(xi) Net indirect tax 150
k
Yo
oo
(xii) Profit 2 00
[CBSE Delhi 2015]
B
Sol. Gross National Product at Market Price

re
= Compensation of employees+ Rent+ Royalty+ Interest+ Profit+ Mixed income+ Consumption

of fixed capital ( Gross domestic capital formation - Net domestic capital formation) + Net
indirect tax+ Net factor income from abroad
ou
ad
= � 500 crore+ � 100 crore+ � 20 crore+ � 110 crore+ � 200 crore+ � 600 crore+ (� 140 crore
Y
- � 120 crore) + � 150 crore+ (- ) � 10 crore

= � 500 crore + � 100 crore + � 20 crore + � 110 crore + � 2 00 crore + � 600 crore + � 20 crore
nd
+ � 150 crore- � 10 crore

Re
= � 1, 690 crore
Fi
Ans. Gross national product at market price= � 1,690 crore.

23. Calculate the 'National Income' :
(i) Rent 200
(ii) Net factor income to abroad 10
(iii) National debt interest 15
(iv) Wages and salaries 700
(v) Current transfers from government 10
(vi) Undistributed profits 20
(vii) Corporation tax 30
(viii) Interest 150
(ix) Social security contributions by employers 100
(x) Net domestic product accruing to government 250
(xi) Net current transfers to rest of the world 5
(xii) Dividend 50
[CBSE (Al) 2015]
= Wages and salaries+ Social security contributions by employers+ Rent+ Interest+ Undistributed
profits+ Corporation tax+ Dividend- Net factor income to abroad
= < 700 crore+ < 100 crore+ < 2 00 crore + < 150 crore+ < 20 crore+ < 30 crore+ < 50 crore
-< 10 crore
= < 1,240 crore
Ans. National income = < 1,240 crore.
24. Calculate the Gross National Product at Market P rice:
Items (< in crore)
(i) Wages and salaries 800
(ii) Personal tax 150
(iii) Operating surplus 200
(iv) Undistributed profits 10
(v) Social security contributions by employers 100
(vi) Corporate tax 50
(viii) Personal disposable income 1,200
(ix) Net indirect tax 70
(x) Consumption of fixed capital 30
(xi) Mixed income of self-employed 500
(xii) Royalty 9
[CBSE (F) 2015]
= Wages and salaries + Social security contributions by employers + Operating surplus + Mixed
income of self-employed + Consumption of fixed capital + Net indirect tax - Net factor income
to abroad
= < 800 crore+ < 100 crore+ < 2 00 crore+ < 500 crore+ < 30 crore+ < 70 crore- (- ) < 20 crore
= < 800 crore+ < 100 crore+ < 2 00 crore+ < 500 crore+ < 30 crore+ < 70 crore + < 20 crore
= < 1,720 crore
Ans. Gross national product at market price = < 1,720 crore.
25. Calculate Net National Product at Market Price:
Items (< in crore)
(i) Net factor income to abroad (-) 10
(ii) Net current transfers to abroad 5
(iv) Compensation of employees 700
(v) Corporate tax 30

(vii) Interest 90
(viii) Rent 100
(ix) Dividends 20
(x) Net indirect tax 110
(xi) Social security contributions by employees 11
[CBSE {F) 2015]
= Compensation of employees+ Rent+ Interest+ Corporate tax+ Undistributed profits+ Dividends
+ Net indirect tax - Net factor income to abroad
= � 700 crore+� 100 crore+� 90 crore+� 30 crore+� 10 crore+� 20 crore+ � 110 crore- (- )� 10
low
crore
= � 700 crore + � 100 crore + � 90 crore + � 30 crore + � 10 crore + � 2 0 crore + � 110 crore
+� 10 crore
= � 1, 070 crore
Ans. Net national product at market price = � 1,070 crore.
ee
2 6. Find National Income:
rF
Fr
(i) Wages and salaries 1,000
or
(iii) Net factor income paid to abroad 10
(iv) Profit
sf 400
u
(v) National debt interest 120
k
(vi) Social security contributions by employers 100
Yo
oo
(vii) Current transfers from government 60
(viii) National income accruing to government 150
B
(ix) Rent 2 00
re
(x) Interest 300

(xi) Royalty 50
ou
ad
[CBSE Delhi 2016]

Y
= Wages and salaries+ Social security contributions by employers+ Rent+ Royalty+ Interest+ Profit
- Net factor income paid to abroad
nd
Re
= � 1, 000 crore+� 100 crore+� 200 crore+� 50 crore+� 300 crore+� 400 crore-� 10 crore
= � 2 , 040 crore
Fi

2 7. Find Net Domestic Product at Factor Cost:
(i) Rent 2 00
(iii) National debt interest 60
(iv) Corporate tax 100
(v) Compensation of employees 900
(vi) Current transfers by government 150
(vii) Interest 400
(viii) Undistributed profits 50
(ix) Dividend 250
(x) Net factor income to abroad (-) 10
(xi) Income accruing to government 120
[CBSE Delhi 2016]
Sol. Net Domestic Product at Factor Cost
= Compensation of employees+ Rent+ Interest+ Cor porate tax+ Undistributed profits+ Dividend
= � 900 crore +� 2 00 crore +� 400 crore +� 100 crore +� 50 crore+� 250 crore
= � 1,900 crore
Ans. Net domestic product at factor cost= � 1,900 crore.
28. Find Net National Product at Market Price:
(i) Personal taxes 2 00
(ii) Wage and salaries 1,200
(iii) Undistributed profit 50
(iv) Rent 300
(v) Corporation tax 2 00
(vi) Private income 2 ,000
(vii) Interest 400
(viii) Net indirect tax 300
(ix) Net factor income to abroad 20
(x) Profit 500
(xi) Social security contributions by employers 250
[CBSE Delhi 2016]
= Wages and salaries+ Social security contributions by employers+ Rent+ Interest+ Profit+ Net
indirect tax - Net factor income to abroad
= � 1,200 crore+� 250 crore+� 300 crore+� 400 crore+� 500 crore+� 300 crore-� 20 crore
= � 2 ,930 crore
Ans. Net national product at market price=� 2 ,930 crore.
29. Calculate National Income:
(i) Com pensation of em ployees 2 ,000
(ii) Rent 400
(iii) Profit 900
(iv) Dividend 100
(v) Interest 500
(vi) Mixed income of self-employed 7,000
(vii) Net factor income to abroad 50
(viii) Net exports 60
(x) Depreciation 150
(xi) Net current transfers to abroad 30
[CBSE (Al} 201 7]
Solved Numericals 41 3
= Compensation of employees + Rent+ Interest + Profit + Mixed income of self-employed - Net
factor income to abroad
= < 2,000 crore+ < 400 crore+ < 500 crore+ < 900 crore+ < 7,000 crore-< 50 crore
= < 10,750 crore
30. Calculate the Net National Product at Market Price:
Items (< in crore)
(i) Mixed income of self-em ployed 8,000
(ii) Depreciation 200
low
(iii) Profit 1,000
(iv) Rent 600
(v) Interest 700
(vi) Com pensation of em ployees 3,000
(vii) Net indirect taxes 500
ee
(viii) Net factor income to abroad 60
rF
Fr
(ix) Net exports (-) 50
(x) Net current transfers to abroad 20
or
[CBSE (Al) 201 7]
sf
u
= Compensation of employees + Rent+ Interest + Profit + Mixed income of self-employed + Net
indirect taxes - Net factor income to abroad
k
Yo
= < 3,000 crore + < 600 crore + < 700 crore + < 1,000 crore + < 8,000 crore + < 500 crore
oo
-< 60 crore
B
= < 13,740 crore

Ans. Net national product at market price = < 13,740 crore.
re
31. Calculate the Gross National Product at Market P rice:

ou
Items (< in crore)

ad
(i) Com pensation of em ployees 2,500

Y
(ii) Profit 700

(iii) Mixed income of self-em ployed 7 ,500
nd
Re
(iv) Government final consumption expenditure 3,000

(v) Rent 400
Fi
(vi) Interest 350

(vii) Net factor income from abroad 50
(viii) Net current transfers to abroad 100
(x) Depreciation 70
(xi) Net exports 40
[CBSE (Al} 201 7]
= Compensation of employees + Rent + Interest + Profit + Mixed income of self-employed
+ Depreciation + Net indirect taxes+ Net factor income from abroad

= < 2 , 500 crore+< 400 crore+< 350 crore+< 700 crore+< 7, 500 crore+< 70 crore+< 150 crore
+ < 50 crore
= < 11,720 crore
Ans. Gross national product at market price = < 1 1 ,720 crore.

Items (< in crore)
(i) Profit 1,000
(ii) Mixed income of self-employed 15 ,000
(iii) Dividends 200
(iv) Interest 400
(v) Compensation of employees 7 ,000
(vi) Net factor income to abroad 100
(vii) Consumption of fixed capital 400
(viii) Net exports (-) 200
(x) Net current transfers to rest of the world 40
(xi) Rent 500
[CBSE {F) 201 7]

= < 7,000 crore+ < 500 crore+ < 400 crore+ < 1,000 crore+ < 15,000 crore-< 100 crore
= < 2 3,800 crore

Items (< in thousand crore)
(ii) Mixed income of self-employed 600
(iii) Profit 80
(iv) Rent 30
(v) Interest 40
(vi) Net factor income to abroad (-) 10
(vii) Net exports 15
(viii) Consumption of fixed capital 20
(x) Net current transfers to abroad 8
[CBSE (F) 201 7]
factor income to abroad + Net indirect taxes

= < 250 thousand crore + < 30 thousand crore + < 40 thousand crore + < 80 thousand crore
+ < 600 thousand crore- H < 10 thousand crore+ < 10 thousand crore
= < 250 thousand crore + < 30 thousand crore + < 40 thousand crore + < 80 thousand crore
+ < 600 thousand crore+ < 10 thousand crore+ < 10 thousand crore
= < 1,020 thousand crore
Ans. Net national product at market price = < 1,020 thousand crore.
Items (< in crore)
(i) Compensation of employees 2,000
(ii) Profit 800
( iii) Rent 300
(iv) Interest 250
(v) Mixed income of self-employed 7,000
(vi) Net current transfers to abroad 200
(vii) Net exports H 100
( viii) Net indirect taxes 1,500
low
(ix) Net factor income to abroad 60
[CBSE {F) 201 7]
ee
rF
= < 2 , 000 crore+ < 300 crore+ < 2 5 0 crore+ < 800 crore+ < 7 , 000 crore-< 60 crore
Fr
= < 10,290 crore
or
35. Calculate ( a) Operating Surplus, and ( b) Domestic Income:
sf
u
Items (< in crore)
(i) Compensation of employees 2, 000
k
Yo
(ii) Rent and interest 800
oo
(iii) Indirect taxes 120
B
( iv) Corporation tax 460

re
(vi) Subsidies 20
(vii) Dividend 940
ou
ad
( viii) Undistributed profits 300

Y
( ix) Net factor income to abroad 150

(x) Mixed income 200
nd
Re
[CBSE 201 8]
Sol. (a) Operating Surplus
Fi
= Rent and Interest+ Undistributed profits+ Corporation tax+ Dividend
= < 800 crore + < 300 crore + < 460 crore + < 940 crore
= < 2 , 5 00 crore
( b) Domestic Income
= Compensation of employees+ Operating surplus+ Mixed income
= < 2, 000 crore+ < 2 , 5 00 crore + < 2 00 crore
= < 4,700 crore
Ans. (a) Operating surplus = < 2 , 5 00 crore.

( b) Domestic income = < 4,700 crore.
36. Calculate the value of "Rent" from the following data:
Items (t in crore)
(i) Gross domestic product at market price 18,000
(ii) Mixed income of self-employed 7,000
(iii) Subsidies 250
(iv) Interest 800
(v) Rent ?
(vi) Profit 975
(vii) Compensation of employees 6,000
(viii) Consumption of fixed capital 1,000
(ix) In d irect tax 2,000
[CBSE 2019 (58/4/1)]
Sol. Rent
= Gross domestic product at market price - Compensation of employees - Interest - Profit
- Mixed income of self-employed- Consumption of fixed capital - Indirect tax+ Subsidies
= t 18,000 crore - t 6,000 crore - t 800 crore - t 975 crore - t 7 , 000 crore - t 1,000 crore
- t 2,000 crore + t 250 crore
= t 475 crore
Ans. Rent = t 475 crore.
37. Calculate value of "Interest" from the followi ng data:
Items (t in crore)
(i) Indirect tax 1,500
(ii) Subsidies 700
(iii) Profits 1, 100
(iv) Consumption af fixed capital 700
(v) Gross domestic product at market price 17,500
(vi) Compensation of employees 9,300
(vii) Interest ?
(viii) Mixed income of self-employed 3,500
(ix) Rent 800
[CBSE 2019 (58/4/2)]
Sol. Interest
= Gross domestic product at market price- Compensation of employees- Rent - Profits- Mixed
income of self-employed -Consumption of fixed capital - Indirect tax+ Subsidies
= t 17, 5 00 crore - t 9,300 crore - t800 crore - t 1, 100 crore - t 3,500 crore - t 700 crore
- t 1, 500 crore+ t 700 crore
= t 1,300 crore
Ans. Interest = t 1,300 crore.
38. Calculate the value of "Mixed Income of Self-employed" from the following data:
Items (t in crore)
(ii) Interest 1,200
(iii) Consumption of fi xed capital 1,100
(iv) Mixed income of self-employed ?
(v) Subsidies 750
(vi) Gross domestic product at market price 27,500
(vii) Indirect taxes 2 ,100
(viii) Profits 1,800
(ix) Rent 2 ,000
[CBSE 201 9 {58/4/3)]
Sol. Mixed Income of Self-employed
= Gross domestic product at market price - Compensation of employees - Rent - Interest
low
- Profits- Consumption of fixed capital - Indirect tax+ Subsidies
= � 27, 500 crore -� 17 , 300 crore -�2,000 crore -� 1,200 crore -� 1,800 crore -� 1, 100 crore
-� 2 , 100 crore+ �750 crore
= � 2,750 crore
Ans. Mixed income of self-employed= � 2 ,750 crore.
ee
rF
Fr
Numericals related to Expend iture Method
39. Calculate 'National Income' from the following data:
or
(i) Private final consumption expenditure
sf 600
u
{ ii) Profit 100
k
(iii) Government final consumption expenditure 700
Yo
oo
(v) Gross domestic capital formation 250
B

re

ou
ad
(ix) Net imports 30

Y
Sol. National Income ( NNP Fcl

= Private final consumption expenditure + Government final consumption expenditure + Gross
nd
domestic capital formation - Net imports - Consumption of fixed capital - Net indirect taxes
Re
+ Net factor income from abroad

Fi
= � 600 crore+ � 700 crore+ � 250 crore-� 30 crore-� 70 crore -� 50 crore+ (-) � 50 crore
= � 600 crore+ � 700 crore+ � 250 crore-� 30 crore-� 70 crore -� 50 crore-� 50 crore
= � 1, 350 crore
40. Calculate 'Private Final Consumption Expenditure' from the following :
Items (� in lakh)
(i) Net imports 60
(ii) Net current transfers to abroad (-) 10
(iii) Net domestic fixed capital formation 300
(iv) Government final consumption expenditure 200
(v) National income 1,050
(vi) Consumption of fixed capital 70
(vii) Net change in stocks 30
(viii) Net factor income to abroad 20
= Private final consumption expenditure + Government final consumption expenditure + Net
domestic fixed capital formation + Net change in stocks - Net imports - Net indirect tax - Net
Or, Private Final Consumption Expenditure
= National income - Government final consumption expenditure - Net domestic fixed capital
formation- Net change in stocks+ Net imports+ Net indirect tax+ Net factor income from abroad
= t l,050 lakh- t200 lakh- t 300 lakh- t 30 lakh + t 60 lakh + t l OO lakh+ t20 lakh
= t 700 lakh
Ans. Private final consumption expenditure = t 700 lakh.
41. Calculate 'Government Final Consumption Expenditure' from the following data:
Items (t in crore)
(i) National income 930
(ii) Net domestic fixed capital formation 100
(iii) Net imports (-) 20
(iv) Net indirect tax 5
(v) Net current transfers from abroad 15
(vi) Private final consumption expenditure 600
(vii) Change in stocks 10
(viii) Net factor income from abroad 5
(ix) Net factor income from abroad 5
(x) Gross domestic fixed capital formation 125
domestic fixed capital formation+ Change in stocks- Net imports- Net indirect tax+ Net factor
income from abroad
Or, Government Final Consumption Expenditure
= National income- Private final consumption expenditure- Net domestic fixed capital formation
- Change in stocks+ Net imports+ Net indirect tax- Net factor income from abroad
= t 930 crore- t 600 crore- t 100 crore- t 10 crore+ (-) t 20 crore+ t 5 crore- t 5 crore
= t 930 crore- t 600 crore- t 100 crore- t 10 crore- t 20 crore+ t 5 crore- t 5 crore
= t 200 crore
Ans. Government final consumption expenditure = t 200 crore.
42. Find out 'Gross Domestic Capital Formation' from the following data:
Items (t in crore)
(i) Net imports (-) 10
(ii) National income 770
(iii) Private final consumption expenditure 600

(v) Factor income from abroad 10
(vi) Government final consumption expenditure 200
(vii) Net factor income to ab road 20
(viii) Net current transfers to abroad 30
- Net factor income to abroad
low
Or, Gross Domestic Capital Formation
= National income - Private final consumption expenditure - Government final consumption
expenditure + Net imports + Consumption of fixed capital + Net indirect taxes + Net factor
income to abroad
ee
= � 770 crore-� 600 crore-� 200 crore+ (- ) � 10 crore+ � 60 crore+ � 70 crore+ � 20 crore
rF
= � 770 crore-� 600 crore-� 200 crore- � 10 crore+ � 60 crore+ � 70 crore+ � 20 crore
Fr
= � 110 crore
Ans. Gross domestic capital formation = � 110 crore.
or
43. Calculate 'National Income' :
sf
u
(i) Personal tax 80
k
Yo
(ii) Private final consumption expenditure 600
oo
(iii) U nd istri buted profits 30
B
(iv) Private income 650

(v) Government final consumption expenditure 100
re
(vi) Corporate tax 50

(vii) Net domestic fixed capital formation 70
ou
ad

Y
(ix) Depreciation 14
(x) Change in stocks (-) 10
nd
Re
(xi) Net imports 20

(xii) Net factor income to abroad 10
Fi
[CBSE Delhi 2015]

domestic fixed capital formation+ Change in stocks- Net imports- Net indirect tax- Net factor
income to abroad
= � 600 crore+� 100 crore+� 70 crore+ (- ) � 10 crore-� 20 crore-� 60 crore-� 10 crore
= � 600 crore+� 100 crore+� 70 crore-� 10 crore-� 20 crore-� 60 crore-� 10 crore
= � 670 crore
Ans. National income=� 670 crore.

44. Calculate 'Net Domestic Product at Factor Cost' :
(i) Net current transfers to abroad 15
(ii) Private fi nal consumption expenditure 800
(iv) Net domestic capital formation 100
(v) Net factor income to abroad 10
(vi) Depreciation 50
(vii) Change in stocks 17
(ix) Government final consumption expenditure 200
(x) Exports 30
[CBSE Delhi 2015]
domestic capital formation - Net imports- Net indirect tax
= � 800 crore+� 2 00 crore+� 100 crore- (-) � 20 crore-� 120 crore
= � 800 crore+� 2 00 crore+� 100 crore+� 20 crore-� 120 crore
= � 1, 000 crore
Ans. Net domestic product at factor cost=� 1, 000 crore.
45. Calculate 'Net National Product at Market Price':
(i) Transfer payments by government 7
(ii) Government final consumption expenditure 50
(iv) Net domestic fixed capital formation 60
(v) Private final consumption expenditure 300
(vi) Private income 280
(viii) Closing stock 8
(ix) Opening stock 8
(x) Depreciation 12
(xi) Corporate tax 60
(xii) Retained earnings of corporations 20
[CBSE (Al} 2015]
domestic fixed capital formation + Closing stock - Opening stock - Net imports - Net factor
income to abroad
= � 300 crore+� 50 crore+� 60 crore+� 8 crore-� 8 crore- (-) � 10 crore- (-) � 5 crore
= � 300 crore+� 50 crore+� 60 crore+� 8 crore-� 8 crore+� 10 crore+� 5 crore
= � 425 crore
Ans. Net national product at market price=� 42 5 crore.

46. Calculate 'Net Domestic Product at Market Price':
Items (< in crore)
(i) Private final consumption expenditure 400
(ii) Opening stock 10
(iv) Imports 15
(v) Government final consumption expenditure 90
(vi) Net current transfers to rest of the world 5
(vii) Gross domestic fixed capital form ation 80
(viii) Closing stock 20
low
(ix) Exports 10
(x) Net factor income to abroad (-) 5
[CBSE (Al) 2015]
Sol. Net Domestic Product at Market Price
ee
rF
domestic fixed capital formation+ Closing stock- Opening stock+ Exports- Imports- Consumption
Fr
of fixed capital
= < 400 crore + < 90 crore + < 80 crore + < 20 crore - < 10 crore + < 10 crore - < 15 crore - < 25
or
crore
= < 550 crore
sf
u
An s. Net domestic product at market price = < 550 crore.
k
Yo
Items (< in crore)
oo
(i) Net imports 5

B
(ii) Net domestic capital formation 15

re
(iii) Personal income 90

(iv) National debt interest 10
ou
ad
(v) Corporate tax 25

(vi) Government final consumption expenditure 20
Y

nd
Re
(ix) U ndistributed profits 0

Fi
(x) Private final consumption expenditure 100

[CBSE (F) 2015]
= Private final consumption expenditure + Government final consumption expenditure
+ Net domestic capital formation - Net imports - Net indirect tax - Net factor income to
abroad
= < 100 crore+ < 20 crore+ < 15 crore- < 5 crore- < 10 crore- (-) < 5 crore
= < 100 crore+ < 20 crore+ < 15 crore- < 5 crore- < 10 crore+ < 5 crore
= < 125 crore
Ans. National income = < 12 5 crore.

48. Find Gross National Product at Market Price:
I tems (� in crore)
(iii) Net factor income to abroad (-) 10
(v) Net indirect tax 150
(vi) Net domestic capital formation 200
(vii) Current transfers from government 40
(ix) Net imports 30
(x) Income accruing to government 90
(xi) National debt interest 50
[CBSE (Al) 201 6]
domestic capital formation + Depreciation - Net imports - Net factor income to abroad
= � 800 crore+ � 300 crore+ � 2 00 crore+ � 100 crore- � 30 crore- (- ) � 10 crore
= � 800 crore+ � 300 crore+ � 2 00 crore+ � 100 crore- � 30 crore+ � 10 crore
= � 1, 380 crore
Ans. Gross national product at market = � 1,380 crore.
(i) Net current transfers to abroad 10
(ii) Private final consumption expenditure 5 00
(iii) Current transfers from government 30
(iv) Net factor income to abroad 20
(v) Net exports (-) 20
(vi) Net indirect tax 120
(vii) National debt interest 70
( viii) Net domestic capital formation 80
(ix) Income accruing to government 60
(x) Government final consumption expenditure 100
[CBSE (Al) 2016]
domestic capital formation + Net exports - Net factor income to abroad
= � 500 crore+ � 100 crore+ � 80 crore+ (- ) � 20 crore- � 20 crore
= � 500 crore+ � 100 crore+ � 80 crore- � 20 crore- � 20 crore
= � 640 crore
Ans. Net national product at market price= � 640 crore.

Items (< in crore)
(i) Corporation tax 100
(iii) Personal income tax 120
(v) Undistributed profits 50
(vi) Change in stocks (-) 20
( vii) Net domestic fixed capital formation 120
(viii) Net imports 10
low
(x) Net factor income from abroad (-) 10
(xi) Private income 1,000
[CBSE (Al) 2016]
Sol. N atio n a l I ncom e
ee
rF
domestic fixed capital formation+ Change in stocks- Net imports- Net indirect tax+ Net factor
Fr
income from abroad
= < 900 crore+< 200 crore+< 120 crore+ (- ) < 20 crore-< 10 crore-< 150 crore+ (- ) < 10 crore
or
= < 900 crore+ < 200 crore+ < 120 crore-< 20 crore-< 10 crore-< 150 crore -< 10 crore
= < 1,030 crore
sf
u
51. Calculate Net Domestic Product at Factor Cost:
k
Yo
Items (< in crore)
oo
(i) Private final consumption expenditure 8,000

B
(ii) Government final consumption expenditure 1,000

re
(iii) Exports 70
(iv) Imports 120
ou
(v) Consumption af fixed capital 60

ad
(vi) Gross domestic fixed capital formation 500

Y
(vii) Change in stock 100

(viii) Factor income to abroad 40
nd
Re
(ix) Factor income from abroad 90

(x) Indirect taxes 700
Fi
(xi) Subsidies 50
(xii) Net current transfers to abroad (-) 30
[CBSE Delhi 201 7]
domestic fixed capital formation+ Change in stock+ Exports - Imports - Consumption of fixed
capital - Indirect taxes+ Subsidies
= < 8,000 crore+ < 1,000 crore+ < 500 crore+< 100 crore+ < 70 crore-< 120 crore-< 60 crore
-< 700 crore+ < 50 crore
= < 8,840 crore
Ans. Net domestic product at factor cost=< 8,840 crore.

Items (< in crore)
(i) Net factor income to abroad (-) 50
(ii) Net indirect taxes 800
(iii) Net current transfers from rest of the world 100
(iv) Net imports 200
(v) Private final consumption expenditure 5,000
(vi) Government final consumption expenditure 3,000
(vii) Gross domestic capital formation 1,000
(ix) Change in stock (-) 50
(x) Mixed income 4,000
(xi) Scholarship to students 80
[CBSE Delhi 201 7]
Sol. N atio n a l I ncom e
= < 5,000 crore+< 3,000 crore+< 1,000crore-< 200crore-< 150crore-< 800crore- (-)< 50crore
= < 5,000 crore+ < 3,000 crore+ < 1,000 crore-< 200 crore-< 150 crore-< 800 crore+< 50 crore
= < 7,900 crore
Ans. National income= < 7 ,900 crore.

Items (< in crore)
(i) Gross domestic fixed capital formation 400
(ii) Private final consu m ption expenditure 8,000
(iii) Government final consumption expenditure 3,000
(iv) Change in stock 50
(v) Consumption af fixed capital 40
(vi) Net indirect taxes 100
(vii) Net exports (-) 60
(ix) Net cu rrent transfers from abroad 100
(x) Dividend 100
[CBSE Delhi 201 7]
domestic fixed capital formation+ Change in stock+ Net exports-Consumption of fixed capital
= < 8,000 crore + < 3,000 crore + < 400 crore + < 50 crore + (-) < 60 crore - < 40 crore
- (-) < 80 crore

= < 8, 000 crore + < 3,000 crore + < 400 crore + < 50 crore -< 60 crore-< 40 crore+ < 80 crore
= < 11,430 crore
Ans. Net national product at market price = < 11,430 crore.

Miscellaneous N u mericals
54. Find national income when GDP M P =< 50, 000, gross capital formation =< 10,000, net capital formation
= < 8,000, capital loss = < 6, 000, and excise duty paid to the government = < 4,000.
Sol. National Income = GDP MP - Depreciation - Excise duty

= < 50,000- (< 10,000-< 8,000) -< 4,000
= < 50,000-< 2,000-< 4,000
= < 44,000
Ans. National income = < 44, 000.
55. Find domestic income when GNP M P =< 1,20,000, indirect taxes =< 20,000, consumption af fixed capital
= < 5,000, net exports = < 5, 000 and factor income from rest of the world = < 3,000.
low
Sol. Domestic Income
= GNP MP - Indirect taxes- Consumption of fixed capital - Factor income from rest of the world
= < 1,20,000- < 20,000- < 5,000-< 3,000
= < 92,000
Ans. Domestic income = < 92,000.
ee
56. Calculate 'Depreciation on Capital Asset' from the following data:
rF
Fr
Items
(i) Capital value of the asset < 1,000 crore
(ii) Estimated life of the asset 20 years
or
(iii) Scrap value < 40 crore
sf
u
Capital value of the asset - Scrap value
Sol. Depreciation on Capital Asset=
Estimated life of the asset
k
Yo
< 1, 000 crore - < 40 crore
oo
20 years
< 960 crore
B
= = ""
, 48 crore
20 years
re
Ans. Depreciation on capital asset = < 48 crore.

57. Calculate 'Depreciation on Capital Asset' from the following data:
ou
ad
Items
Y
(i) Estimated life of the asset 10 years

(ii) Capital value of the asset < 400 lakh
nd
Re
(iii) Scrap value Nil

Capital value of the asset - Scrap value
Sol. Depreciation on Capital Asset= -------------
Fi
Estimated life of the asset

< 400 lakh - 0
10 years
< 400 lakh
= < 40 lakh
10 years
Ans. Dep reciation on capital asset = < 40 lakh.
58. From the following data, calculate the (a) Gross Domestic Product at Factor Cost, and (b) Net National
Product at Market Price :
Items (< in crore)
(i) Gross investment 90
(ii) Net exports 10

(iii) Net indirect taxes 5
(vi) Personal consumption expenditure 350
(vii) Government purchases of goods and services 100
Sol. (a) Gross Domestic Product at Factor Cost
= Personal consumption expenditure + Government purchases of goods and services + Gross
investment+ Net exports - Net indirect taxes

= � 350 crore+ � 100 crore+ � 90 crore+ � 10 crore- � 5 crore
= � 545 crore
( b) Net National Product at Market Price

= Gross domestic product at factor cost - Depreciation + Net indirect taxes + Net factor income
from abroad
= � 545 crore- � 15 crore+ � 5 crore+ (- ) � 5 crore
= � 545 crore- � 15 crore+ � 5 crore - � 5 crore
= � 5 30 crore
Ans. (a) Gross domestic product at factor cost = � 545 crore.

( b) Net national product at market price = � 5 30 crore.
59. From the following data, calculate (a) Gross National Product at Market Price, and (b) National Income:
(i) Sale 70,000
(ii) Stock in the beginning of year 5,000
(iii) Stock in the end of year 25,000
(iv) Intermediate consumption 10,000
(v) Depreciation 1,000
(vi) Indirect tax 300
(vii) Subsidy 100
Sol. (a) Gross National Product at Market Price
= Sales+ Change in stock {Stock in the end of year- Stock in the beginning of year)- lntermediate
consumption + Net factor income from abroad

= � 70,000 crore+ (� 2 5 ,000 crore- � 5,000 crore) - � 10,000 crore+ O
= � 70,000 crore+ � 20,000 crore - � 10,000 crore+ O
= � 80,000 crore
( b) National Income
= Gross National Product at Market Price - Depreciation - Indirect tax+ Subsidy
= � 80,000 crore- � 1,000 crore - � 300 crore + � 100 crore
= � 78,800 crore
Ans. (a) Gross national product at market price = � 80,000 crore.

( b) National income = � 78,800 crore.
60. Calculate (a) Gross Domestic Product at Market Price by Income Method, and ( b) Net National
Product at Factor Cost by Expenditure Method from the following data:
Items (� in lakh)
(ii) Operating surplus 520

(iv) Indirect taxes 60
(v) Mixed income of self-employed 20
(vii) Change in stock 30
(viii) Gross domestic capital formation 330
(ix) Compensation of employees 200
(x) Net exports {-) 10
(xi) Net factor income from abroad {-) 10
(xii) Subsidies 10
low
Sol. (a) I ncome Method:
Gross Domestic Product at Market Price
= Compensation of employees + Operating surplus + Mixed income of self-employed
+ Consumption of fixed capital+ Indirect taxes- Subsidies
ee
= � 200 lakh+ � 520 lakh + � 20 lakh+ � 30 lakh+ � 60 lakh- � 10 lakh
= � 820 lakh
rF
Fr
( b) Expenditure Method:
Net National Product at Factor Cost
or
= Private final consumption expenditure+ Government final consumption expenditure+ Gross
domestic capital formation + Net exports - Consumption of fixed capital - Indirect taxes
sf
u
+ Subsidies+ Net factor income from abroad
= � 450 lakh+ � 50 lakh+ � 330 lakh+ (- ) � 10 lakh- � 30 lakh- � 60 lakh+ � 10 lakh+ (- ) � 10 lakh
k
Yo
= � 450 lakh+ � 50 lakh+ � 330 lakh - � 10 lakh- � 30 lakh- � 60 lakh+ � 10 lakh- � 10 lakh
oo
= � 7 30 lakh
B
Ans. (a) Gross domestic product at market price ( by income method ) = � 820 lakh.
re
( b) Net national product at factor cost ( by expenditure method )= � 7 30 lakh.

61. Given the following data, find Net National Product at Market Price by (a) Expenditure Method, and
ou
(b) Income Method :

ad
Items (� in lakh)
Y
(i) Personal consumption expenditure 1,400

(ii) Wages and salaries 1,400
nd
Re
(iii) Employers' contribution to social security 200

(iv) Contribution to provident fund by the employees through the employer 100
Fi
(v) Gross business fixed capital formation 120

(vi) Gross residential construction investment 120
(vii) Gross public expenditure 480
(viii) Rent 100
(ix ) Inventory investment 40
(x ) Dividend and corporate profit tax 120
(xi) Corporate saving 80
(xii) Excess of exports over imports 40
(xiii) Interest 80
(xiv) Mixed income of self-employed 200

(xv) Net factor income to abroad 20
(xvi) Depreciation (Depreciation = Gross capital formation - Net capital formation) 0
(xvii) Indirect taxes 40
(xviii) Subsidy 20
Sol. (a) Expe nditure Method
= Personal consumption expenditure+ Gross business fixed capital formation + Gross residential
construction investment+ Gross public expenditure+ Inventory investment+ Excess of exports
over imports
= < 1,400 lakh + < 120 lakh+ < 120 lakh + < 480 lakh+ < 40 lakh+ < 40 lakh
= < 2,200 lakh
Net National Product at Market Price
= Gross domestic product at market price- Depreciation- Net factor income to abroad
= < 2,200 lakh-< 0 lakh-< 20 lakh
= < 2, 180 lakh
( b ) I ncome M ethod
Net Domestic Product at Factor Cost
= Wages and salaries + Employers' contribution to social security + Rent + Interest + Dividend
and corporate profit tax+ Corporate saving+ Mixed income of self-employed
= < 1,400 lakh+< 200 lakh+< 100 lakh+< 80 lakh+< 120 lakh+< 80 lakh+< 200 lakh
= < 2, 180 lakh
Net National Product at Market Price
= Net domestic product at factor cost+ Net indirect taxes- Net factor income to abroad
= < 2, 180 lakh + (< 40 lakh-< 20 lakh)-< 20 lakh
= < 2, 180 lakh +< 20 lakh-< 20 lakh
= < 2, 180 lakh
Ans. Net national product at market price (by expenditure and income methods) =< 2,180 lakh.
62. Calculate Gross Domestic Product at Market Price using (a) Product Method , and (b) Income Method:
Items (< in crore)
(i) Intermediate consumption of
(a) Primary sector 1,000
(b) Secondary sector 800
(c) Tertiary sector 600
(ii) Value of output of
(a) Primary sector 2, 000
(b) Secondary sector 1,800
(c) Tertiary sector 1,400
(iii) Rent and royalty 20
(iv) Compensation of employees 800
(v) Benefit of rent free accommodation, and interest free loans to the employees 400
(vi) Mixed income of the people using family inputs 1,300
{vii) Operating surplus 600

(viii) Net factor income to rest of the world 40
(ix) Interest 10
(xi) Net indirect taxes 20
Sol. (a) Product M ethod
= Value of output- Intermediate consumption
= (< 2,000 crore + < 1,800 crore + < 1,400 crore) - (< 1,000 crore + < 800 crore + < 600 crore)
= < 5,200 crore-< 2,400 crore
= < 2,800 crore
low
( b ) I ncome M ethod
= Compensation of employees + Operating surplus + Mixed income + Consumption of fixed
capital+ Net indirect taxes
= < 800 crore + < 600 crore + < 1, 300 crore + < 80 crore + < 20 crore
ee
= < 2,800 crore
rF
Fr
Ans. Gross Domestic Product at Market Price (by product and income methods) =< 2,800 crore.
63. Calculate National Income by (a) Income Method, and (b) Expenditure Method .
or
Items (< in crore)
(i) Capital transfers from rest of the world 200
sf
u
k
(iii) Current transfers from rest of the world 200
Yo
oo
(iv) Wages and salaries 7,600
(v) Dividend 1,000
B
(vi) Rent and royalty 400

re
(vii) Interest 300

(viii) Addition to the stock of capital 1,000
ou
ad
(ix) Profit 1, 600

Y
(x) Employers' contri bution to social security on behalf of employees 400

(xi) Excess of imports over exports 100
nd
(xii) Excess of factor income earned by the non-residents from the domestic territory 60
Re
over the factor income earned by the residents from rest of the world
Fi
(xiii) Consumption of fixed capital 80

(xiv) Private final consumption expenditure 8,000
(xv) Net indirect taxes 600
Sol. (a) I ncome M ethod
National Income
= Wages and salaries + Rent and royalty + Interest + Profit + Employers' contribution to social
security - Excess of factor income earned by the non-residents
= < 7,600 crore + < 400 crore + < 300 crore + < 1, 600 crore + < 400 crore-< 60 crore
= < 10,240 crore

( b ) Expe nditure Method
National Income
= Government final consumption expenditure + Private final consumption expenditure
+ Addition to the stock of capital- Excess of imports over exports- Net indirect taxes- Excess
of factor income earned by the non-residents
= t 2,000 crore + t 8, 000 crore+ t 1, 000 crore- t 100 crore- t 600 crore- t 60 crore
= t 10,240 crore
Ans. National I ncome (by income and expenditure methods)= t 10,240 crore.
64. From the following information, calculate Gross National Product at Factor Cost by (a) Income
Method, and (b) Expenditure Method:
Items (t in crore)
(i) Factor income from abroad 10
(ii) Compensation of employees 150
(iii) Net domestic capital formation so
(iv) Private final consumption expenditure 220
(v) Factor income to abroad 15
(vii) Employer's contribution to social security schemes 10
(ix) Interest 40
(x) Exports 20
(xi) Imports 25
(xii) Indirect taxes 30
(xiii) Subsidies 10
(xiv) Rent 40
(xv) Government final consumption expenditure 85
(xvi) Profit 100
Sol. (a) I ncome M ethod
Gross National Product at Factor Cost
= Compensation of employees + Interest + Rent + Profit + Factor income from abroad
+ Consumption of fixed capital- Factor income to abroad
= t 150 crore+ t 40 crore+ t 40 crore+ t 100 crore+ t 10 crore+ t 15 crore- t 15 crore
= t 340 crore
( b ) Expe nditure Method
Gross National Product at Factor Cost
domestic capital formation+ Consumption of fixed capital+ Exports- Imports- Indirect taxes
+ Subsidies+ Factor income from abroad - Factor income to abroad
= t 220crore+ t 85 crore+t SO crore+t 15 crore+ t 20crore-t 25 crore-t 30crore+ t l O crore
+ t 10 crore - t 15 crore
= t 340 crore
Ans. Gross National Product at Factor Cost ( by income and expenditure methods) = t 340 crore.

65. Calculate (a) Gross National Product at Market Price by Income Method, and (b) National Income by
Expenditure Method on the basis of the following data :
I tems (t in lakh)
(i) Net expor t 10
(ii) Rent 20
(iv) Interest 30
(v) Dividend 45
(vi) Undistributed profit 5
( vii) Cor porate tax 10
low
(viii) Government final consumption expenditure 100
(ix) Net domestic capital formation 50
(x) Compensation of employees 400
(xi) Consumption of fixed capital 10
ee
(xii) Net indirect tax 50
(xiii) Net factor income from abroad
rF (-) 10
Fr
Sol. (a) Income Method
Gross National Product at Market Price
or
= Compensation of employees+ Rent+ Interest+ Dividend+ Undistributed profit+ Cor porate tax
+ Consum ption of fixed capital+ Net indirect tax+ Net factor income from abroad
sf
u
= t 400 lakh + t 20 lakh+ t 30 lakh + t 45 lakh+ t 5 lakh + t 10 lakh+ t 10 lakh + t 50 lakh
+ (- ) t 10 lakh
k
Yo
= t 400 lakh + t 20 lakh + t 30 lakh + t 45 lakh + t 5 lakh + t 10 lakh + t 10 lakh + t 50 lakh
oo
- t 10 lakh
B
= t 560 lakh
re
(b) Expenditure Method

National Income
ou

ad
domestic capital formation+ Net export - Net indirect tax+ Net factor income from abroad
Y
= t 400 lakh+ t 100 lakh+ t 50 lakh+ t 10 lakh- t 50 lakh+ (- ) t 10 lakh

= t 400 lakh+ t 100 lakh+ t 50 lakh+ t 10 lakh- t 50 lakh- t 10 lakh
nd
Re
= t 500 lakh
Ans. Gross national product at market price ( by income method )= t 560 lakh.
Fi
National income ( by expenditure method ) = t 500 lakh.

66. Given the following data, find the missing value of 'Government Final Consumption Expenditure' and
'Mixed Income of Self-employed'.
I tems (t in crore)
(i) National income 71,000
(ii) Gross domestic capital formation 10,000
(iii) Government final consumption expenditure ?
(v) Net factor income from abroad 1,000
(vi) Net indirect taxes 2,000

(vii) Profits 1,200
(viii) Wages and salaries 15 ,000
(ix) Net exports 5 ,000
(x) Private final consumption expenditure 40,000
(xi) Consumption of fixed capital 3,000
(xii) Operating surplus 30,000
[CBSE 2019 (58/1/1)]
Sol. Government Final Consumption Expenditure
= National income - Private final consumption expenditure - Gross domestic capital formation
- Net exports+ Consumption of fixed capital+ Net indirect taxes- Net factor income from abroad
= � 7 1,000 crore-� 40,000 crore-� 10,000 crore-� 5,000 crore+� 3,000 crore+� 2,000 crore
-� 1, 000 crore
� 20, 000 crore
=
Mixed Income of Self-employed

= National income - Wages and salaries - Operating surplus - Net factor income from abroad
= � 7 1, 000 crore-� 15 ,000 crore-� 30, 000 crore-� 1,000 crore

= � 25, 000 crore
Ans. Government final consumption expenditure =� 20, 000 crore.
Mixed income of self-employed =� 25 ,000 crore.
67. Given the following data, find the missing values of 'Private Final Consumption Expenditure' and
'Operating Surplus'.
Items �
( in crore)
(ii) Net indirect taxes 1,000
(iii) Private fi nal consumption expenditure ?
(iv) Gross domestic capital formation 17 ,000
(v) Profits 1,000
(vi) Government fi nal consumption expenditure 12,500
(vii) Wages and salaries 20,000
(ix) Mixed income of self-employed 13,000
(x) Operating surplus ?
(xi) Net factor income from abroad 5 00
(xii) Net exports 2,000
[CBSE 2019 (58/1/2)]
Sol. Private Final Consumption Expenditure
= National income - Government final consumption expenditure - Gross domestic capital
formation- Net exports+ Consumption of fixed capital+ Net indirect taxes- Net factor income
from abroad
= � 5 0, 000 crore-� 12, 500 crore-� 17, 000 crore-� 2, 000 crore+� 700 crore+� 1,000 crore
-� 500 crore
= � 19,700 crore

Operating Surplus
= National income - Wages and salaries - Mixed income of self-employed - Net factor income
from abroad
= � 5 0, 000 crore-� 20,000 crore-� 13, 000 crore-� 500 crore
= � 16, 500 crore
An s. Private final consumption expenditure =� 19,700 crore.

Operating surplus =� 16, 500 crore.
68. Given the following data, find the missing values of 'Gross Domestic Capital Formation' and 'Wages
and Salaries'.
Items �
( in crore)
low
(i) Mixed income of self-employed 3,500
(iii) Wages and salaries ?
(iv) Government final consumption expenditure 14,000
(v) Net exports 3,000
ee
rF
Fr
(vii) Net factor income from abroad 700
(viii) Operating surplus 12,000
or
(ix) National income 30,000
(x) Profits 500
sf
u
(xi) Gross domestic capital formation ?
(xii) Private final consumption expenditure 11, 000
k
Yo
oo
[CBSE 2019 (58/1/3)]
Sol. Gross Domestic Capital Formation
B
expenditure - Net exports + Consumption of fixed capital + Net indirect taxes - Net factor
re
income from abroad

= � 30,000 crore -� 11,000 crore-� 14,000 crore-� 3, 000 crore + � 300 crore + � 300 crore
ou
ad
-� 700 crore
Y
= � 1,900 crore
Wages and Salaries

nd
Re
= National income- Operating surplus- Mixed income of self-employed- Net factor income from
abroad
Fi
= � 30,000 crore-� 12,000 crore-� 3, 5 00 crore-� 700 crore
= � 13,800 crore
Ans. Gross domestic capital formation =� 1,900 crore.

Wages and salaries =� 13,800 crore.
69. Given the following data, find the values of 'Gross Domestic Capital Fo rmation' and 'O perating Surplus'.
(ii) Wages and salaries 12,000
(iii) Private final consumption expenditure 7,200

(v) Gross domestic capital formation ?
(vi) Depreciation 500
(vii) Government final consumption expenditure 6,100
(viii) Mixed income of self-employed 4,800
(ix) Operating surplus ?
(x) Net exports 3,400
(xi) Rent 1,200
(xii) Net factor income from abroad (-) 150
[CBSE 2019 (58/2/1)]
Sol. Gross Domestic Capital Formation
expenditure- Net exports+ Depreciation + Net indirect taxes- Net factor income from abroad
= � 22, l OO crore-� 7,200 crore-� 6, l OO crore-� 3,400 crore+� 500 crore+� 700 crore
- (-)� 150 crore

= � 22,100 crore-� 7,200 crore-� 6, 100 crore-� 3,400 crore+� 500 crore+� 700 crore
+� 150 crore
= � 6,750 crore
Operating Surplus
from abroad
= � 22, 100 crore-� 12,000 crore-� 4,800 crore- (-) � 150 crore
= � 22, 100 crore-� 12,000 crore -� 4,800 crore +� 150 crore
= � 5,450 crore
Ans. Gross domestic capital formation =� 6,750 crore.

Operating surplus =� 5,450 crore.
70. Given the following data, find the values of 'Government Final Consumption Expenditure' and ' Mixed
Income of Self-employed' :
Items (t in crore)
(i) National income 7 ,100
(ii) Government fi nal consumption expenditure ?
(iii) Gross domestic capital formation 1, 000
(v) Net indirect taxes 200
(vi) Net facto r income from abroad 100
(vii) Private final consumption expenditure 4,000
(ix) Profits 120
(x) Wages and salaries 1,500
(xi) Net exports 500
( xii) Operating surplus 3,000
[CBSE 2019 (58/3/1)]

Sol. Government Final Consumption Expenditure
= National income - Private final consumption expenditure - Gross domestic capital formation
- Net exports + Consumption of fixed capital + Net indirect taxes - Net factor income from
abroad
= � 7, 100 crore - � 4, 000 crore - � 1, 000 crore - � 500 crore + � 300 crore + � 200 crore
-� 100 crore
= � 2, 000 crore
Mixed Income of Self-employed

= National income - Wages and salaries - Operating surplus - Net factor income from abroad
= � 7, 100 crore-� 1, 500 crore-� 3, 000 crore-� 100 crore
low
= � 2, 500 crore
An s. Government final consumption expenditure =� 2, 000 crore.

Mixed income of self-employed =� 2, 500 crore.
71. Given the following data, find the values of 'Operating Surplus' and 'Gross Domestic Capital
Formation' :
ee
Items �
( in crore)
rF
Fr
(i) Government final consumption expenditure 2,000
(iii) National income 12,000
or
(iv) Net factor income from abroad 200
sf
u
(v) Operating surplus ?
(vi) Profits 500
k
Yo
oo
(viii) Net indirect taxes 700
(ix) Net exports 1,800
B

re
(xi) Gross domestic capital formation ?

(xii) Wages and salaries 6,000
ou
ad
[CBSE 201 9 (58/3/2)]

Y
Sol. Operating Surplus

from abroad
nd
Re
= � 12, 000 crore-� 6,000 crore-� 1, 500 crore-� 200 crore

Fi
= � 4, 300 crore
Gross Domestic Capital Formation

expenditure - Net exports + Consumption of fixed capital + Net indirect taxes - Net factor
income from abroad
= � 12, 000 crore-� 6,000 crore-� 2, 000 crore-� 1,800 crore+� 600 crore+� 700 crore
-� 200 crore
= � 3, 300 crore
Ans. Operating surplus =� 4, 300 crore.

Gross domestic capital formation =� 3, 300 crore.

72. Given the following data, find the values of 'Operating Surplus' and ' Net Exports' :
Items (t in crore)
(i) Mixed income of self-employed 700
(ii) Net factor income from abroad 150
(iii) Private final consumption expenditure 2,200
(iv) Profits 200
(vi) National income 5,000
(vii) Gross domestic capital formation 1,100
(viii) Wages and salaries 2,200
(ix) Net expor ts ?
(x) Government final consumption expenditure 1,300
(xii) Operating surplus ?
[CBSE 2019 (58/3/3)]
from abroad
= � 5 , 000 crore-� 2,200 crore-� 700 crore-� 150 crore
= � 1,950 crore
Net Exports
expenditure- Gross domestic capital formation+ Consumption of fixed capital+ Net indirect taxes
= � 5 , 000 crore -� 2,200 crore -� 1, 300 crore -� 1, 100 crore + � 200 crore + � 150 crore
-� 150 crore
= � 600 crore
Ans. Operating surplus =� 1,950 crore.

Net exports =� 600 crore.
73. Given the following data, find the values of 'Operating Sur plus' and 'Net Exports':
Items (t in crore)
(i) Wages and salaries 2,400
(ii) N ational income 4, 200
(iii) N et exports ?
(iv) N et factor income from abroad 200
(v) Gross domestic capital formation 1,100
(vi) Mixed income of self-employed 400
(ix) Operating surplus ?
(x) Government final consumption expenditure 1,000
(xii) Profits 500
[CBSE 2019 (58/5/1)]

from abroad
= � 4,200 crore-� 2,400 crore-� 400 crore-� 200 crore
= � 1,200 crore
Net Exports
expenditure- Gross domestic capital formation+ Consumption of fixed capital+ Net indirect taxes
= � 4,200 crore -� 2,000 crore -� 1,000 crore -� 1, 100 crore +� 100 crore +� 150 crore
low
-� 200 crore
= � 150 crore
Ans. Operating surplus =� 1,200 crore.

Net exports =� 150 crore.
74. Giving reason, explain how the following are treated while estim ating national income:
ee
(i) Payment of fees to a lawyer engaged by a firm.
rF
Fr
(ii) Rent free house to an employee by an employer.
(iii) Purchases by foreign tourists.
Sol. (i) Services purchased by one firm from another, like consultancy services of an advocate, are
or
treated as a part of intermediate consumption. Accordingly, payment of fees to a lawyer engaged
by a firm is not to be included in the estimation of national income.
sf
u
( ii) Rent free house to an employee by an employer is a component of compensation of employees.
Therefore, it is included in national income.
k
Yo
( iii) Purchases by foreign tourists are like export of goods and services to the non-residents. It is a
oo
part of expenditure on domestic product, and therefore, a part of national income, as estimated
B
using expenditure method.

75. Giving reason, explain how should the following be treated in estimating gross domestic product at
re
market price.
(i) Fees to a mechanic paid by a firm.
ou
ad
(ii) Interest paid by an individ ual on a car loan taken from a bank.
(iii) Expenditu re on purchasing a car for use by a firm.
Y
Sol. (i) Fees to a mechanic paid by a firm will not be included in the estimation of gross domestic
product at market price because this fees is an intermediate expenditure for the firm and not a
nd
Re
final expenditure.
( ii) Interest paid by an individual on a car loan taken from a bank will not be included in estimation
Fi
of gross domestic product at market price because such loans are not used for production
purpose, rather are made for consumption purposes.
( iii) Expenditure on purchasing a car for use by a firm will be included in the estimation of gross
domestic product at market price because it is an investment expenditure. The car purchased
will be used by the firm for many years and the firm will be a final user of the car, provided it is
neither a second hand car nor purchased for further sale.
76. How should the following be treated in estimating national income of a country? You must give
reason for your answer.
(i) Taking care of aged parents.
(ii) Salaries paid to non-resident Indian s working in Indian embassy in America.
(iii) Expenditu re on providing police services by the government.

Sol. (i) If it is a domestic care through personal services ( of which valuation is not possible), it should
not be included in the estimation of national income. However, if the care involves expenditure,
it should be accounted for as private final consumption expenditure.
( ii) Salaries paid to non-resident Indians working in Indian embassy in America is reflected in the
national income of India as a negative component because it is a part of factor income to rest of
the world.
( iii) Expenditure on providing police services by the government should be included in the estimation
of national income because expenditure incurred by the government is a part of government 's
final consumption expenditure.
77. How should the following be treated wh ile estimating national income? You must give reason in
support of your answer.
(i) Bonus paid to employees.
(ii) Addition to stocks during a year.
(iii) Purchase of taxi by a taxi driver.
Sol. (i) Bonus paid to employees will be included in the estimation of national income since it is a
component of compensation of employees.
( ii) Addition to stocks during a year will be included in the estimation of national income because
change in stock is a part of investment expenditure.
( iii) Purchase of taxi by a taxi driver will be included in the estimation of national income because it is
an investment expenditure. A taxi will be used by the taxi driver for several years to earn his living.
78. Giving reasons, explain how should the following be treated in estimation of national income:
(i) Expenditure by a firm on payment of fees to a chartered accountant.
(ii) Payment of corporate tax by a firm.
(iii) Purchase of refrigerator by a firm for own use. [CBSE Delhi 2015]
Sol. (i) Expenditure by a firm on payment of fees to a chartered accountant is not included in the
estimation of national income because fees to a chartered accountant is an intermediate
expenditure for the firm and not a final expenditure.
( ii) Payment of corporate tax by a firm should not be included in the estimation of national income
because it is a transfer payment by the firm. It is paid out of income and therefore, it is not to be
separately added in the national income.
( iii) Purchase of refrigerator by a firm is included in the estimation of national income because it is
investment expenditure or capital formation. A refrigerator is used by the firm for several years
and the firm is a final user of it.
79. Giving reasons, explain how the following should be treated in estimation of national income:
(i) Payment of interest by a firm to a bank.
(ii) Payment of interest by a bank to an individual.
(iii) Payment of interest by an individual to a bank. [CBSE (Al} 2015]
Sol. (i) Payment of interest by a firm to a bank is included in national income because firm borrows
money for production purpose and thus, it is a factor payment.
( ii) Payment of interest by a bank to an individual is included in national income because the bank
is expected to have used individual's saving for productive purpose and thus, this is a factor
payment.
( iii) Payment of interest by an individual to a bank is not included in national income because the
individual uses the loan amount for consumption purpose and not for investment or productive
purpose.

80. Giving reasons, explain how should the following be treated in estimation of national income:
(i) Payment of corporate tax by a firm.
(ii) Purchase of machinery by a factory for own use.
(iii) Purchase of uniforms for nurses by a hospital. [CBSE {F} 2015]
Sol. (i) Payment of corporate tax by a firm should not be included in the estimation of national income
because it is a transfer payment by the firm. It is paid out of income and therefore, it is not to be
separately added in the national income.
( ii) Purchase of machinery by a factory is included in the estimation of national income because it
is investment expenditure or capital formation.
(iii) Purchase of uniforms for nurses by a hospital is not included in the estimation of national
low
income, because uniform is provided by the hospital at the time of work. It is to be treated as an
intermediate consumption.
81. How will you treat the following while estimating domestic product of a country? Give reasons for
your answer:
(i) Profits earned by branches of country's bank in other countries.
ee
(ii) Gifts given by an employer to h is employees on independence day.
rF
Fr
(iii) Purchase of goods by foreign tourists. [CBSE Delhi 201 7]
Sol. (i) Profits earned by branches of country 's bank in other countries is not a part of domestic product
of India because the branches are outside the domestic territory of India. Hence, it is not
or
included in domestic product of India.
( ii) Gifts given by an employer to his employees is not included in domestic product of India because
sf
u
these are transfer payments.
(iii) Purchase of goods by foreign tourists is included in domestic product of India since these are like
k
Yo
exports which is a component of gross domestic product.
oo
82. Will the following be included in the domestic product of India? Give reasons for your answer.
B
(i) Profits earned by foreign companies in India.

re
(ii) Salaries of Indians working in the Russian Embassy in Ind ia.

(iii) Profits earned by a branch of State Bank of India in Japan. [CBSE {Al) 201 7]
ou
ad
Sol. (i) Profits earned by foreign companies in India is a part of domestic product of India because the
companies are within the domestic territory of India.
Y
( ii) Salary of Indians working in the Russian Embassy in India is not included in the domestic product
of India because Russian Embassy is not a part of domestic territory of India.
nd
Re
(iii) Profits earned by a branch of State Bank of India in Japan is not a part of the domestic product of
India because the branch of State Bank of India in Japan is not within the domestic territory of India.
Fi
83. Will the following be included in the national income of India? Give reasons for your answer.
(i) Financial assistance to flood victi ms.
(ii) Profits earned by the branches of a foreign bank in India.
(iii) Salaries of Indians working in the American Embassy in India. [CBSE {Al} 201 7]
Sol. (i) Financial assistance to flood victims is not included in the national income of India. This is
because financial assistance is a transfer income.
( ii) Profits earned by the branches of a foreign bank in India is reflected in the national income of
India as a negative component because it is a part of factor income to rest of the world.
(iii) Salaries of Indians working in the American Embassy in India is included in national income of
India because it is a part of factor income from rest of the world.

BAN KI NG
1. If CRR (cash reserve ratio) is enhanced from 10% to 20%, what should b e the change i n credit supply,
other things remaining constant? Give reason.
Sol. We know,
Credit Multiplier =
c!R
When CRR enhances from 10% to 20% , credit multiplier is reduced to half of its earlier value.
Accordingly, creation of credit or supply of credit in the economy should reduce to half, when other
things are constant.
2. How would you interpret a fall in repo rate from 7% to 6% in the context of money supply in the economy?
Sol. If there is a fall in repo rate from 7% to 6% , the central bank is giving a signal of 'easy money
policy'. Funds will be easily available from the central bank in case commercial banks need them.
Accordingly, commercial banks need not maintain high reserves of vault cash. Creation of credit by
the commercial banks is likely to be more responsive to the demand for credit. Accordingly, supply
of money is likely to increase.
AG G REGATE DEMAN D. AG G REGATE SUPPLY

AN D RELATED CONCEPTS
1. Find out the marginal propensity to consume from the following data.
I n come Consu mption
(t) (t)
1,000 1,500
2,000 2,000
Sol.
I ncome Change i n I ncome Consu mption
I Change in Cons u m ption
I
(t) ( 1W ) ( t) ( t) ( L'.C ) (t)
1,000 - 1,500 -
2, 000 2,000 - 1,000 = 1,000 2,000 2,000 - 1,500 = 500
Margma . to consume = �C
. I propensity =
500 = 0.5
�Y l ,OOO
Ans. MP C = 0.5.
2. Find out the marginal propensity to consume and marginal propensity to save from the following
data:
F
I ncome Saving
(t) (t)
100 60
200 100
Sol.
I n come Change in I ncome Saving Consumption Change in
(t) (L'.Y) (t) (t) Consumption ( L'.C )
(t) (t)
100 - 60 40 -
200 200 - 100 = 100 100 100 100 - 40 = 60

. to consume = LiC = 60 = 0.6
. I propensity
Margma
LiY 100
MPS = 1- MPC
= 1- 0. 6= 0.4
Ans. M P C = 0. 6 and MPS= 0.4.
3. Find aggregate demand , given the following information:
Items (< in crore)
(i) Private consumption expenditure 50, 000
(ii) Private investment expenditure 30, 000
(iii) Government expenditure 20,000
(iv) Exports 10,000
low
(v) Imports 5, 000
Sol. Aggregate Demand
= Private consumption expenditure ( C) + Private investment expenditure ( I ) + Government
expenditure ( G) + [Exports- Imports ( NX)]
= < 5 0, 000 crore+ < 30,000 crore + < 20, 000 crore+ (< 10, 000 crore-< 5 , 000 crore)
ee
= < 1, 05 , 000 crore
rF
Fr
Ans. Aggregate demand=< 1,05,000 crore.
4. In an economy (= 50 and MP S= 0. 5 . Draw a d iagram showing behaviou r of consumption corresponding
to income levels of 0, 100 and 200.
or
Sol. C indicates autonomous consumption.
sf
u
b= MPC= l- MPS
= 1- 0. 5 = 0.5
k
Yo
Thus, we have consumption function of the following y
oo
type: C = C + bY
C = C + bY § 1 50 t-----------:;;;,,r
B
Substituting the values of Y as 0, 100 and 200, we get: ·g_

re
C = 50+ 0. 5 ( O ) � 1 00 +-----:;;;,,re------,
= 50 0
u _
ou
c�so
ad
When Y = 100, C = 50+ 0. 5 (100)

= 50+ 50= 100
Y
- ---- -
0�-- 1 01- 0 201-0 -- X
and Y = 200, C = 50+ 0. 5 (200) Y (l ncome)/GDP
= 50+ 100= 150
nd
Re
5. Income generated in the economy is twice the increase in autonomous investment. Find the values of
M P C and MPS.
Fi
Sol. We know that,

Multiplier ( K) = !;
Let the increase in investment=< 100
Increase in income = 2 x < 100= < 200
200
K= =2
100
1 1
K = ----
1- MPC MPS
1
Or, MPS = -
K

=> MPS = _l_= 0.5
2
MPC+ MPS = 1
MPC = 1- MPS
= 1- 0. 5 = 0.5
Ans. M P C = 0.5 a n d MPS= 0. 5.
6. Find saving function when consumption function is given as: C = 5 00 + 0. 5Y.
Sol. S= -C + (l - b)Y
Where, -C = Savings when Y = 0
a n d 1 - b = M PS
S = -500 + ( 1 - O.S)Y
S = -500 + O.SY
An s. Saving function= -500 + 0.5Y.
7. Estimate the val u e of aggregate dema nd in an economy if:
(a) Autonomous investment (I)=� 100 crore.
(b) M arginal propensity to save (MPS)= 0.2
(c) Level of income (Y) = � 4,000 crore.
(d) Autonomous consumption expenditure (C) = � 5 0 crore. [CBSE Sample Paper 2019]
Sol. Given, autonomous investment (I)= � 100 crore
Marginal propensity to save ( MPS)= 0.2
Level of income (Y) =� 4,000 crore
Autonomous consumption expenditure (C) =� 50 crore
Marginal propensity to consume ( MPC) = 1- MPS= 1- 0.2 = 0.8
We know that,
AD = C+ I
Or, AD = C+ MPC (Y) + I
= 50 + 0.8 ( 4,000) + 100
= 50 + 3,200+ 100
= 3, 350
Ans. Aggregate demand= � 3,350 crore.
8. If marginal propensity to save is 20% a nd is constant at all levels of income and the a utonomous
consumption is� 100 crore, construct consumption function of the given hypothetical economy.
[CBSE 2019 (58/3/1)]
0
Sol. Given, marginal propensity to save ( MPS)= 20% = � = 0.2
1 0
MPC= 1- MPS= 1- 0.2 = 0.8
Autonomous consumption (C) =� 100 crore
Consumption function would be:
C = C+ MPC (Y)
= 100+ 0.8Y
9. If marginal propensity to save is 10% and is constant at all levels of income, and the a u tonomous
consumption is � 200 crore, construct consumption function of the given hypothetical economy.
[CBSE 2019 (58/3/2)]
0
Sol. Given, marginal propensity to save ( MPS)= 10%= � = 0.1
1 0

MPC= 1- MPS = 1- 0.1= 0.9
Autonomous consum ption (C) = � 200 crore
Consum ption function would be:
C = C + MPC (Y)
= 200 + 0.9Y
10. If marginal propensity to consume is 80% and is constant at all levels of income, and the autonomous
consumption is< 400 crore, construct consumption function of the given hypothetical economy.
[CBSE 2019 (58/3/3 )]
Sol. Given, marginal propensity to consume ( MPC) 80% = �� = 0.8
=
1
Autonomous consum ption (C) = � 400 crore
low
Consum ption function would be:
C = C+ MPC (Y)
= 400 + 0.8Y
11. The consumption function of an economy is: C= 40+ 0.8Y (amount in< crore) . Determine that level
ee
of income where average propensity to consume will be one. [CBSE 2019 (58/4/1 )]
Sol. Given, C = 40 + 0.8Y
rF
Fr
Average propensity to consume ( APC = � ) will be one when:
Y =C
or
Y = 40 + 0.8Y
sf
u
Y- 0.8Y = 40
0.2Y = 40
k
Yo
40
Y= 200
oo
0.2 =
An s. Average propensity to consume will be one when the level of income = � 200 crore.
B
re
S H O RT RU N EQU I LI BRI U M OUTPUT

1. Find out the size of multi plier, when MPC is (i) 0, (ii) 0.5, (iii) 0. 9 respectively.
ou
ad
Sol. (i) MPC = 0

Y
1 1
= - = _!_ = 1
Multiplier =
1- MPC 1- - 0 1
( ii) MPC = 0. 5
nd
Re
1 1 1
Multiplier = ---- ___ = _!_ = 2
Fi
-1 _ MPC 1- 0. 5 1
1- 1-
2 2
( iii) MPC = 0.9
1 1 1
Multiplier = ---- -1- = 10
=
-1 _ MPC 1- 0.9 1
1- .2.._
10 10
2. Find out multiplier when MPS is (i) 0.4, (ii) 0. 5, (iii) 0.8.
Sol. (i) MPS = 0.4
1 1
Multiplier = -- = -- = -1- = _!_ = 2.5
MPS 0.4 - 4 -2
10 5

( ii) MPS= 0.5
1 1 l
Multiplier= --= --= __= __1_= 2
MPS 0.5 - 5 1
-
10 2
( iii) MPS= 0.8
1 1
Multiplier= --= --= -1-= __1_= 1.2 5
MPS 0.8 - 8 4
-
10 5
3. As a result of increase in investment by t 12 5 crore, national income increases by t 500 crore.
Calculate marginal propensity to consume.
!;
Sol. We know,
Multiplier ( K) =
Given, I).Y= t 500 crore, M = t 12 5 crore, we get,
500
K = =4
12 5
1- 1
We also know, K =--
1- MPC MPS
_ 1_
=4
MPS
MPS = � = 0.2 5
MPC = 1- MPS
= 1- 0.2 5 = 0.75
Ans. Marginal propensity to consume = 0. 75.
4. As a result of increase in investment, national income rises by t 600 crore. If marginal propensity to
consume is 0. 75, calculate the increase in investment.
Sol. Increase in national income ( !).Y) = t 600 crore
MPC= 0 .75
1
Multiplier ( K) =
l - MPC
1 -1
= -= 4
1- 0.75 0 .25
We know, K = M
M
=> M = y = 6 = 15 0
I). 00
K 4
Ans. Increase in investment= t 150 crore.
5. If marginal propensity to consume is 0. 9, what is the value of multi plier? How much investment is
needed to increase national income by t 5,000 crore? Calculate.
Sol. Desired increase in national income (!).Y) = t 5 ,000 crore
MPC= 0 .9
l 1
Multiplier ( K) = = --= 10
l - �PC 1- 0 .9 0 . 1
We know, K = M
M
M 5 ,000
=> M=
K
= = 5 00
10
Ans. Multiplier ( K) = 10
Desired increase in investment= t 5 00 crore.

6. In an economy, an increase in investment leads to increase in national income which is three times
more than the increase in investment. Calculate marginal propensity to consume.
Sol. Increase in national income = 3 times more than the increase in investment
3 times more than increase in investment = 3 times of investment+ Initial investment
Or, M = 3M + M :::::, M= 4M
Or, 4 = M
L'1I
Or, Multiplier ( K) = 4
1 1
(- :
K=
!1 )
We know, K = :::::, 4=
1- M P C 1- M PC
1
low
:::::, 4 ( 1- M PC ) = 1 :::::, 1- M PC = -
4
:::::, l- M PC = 0.25 :::::, M P C= 1- 0.2 5
:::::, M PC = 0.75
7. It is planned to increase national income by � 1,000 crore. How much increase in investment is
ee
required to achieve this goal? Assume that marginal propensity to consume is 0.6. Calculate.
rF
Fr
Sol. Desired increase in national income (�Y) =� 1, 000 crore
MPC = 0 . 6
or
Multiplier ( K) =
l - �PC
1 1
sf
u
= -- = 2.5
1- 0 . 6 0.4
k
K = M
Yo
We know,
L'1I
oo
1, 000 =
L'1I = M = 400
B
K 2.5
re
Ans. Desired increase in investment= � 400 crore.

8. In an economy, marginal propensity to consu me is 0 . 75. If investment expenditure is increased by
ou
� 500 crore, calculate the increase in income and consumption expenditure.

ad
Sol. Increase in investment ( M ) = � 500 crore

Y
M PC = 0.75
Multiplier ( K) = __1__ = _ 1_ =
4
nd
Re
l - � P C 1- 0.75 0 .25
We know, K = M
Fi
L'1I
= K x �I = 4 x 500 = 2,000
M
� C = M ( M PC ) = 2,000 (0.75) = 1, 500
Ans. Increase in income =� 2, 000 crore.
Increase in consumption expenditure =� 1, 5 00 crore
9. What is the value of multi plier when marginal propensity to save is zero? [CBSE Sample Paper 2013]
Sol. Given, M P S = 0 ( zero)
1 1
- = - = oo
We know that, M u I tip
. 1 ·1er =
-
MPS 0
Ans. Multiplier = oo ( infinity).

10. An economy is in equilibrium. Calculate national income from the following :
Autonomous consumption = 100.
Marginal propensity to save = 0.2 .
Investment expenditure = 200. [CBSE Delhi 2015]
Sol. Given, autonomous consumption (C) = 100
Investment expenditure ( I ) = 200
Marginal propensity to consume ( MPC) = 1- MPS
= 1- 0.2 = 0.8
At the equilibrium level,
Y =C+I
Or, Y = C + MPC (Y) + I
=> Y = 100 + 0.8Y + 200 Y = 300 + 0.8Y
=> Y- 0.8Y = 300 0.2Y = 300
300
=> Y=
0.2
= 1 500
'
Ans. National income 1,500.
=
11. An economy is in equilibrium. Find 'autonomous consumption' from the following:

National income = 1,000.
Marginal propensity to consume = 0.8.
Investment expenditure = 100. [ CBSE Delhi 2015]
Sol. Given, national income (Y) = 1,000
Marginal propensity to consume ( MPC) = 0.8
Y =C + I
Or, Y = C + MPC (Y) + I
c
1,000 = + o.8 ( 1,000) + 100
1,000 = C + 800 + 100
1,000 = C + 900
C = 1,000- 900 = 100
Ans. Autonomous consumption = 100.
12. An economy is in equilibrium. Find marginal propensity to consume from the following:
National income = 2, 000.
Investment expenditure= 200. [CBSE Delhi 2015]
Autonomous consumption (C) = 400
Y =C + I
Or, Y = C + MPC (Y) + I
2,000 = 400+ MPC ( 2 , 000) + 200
2,000 = 600 + 2,000 ( MPC)

2,000 ( MPC) = 2,000- 600
2,000 ( MPC) = 1,400
l,400
MPC = = 0.7
2,000
Ans. Marginal propensity to consume 0. 7.=
13. An economy is in eq uilibrium. Calculate the investment expenditure from the following:
National income = 800.
Marginal propensity to save = 0.3.
Autonomous consumption = 100. [CBSE (Al) 2015]
Sol. Given, national income (Y) = 800
Marginal propensity to save ( MPS)= 0. 3
low
= 1- 0. 3 = 0.7
Y =C + I
ee
Or, Y = C + MPC (Y) + I
=>
rF
Fr
800 = 100 + 0.7 ( 800) + I
=> 800 = 100 + 560 + I
=> 800 = 660 + I
or
=> I = 800- 660 = 140
sf
u
Ans. Investment expenditure = 140.
14. An economy is in equilibrium. Calculate the marginal propensity to save from the following:
k
Yo
oo
Investment = 120. [CBSE (Al) 2015]
B

re

Investment ( I ) = 120
ou

ad
Y =C+I
Y
Or, Y = C + MPC (Y) + I

1,000 = 100+ MPC ( 1,000) + 120
nd
Re
1,000 = 220 + 1,000 ( MPC)

1,000 ( MPC) = 1,000- 220
Fi
1,000 ( MPC) = 780

MPC = �= 0.78
1,000
MPS = 1- MPC
MPS = 1- 0.78 = 0.22
Ans. Marginal propensity to save = 0.22.
15. An economy is in eq uilibrium. Calculate the national income from the following:
Investment expenditure = 150. [CBSE (Al} 2015]

Sol. Given, autonomous consumption (C) = 120
= 1- 0.2 = 0.8
Y =C + I
Or, Y = C + MPC (Y) + I
=> Y = 120 + 0.8Y + 150
=> Y = 270 + 0.8Y
=> Y- 0.8Y = 270
=> 0.2Y = 270
270
=> Y =
0.2
= 1' 350
Ans. National income 1,350.
=
16. An economy is in equilibrium. Calculate marginal propensity to save from the following:
Investment expenditure = 200. [CBSE {F) 2015]
Y =C + I
Or, Y = C + MPC (Y) + I
=> 1,000 = 100 + MPC ( 1,000) + 200
=> 1,000 = 300 + 1,000 ( MPC)
=> 1,000 ( MPC) = 1,000- 300
=> 1,000 ( MPC) = 700
=> MPC = __lQQ_= 0.7
1,000
=> MPS = 1- MPC
=> MPS = 1- 0.7 = 0. 3
Ans. Marginal propensity to save 0. 3.
=
1 7. An economy is in equilibrium. Find the investment expenditure from the following:

National income = 750.
Marginal propensity to save= 0.4. [CBSE (F) 2015]
Sol. Given, national income (Y) = 750
= 1- 0.4 = 0.6
Y =C + I
Or, Y = C + MPC (Y) + I

:::::, 75 0 = 2 00 + 0 . 6 ( 7 5 0 ) + I
:::::, 75 0 = 2 00 + 45 0 + I
:::::, 75 0 = 65 0 + I
:::::, I = 75 0- 65 0 = 100
18. An economy is in equilibrium. Calculate autonomous consumption from the following:
Investment expenditure = 150. [CBSE {F) 2015]
Sol. Given, national income (Y) = 1,2 50
Marginal propensity to save ( MPS)= 0 .2
low
Investment expenditure (I) = 15 0
= 1- 0 .2 = 0 .8
Y =C + I
ee
Or, Y = C + M PC (Y) + I
rF
c
Fr
:::::, 1,25 0 = + o.8 ( 1,25 0 ) + 15 0
:::::, c
1,25 0 = + 1, 000 + 15 0
:::::, c
1,25 0 = + 1, 15 0
or
:::::, C = 1,250- 1, 150 = 100
sf
u
19. In an economy investment is increased by � 300 crore. If marginal propensity to consume is � ,
k
Yo
calculate increase in national income. [CBSE Delhi 2016]
oo
Sol. Given, increase in investment expenditure (AI) = � 300 crore
B
Marginal propensity to consume ( M P C ) = �

re
Multi plier ( K) = __1_= __!__= 3

l - � PC
1-2
ou
3 3
ad
We know, K = M
Y
AI
:::::, M = K x L'll
nd
Re
= 3 X 300 = 900
Ans. Increase in national income = � 900 crore.
Fi
2 0 . Su ppose marginal propensity to consume is 0. 8. How much increase in investment is required to

increase national income by � 2, 000 crore? Calculate. [CBSE Delhi 201 6]
Sol. Given, desired increase in national income ( L'lY) =� 2, 000 crore
Marginal propensity to consume ( MPC) = 0 .8
l 1
Multi plier ( K) = = -= 5
l - �PC 1- 0 .8 - 0 .2
M
We know, K =
AI
M 2, 000
:::::, AI = = = 400
K 5
Ans. Increase in investment=� 400 crore.

21. In an economy an increase in investment by � 100 crore led to 'increase' in national income by
� 1, 000 crore. Find marginal propensity to consume. [CBSE Delhi 2016]
Sol. Given, increase in investment ( 111 ) = � 100 crore
Increase in national income (�Y) = � 1, 000 crore
We know,
M --= 1, 000
Mu I tl. p 1 .1er ( K) = -= lO
111 100
We also know,
1 1
K =--- 10= ____
1- MPC 1- MPC
1
::::, 1- MPC = -- ::::, 1- MPC= O . l
10
::::, MPC = 1- 0. 1 = 0.9
Ans. Marginal propensity to consume = 0.9.
22. An economy is in equilibrium. Calculate marginal propensity to consume.
Autonomous consumption expenditure = 200.
Investment expenditure = 100. [CBSE (Al) 2016]
Sol. Given, national income (Y) = 1, 000
Autonomous consumption expenditure (C) = 2 00
Now, we know that, Y =C + I
Here, C = C + bY, where b = MPC
Putting the given values, we get
1,000 = 200 + b X 1,000 + 100
1,000 = 300 + b X 1,000
1, 000 b = 1, 000- 300
1, 000 b = 7 00
b = _lQQ_ = 0.7
1, 000
23. An economy is in equilibrium. Find investment expenditure.
Marginal propensity to consume = 0.8. [CBSE (Al} 2016]
Autonomous consumption expenditure (C) = 150
Y =C + I
Or, Y = C + MPC (Y) + I
1,200 = 150 + 0.8 ( 1,200) + I
1,200 = 150 + 960 + I
1,200 = 1, 110 + I
I = 1,200- 1, 110 = 90
Ans. Investment expenditure= 90.

24. An economy is in equilibrium. Find investment expenditure.
Marginal propensity to consume = 0.8 [CBSE (Al) 2016]
Y =C+I
Or, Y = C + MPC (Y) + I
1,000 = 100 + 0.8 ( 1,000) + I
low
1,000 = 100 + 800 + I
1,000 = 900 + I
I = 1,000- 900= 100
25. Find equilibrium national income.
ee
rF
Fr
Marginal propensity to consume = 0.9.
Investment expenditure = 1,100. [CBSE (F) 2016]
Sol. Given, autonomous consumption expenditure (C) = 120
or
Investment expenditure (I) = 1, 100
sf
u
Y =C + I
k
Yo
Or, Y = C + MPC (Y) + I
oo
Y = 120 + 0.9Y + 1, 100

B
Y = 1,220+ 0.9Y
re
Y- 0.9Y = 1,220
O . lY = 1,220
ou
1, 220
ad
Y = o.1 = 12, 200

Y
Ans. National income = 12,200.

26. An economy is in eq u ilibrium. Find marginal propensity to consume.
nd

Re
Investment expenditure = 100.

Fi
National income = 2,000. [CBSE (F) 201 6]

Sol. Given, autonomous consumption expenditure (C) = 100
National income (Y) = 2,000
Now, we know that, Y =C + I
c
Here, C= + bY, where b= MPC
2,000 = 100 + b X 2,000 + 100
2,000 = 200 + b X 2,000
2,000b = 2,000- 200
2,000b = 1,800

1,800
b = = 0.9
2 , 000
Ans. Marginal propensity to consume = 0.9.
27. An economy is in equilibrium. Find autonomous consumption expenditure.
Investment expenditure = 300.
Marginal propensity to consume = 0.8. [CBSE {F) 201 6]
Y =C + I
Or, Y = C + MPC (Y) + I
c
1,600 = + o.8 ( 1, 600) + 300
1,600 = C + 1,280 + 300
1,600 = C + 1, 580
c = 1, 600- 1, 580 = 2 0
An s. Autonomous consumption expenditure = 20.
(a) Consumption function is given by C = 100+ 0. 75Y, and
(b) Autonomous investment is � 15 0 crore.
Estimate (i) Equilibrium level of income, and (ii) Consumption and Savings at the equilibrium level of
income. [CBSE Sample Paper 201 7]
Sol. (i) Given, C= 100 + 0.75Y
Autonomous investment (I) =� 150 crore
y = C+ j
Y = 100+ 0.75Y+ 150
Y = 250+ 0.75Y
Y- 0.75Y = 250
0.2 5Y = 250
250
Y = = 1 000
0.25
( ii) At Y = 1, 000
Consumption, C = 100 + 0.75Y
= 100 + 0.75 ( 1, 000)
= 100 + 750 = 850
We know that, Y =C + S
Or, S = Y- C
=> S = 1,000- 850 = 150
Ans. (i) Equilibrium level of income=� 1,000 crore.
( ii) Consumption at equilibrium level of income=� 850 crore.
Savings at equilibrium level of income=� 150 crore.

29. An economy is in equilibrium. From the following data about an economy, calculate autonomous
consum ption:
(a) Income = 5, 000.
(b) Marginal propensity to save = 0. 2.
(c) Investment expenditure = 800. [CBSE Delhi 201 7]
Sol. Given, income (Y) = 5,000.
Marginal propensity to save ( MPS)= 0.2.
Investment expenditure ( I ) = 800.
= 1- 0.2 = 0.8
low
Now, we know that Y =C + I
Here, C= C + bY, where b= MPC
c
s,ooo = + o.8 ( s ,ooo ) + 800
c
s,ooo = + 4,ooo + 800
c
ee
s,ooo = + 4,800
c
rF
Fr
= s,ooo - 4,800
= 200
An s. Autonomous consumption = 200.
or
30. An economy is in equilibrium. From the following data about an economy, calculate investment expenditure:
(a) Income = 10, 000.
sf
u
(b) Marginal propensity to consume = 0.9.
k
(c) Autonomous consumption = 100. [CBSE Delhi 201 7]
Yo
oo
Sol. Given, income (Y) = 10,000
B

re
Now, we know that

Y =C + I
ou

ad

Y
10,000 = 100+ 0.9 ( 10,000) + I

10,000 = 100 + 9,000 + I
nd
10,000 = 9, 100 + I
Re
I = 10,000- 9 , 100
Fi
I = 900
An s. Investment expenditure = 900.
31. An economy is in equilibrium. From the following data, calculate autonomous consum ption:
(a) Income = 10,000.
(b) Marginal propensity to save = 0. 2.
(c) Investment = 1,500. [CBSE Delhi 201 7]
Investment ( I ) = 1, 500
= 1- 0.2 = 0.8

Now, we know that Y =C + I
c
10,000 = + o.8 ( 10,000) + 1, 500
c
10,000 = + 8,000 + 1, 500
c
10,000 = + 9, 500
c= 10,000- 9,500
= 500
32. An economy is in equilibrium. From the following data, calculate the marginal propensity to save:
(a) Income = 10, 000.
(b) Autonomous consumption = 500.
(c) Consumption expenditure = 8,000. [CBSE (Al) 201 7]
Consumption expenditure (C) = 8,000
We know that, C = C + MPC (Y)
8,000 = 500 + MPC ( 10,000)
8,000 = 500 + 10,000 ( MPC)
10,000 ( MPC) = 8,000 - 500
10,000 ( MPC) = 7, 500
7, 500
MPC = = 0.75
lO, OOO
MPS = 1- MPC
= 1- 0.75= 0.25
Ans. Marginal propensity to save = 0.25.
33. An economy is in equilibrium. From the following data, calculate investment expenditure.
(i) Marginal propensity to consume = 0.9.
(i i) Autonomous consumption = 200.
(iii) Level of income = 10,000. [CBSE (F) 201 7]
Sol. Given, marginal propensity to consume ( MPC) = 0.9.
Autonomous consumption (C) = 200.
Level of income (Y) = 10,000.
Y =C + I
Or, Y = C + MPC (Y) + I
10,000 = 200+ 0.9 ( 10,000) + I
10,000 = 200 + 9,000 + I
10,000 = 9,200 + I
I = 10,000- 9,200
= 800
An s. Investment expenditure= 800.

34. In an economy, investment increased by 1,100 and as a result of it income increased by 5, 500. Had
the marginal propensity to save been 25 per cent, what would have been the increase in income?
[CBSE {F) 201 7]
Sol. We know,
tl.Y
Multiplier ( K) = "KI
5 ,500
=
1,100 =5
25
When marginal propensity to save ( MPS) is 25 per cent, i. e.,
100 = 0.25
1 1
K=
MPS = 0.25 = 4
low
tl.Y
As we know, K= "KI
LW = K x AI
= 4 X 1, 100 = 4,400
Ans. Increase in income = 4,400.
ee
35. In an economy C = 200 + 0. 5Y is the consu mption function where C is the consumption expenditure
rF
Fr
and Y is the national income. Investment expenditure is � 400 crore. Is the economy in eq uilibrium
at an income level� 1,500 crore? Justify your answer. [CBSE Sample Paper 2019]
Sol. Given, consumption function, C = 200+ 0.5Y
or
Investment expenditure = � 400 crore
sf
u
Y= C + I
Y = 200 + O .SY + 400
k
Yo
Y = 600 + O .SY
oo
Y- 0.SY = 600
B
O .SY = 600
600
re
Y= 1, 200
0.5 =
Ans. The economy is in equilibrium when the equilibrium level of income is� 1,200 crore. Accordingly, if
ou
ad
the equilibrium income =� 1,500 crore, the economy is not in equilibrium.

Reason: Eq uilibrium is struck only when income = expenditure = � 1,200 crore.
Y
Change in initial investments (tsl) = � 500 crore.
nd
Re
Marginal propensity to save (MP S) = 0.2.

Find the values of the following:
Fi
( a) Investment multiplier (K).

(b) Change in final income (LW). [CBSE 2019 (58/1/1)]
Sol. Given, change in initial investments (�I ) = � 500 crore
Marginal propensity to save ( MPS) = 0.2
We know that,
Multiplier ( K) = 5
M�S = 0\ =
Increase in Income (�Y) = K x �I
= 5 X 500 = 2 ,500
Ans. Investment multiplier = 5 .
Change in final income = � 2 ,500 crore.

Change in initial investments (M) = � 700 crore.
Marginal propensity to save (MPS)= 0.2.
Find the values of the following:
(a) Investment multiplier (K).
(b) Change in final income (L'IY) . [CBSE 2019 (58/1/2)]
Sol. Given, change in initial investments (AI) = � 700 crore
Marginal propensity to save (MPS) = 0.2
We know that,
Multiplier (K) = 5
M�S = 0\ =
Increase in Income (11Y) = K x AI
= 5 X 700 = 3,500
Ans. Investment multiplier 5.=
Change in final income=� 3,500 crore.

Change in initial investment (L'II) = � 1,200 crore.
Marginal propensity to save (MPS)= 0.2.
Find the values of:
(a) Investment multiplier (K).
(b) Change in final income (L'IY) . [CBSE 2019 (58/1/3)]
Sol. Given, change in initial investment (AI)=� 1,200 crore
Marginal propensity to save (MPS) = 0.2
We know that,
Multiplier (K) = 5
M�S = 0\ =
Increase in Income (11Y) = K x AI
= 5 X 1,200
= 6,000
Ans. Investment multiplier = 5.
Change in final income = � 6,000 crore.
39. Calculate change in final income, if marginal propensity to consume (MPC) is 0.8 and change in initial
investment is� 1,000 crore. [CBSE 2019 (58/2/1)]
Sol. Given, marginal propensity to consume (MPC) = 0.8
Change in initial investment (111) = � 1,000 crore
We know that,
1
Multiplier (K) = - � C 5
1 P = 1- 0.8 = o\ =
Increase in Income (11Y) = K x 111
= 5 X 1,000 = 5,000
Ans. Change in final income=� 5,000 crore.
40. Estimate the change in initial investment if marginal propensity to save (MPS) is 0·10 and change in
final income is� 15,000 crore. [CBSE 2019 (58/2/2)]
Sol. Given, marginal propensity to save (MPS) = 0.10
Change in final income (M) = � 15,000 crore

We know that,
Multiplier (K) = 10
M�S = O.�O =
We also know, K = ll.Y
fl.
I
15,000
10 = fl.
I
15,000
M= 1,500
10 =
Ans. Change in initial investment = < 1,500 crore.
41. Estimate the change in final income if marginal propensity to consume (MPC) is 0.75 and change in
low
initial investment is < 2,000 crore. [CBSE 2019 (58/2/3)]
Sol. Given, marginal propensity to consume (MPC) = 0.75
Change in initial investment (M) =< 2,000 crore
We know that,
1 -1-
Multiplier (K) = 4
ee
l -�PC = 1-0.75 = 0.25 =
rF
Fr
Increase in Income (11Y) = K x M
= 4 X 2,000= 8,000
Ans. Change in final income =< 8,000 crore.
or
42. The saving function of an economy is given as:
S = -25 + 0.25Y
sf
u
If the planned investment is< 200 crore, calculate the following:
(i) Equilibrium level of income in the economy.
k
Yo
oo
(ii) Aggregate demand at income of < 500 crore. [CBSE 2019 (58/5/1)]
Sol. Given, S =-25 + 0.25Y
B
Planned investment (I) =, 200 crore

re
At equilibrium, S =I
-25 + 0.25Y = 200
ou
ad
0.25Y = 200 + 25
0.25Y = 225
Y
225
y= = 900
0.25
nd
Re
We know at equilibrium, AD= C + I

= 25 + (1- 0.25)Y + 200
Fi
= 25 + 0.75 (500) + 200

= 25 + 375 + 200
= 600
Ans. (i) Equilibrium level of income in the economy=< 900 crore.
(ii) Aggregate demand at income of< 500 crore=< 600 crore.
S = (-) 10 + 0·20Y
If the ex-ante investments are< 240 crore, calculate the following:
(ii) Additional investments which will be needed to double the present level of equilibrium income.
[CBSE 2019 (58/5/2)]

Sol. Given, S =-10 + 0. 20Y
Ex-ante investments (I)=� 240 crore
-10 + 0. 20Y = 240
0. 20Y = 24 0 + 10
0. 20Y = 250
250
Y= = 1,250
0. 20
We know that,
1
K = MPS
1
K = 0. 20 = 5
We also know that, multiplier (K) = !;

1, 250
5=
�
1, 250
�I=--= 250
5
Ans. (i) Equilibrium level of income in the economy=, 1,250 crore.
(ii) Additional investments needed to double the present level of equilibrium income=, 250 crore.
S = (-) 50 + O.lOY
If the ex-ante investments are < 450 crore, calculate the following:
(ii) Additional investments which will be needed to gain an additional income level of<' 3, 00 0 crore.
[CBSE 2019 (58/5/3)]
Sol. Given, S =-50 + O.lOY
Ex-ante investments (I) =� 450 crore
-50 + O.lOY = 450
O.lOY = 450 + 50
O.lOY = 500
500
Y= = 5,000
0.10
We know that,
1
K = MPS
1
K = 0.10 =10
We also know that, multiplier (K) = !;

3,000
=> 10 =
�
3,000
=> �I =
10= 300
Ans. (i) Equilibrium level of income in the economy=� 5,000 crore.
(ii) Additional investments needed to gain an additional income level of< 3,000 crore=� 300 crore.

GOVERNMENT BUDGET AND THE ECONOMY
1. In a government budget, if revenue receipts = < 100 lakh, capital receipts = < 50 lakh and revenue
deficit = < 25 lakh, how much is the revenue expenditure?
Sol. Revenue expenditure =Revenue receipts + Revenue deficit
=< 100 lakh +< 25 lakh
=< 125 lakh
Ans. Revenue expenditure < 125 lakh.
=
2. Find Budget Deficit from the following data:

Items (< in crore)
(i) Revenue receipts 40,000
low
(ii) Revenue expenditure 30,000
(iii) Capital receipts 30,000
(iv) Capital expenditure 50,000
Sol. Budget Deficit = (Revenue expenditure + Capital expenditure)- (Revenue receipts + Capital receipts)
= (< 30,000 crore + < 50,000 crore)- (< 40,000 crore + < 30,000 crore)
ee
=< 80,000 crore-< 70,000 crore
rF
Fr
=< 10,000 crore
Ans. Budget deficit = < 10,000 crore.
3. Find Fiscal Deficit, given the following information:
or
Items (<)
(i) Estimated total expenditure of the government
sf 1,50,000
u
(ii) Revenue receipts 1,20,000
k
(iii) Non-debt capital receipts 10,000
Yo
oo
Sol. Fiscal Deficit = Total expenditure of the government- (Revenue receipts + Non-debt capital receipts)
=< 1,50,000- (< 1,20,000 + < 10,000)
B
= < 1,50,000- < 1,30,000

re
= < 20,000
Ans. Fiscal deficit < 20,000.
=
ou
ad
4. Payment of interest by the government during the year is estimated to be< 75,000 while the excess
of budgetary expenditure over budgetary receipts (net of borrowing) is estimated to be < 1,15,000.
Y
Find primary deficit.

Sol. Fiscal Deficit=< 1,15,000
nd
Re
Interest Payment=< 75,000

Primary Deficit= Fiscal deficit- Interest payment
Fi
=< 1,15,000-< 75,000

= < 40,000
Ans. Primary deficit = < 40,000.
5. From the following data about a government budget, find out (a)Revenue Deficit, (b) Fiscal Deficit, and
(c) Primary Deficit:
Items (< in crore)
(i) Revenue receipts 55
(ii) Capital receipts 42
(iii) Non-tax revenue 18
(iv) Borrowings 40

(v) Revenue expenditure 88
(vi) Interest payments 28
Sol. (a) Revenue Deficit=Revenue expenditure-Revenue receipts
= � 88 crore- � 55 crore
= � 33 crore
(b) Fiscal Deficit= Borrowings
= � 40 crore
(c) Primary Deficit= Fiscal deficit- Interest payments
= � 40 crore- � 28 crore
= � 12 crore
Ans. (a) Revenue deficit= � 33 crore.
(b) Fiscal deficit= � 40 crore.
(c) Primary deficit= � 12 crore.
6. From the following data about a government budget, find (a)Revenue Deficit, (b) Fiscal Deficit, and
(c) Primary Deficit:
Items (� in lakh)
(i) Tax revenue 50
(ii) Revenue expenditure 110
(iii) Capital expenditure 210
(iv) Non-tax revenue 30
(v) Capital receipts net of borrowing 140
(vi) Interest payments 20
Sol. (a) Revenue Deficit=Revenue expenditure - Revenue receipts (Tax revenue
+ Non-tax revenue)
= � 110 lakh - ( � 50 lakh + � 30 lakh)
= � 110 lakh- � 80 lakh
= � 30 lakh
(b) Fiscal Deficit=Revenue expenditure + Capital expenditure-Revenue
receipts- Capital receipts net of borrowing
= � 110 lakh + � 210 lakh- (� 50 lakh + � 30 lakh)-� 140 lakh
= � 110 lakh + � 210 lakh - � 80 lakh- � 140 lakh
= � 320 lakh - � 220 lakh
= � 100 lakh
(c) Primary Deficit= Fiscal deficit- Interest payments
= � 100 lakh - � 20 lakh
= � 80 lakh
Ans. (a) Revenue deficit= � 30 lakh.
(b) Fiscal deficit= � 100 lakh.
(c) Primary deficit= � 80 lakh.
7. Find (a) Fiscal Deficit, and (b) Primary Deficit from the following:
Revenue expenditure = 70,000
Borrowings = 15,000
Revenue receipts = 50,000
Interest payments = 25% of revenue deficit. [CBSE Sample Paper 2013]

Sol. Revenue Deficit = Revenue expenditure-Revenue receipts
= � 70,000 crore- � 50,000 crore
= � 20,000 crore
Here, Interest payments = 25% of revenue deficit

25
Or, Interest payments = x 20,000
100
= � 5,000 crore
(a) Fiscal Deficit = Borrowings

= � 15,000 crore
(b) Primary Deficit = Fiscal deficit- Interest payments

= � 15,000 crore- � 5,000 crore
low
= � 10,000 crore
Ans. (a) Fiscal deficit = � 15,000 crore.

(b) Primary deficit = � 10,000 crore.
8. Is the following revenue expenditure or capital expenditure in the context of government budget?
Give reason.
ee
(i) Expenditure on collection of taxes.
rF
Fr
(ii) Expenditure on purchasing computers.
Sol. (i) Expenditure on collection of taxes is a revenue expenditure because it neither causes a rise in
assets of the government nor does it lead to a reduction in the liabilities of the government.
or
(ii) Expenditure on purchasing computers is a capital expenditure because this results in the creation
sf
of assets for the government. Hence, such expenditures add to the assets of the government.
u
9. Is the following revenue receipt or a capital receipt in the context of government budget and why?
k
(i) Tax receipts.
Yo
oo
(ii) Disinvestment.
Sol. (i) Tax receipt is a revenue receipt because it neither creates any liability nor reduces the assets of the
B
government.
re
(ii) Disinvestment is a capital receipt. Capital receipts either create a liability or lead to a reduction in
the assets of the government. Disinvestment results in the reduction of assets of the government.
10. Giving reason, state whether the following is a revenue expenditure or a capital expenditure in a
ou
ad
government budget:
Y
(i) Expenditure on scholarship.

(ii) Expenditure on building a bridge.
nd
Sol. (i) Expenditure on scholarship is a revenue expenditure because it neither reduces liability nor
Re
adds to the assets of the government.

Fi
(ii) Expenditure on building a bridge is a capital expenditure because it adds to the assets of the
government.
11. Giving reasons, classify the following into revenue receipts and capital receipts:
(ii) Profits of public sector undertakings.
(iii) Borrowings. [CBSE (F) 2017]
Sol. (i) Recovery of loans is a capital receipt because it leads to reduction in assets of the government.
(ii) Profits of public sector undertakings are revenue receipts because they neither create a liability
for the government nor lead to reduction in assets of the government.
(iii) Borrowings are capital receipts because they create a liability for the government.

12. Classify the following statements as revenue receipts or capital receipts. Give valid reasons in support
of your answer.
(i) Financial help from a multinational corporation for victims in a flood affected area.
(ii) Sale of shares of a Public Sector Undertaking (PSU) to a private company, Y Ltd.
(iii) Dividends paid to the Government by the State Bank of India.
(iv) Borrowings from International Monetary Fund (IMF). [CBSE 2019 (58/2/1)]
Sol. (i) Financial help from a multinational corporation for victims in a flood affected area is a revenue
receipt, as it does not add to liability or does not lead to reduction in assets.
(ii) Sale of shares of a Public Sector Undertaking (PSU) to a private company, Y Ltd. is a capital
receipt, as it involves reduction in assets.
(iii) Dividends paid to the government by the State Bank of India is a revenue receipt, as it does not
add to liability or does not lead to reduction in assets.
(iv) Borrowings from International Monetary Fund (IMF) are capital receipts because they create a
liability.
13. Given the following data estimate the values of (a) Revenue Deficit, and (b) Fiscal Deficit:
Items (t in crore)
(i) Tax revenue 1,000
(ii) Non-tax revenue 150
(iii) Net borrowings by government 780
(iv) Disinvestment proceeds 50
(v) Revenue expenditure 1,500
(vi) Capital expenditure 480
[CBSE 2019 (58/3/1)]
Sol. (a) Revenue Deficit= Revenue expenditure -Revenue receipts (Tax revenue+ Non-tax revenue)
= t 1,500 crore -(t 1,000 crore+ t 150 crore)
= t 1,500 crore -t 1,150 crore
= t 350 crore
(b) Fiscal Deficit= Net borrowings by government
= t 780 crore
Ans. (a) Revenue deficit= t 350 crore.
(b) Fiscal deficit= t 780 crore.
BALANCE OF PAYMENTS
1. Find the value of imports, if balance of trade= t 180 crore and value of exports= t 280 crore.
Sol. Balance of Trade = Value of exports - Value of imports
t 180 crore= t 280 crore -Value of imports
Value of imports= t 280 crore -t 180 crore
= t 100 crore
Ans. Value of imports= t 100 crore.
2. If balance of trade is found to be in a state of balance, find the deficit on account of 'invisibles' if
balance of payments on capital account shows a surplus oft 20,000 on account of borrowing from
rest of the world.
Sol. Deficit on account of invisibles= t 20,000.

3. Find Current Account Balance from the following:
Items (< in crore)
(i) Export of goods 80
(ii) Export of services 20
(iii) Balance of visible trade 50
(iv) Transfers from one country to an another country 5
Sol. Current Account Balance Balance of visible trade+ Export of services+ Transfers from
=
one country to an another country

= < 50 crore+ < 20 crore+ < 5 crore
= < 75 crore
low
Ans. Current account balance = < 75 crore.
4. Find the Balance on the Balance of Payments Account. Is the overall balance of payments balances?
Items (< in lakh)
(i) Capital account balance (-) 400
(ii) Value of imports 150
ee
(iii) Value of exports
rF 450
Fr
(iv) Unilateral transfers 100
(v) Balance of visible trade 200
or
Sol. Balance on the Balance of Payments Account
= Value of exports - Value of imports+ Unilateral transfers+ Capital account balance
sf
u
= < 450 lakh - < 150 lakh+ < 100 lakh+ (-) < 400 lakh
= < 450 lakh - < 150 lakh+ < 100 lakh - < 400 lakh
k
Yo
oo
= 0
Ans. Balance on the balance of payments account is O (zero). Yes, the overall balance of payments
B
balances.
re
[Note: Balance of visible trade excludes the balance of invisible trade.]

Ill
ou
ad
Y
nd
Re
Fi

NATIONAL INCOME AND RELATED AGGREGATES
Numericals related to Nominal GDP
1. If the Real GDP is 660 and price index (with base = 100) is 105, calculate Nominal GDP.
[Ans. Nominal GDP = 693]
2. If real income is� 820 and price index is 110, find nominal income.
[Ans. Nominal income =� 902]
Numericals related to Real GDP
3. If the Nominal GDP is� 1,050 and price index (with base = 100) is 125, calculate Real GDP.
[Ans. Real GDP =� 840)
4. If nominal income is� 550 and price index is 110, calculate real income.
[Ans. Real income =� 500]
5. If nominal income is� 220 and price index is 100, find real income.
[Ans. Real income =� 220]
Numericals related to Price Index
6. If the Real GDP is 440 and Nominal GDP is 495, calculate price index (base = 100).
[Ans. Price index = 112.5]
7. If the Real Gross Domestic Product is � 260 and the Nominal Gross Domestic Product is � 312,
calculate the price index (base = 100).
[Ans. Price index = 120]
METHODS OF CALCULATING NATIONAL INCOME

Numericals related to Value Added/Product Method
1. From the following about firm 'X', calculate 'Gross Value Added at Factor Cost' by it:
Items (� in thousand)
(i) Sales 500
(iii) Closing stock 20
(iv) Purchase of intermediate products 300
(v) Purchase of machinery 150
(vi) Subsidy 40
[Ans. Gross value added at factor cost by firm X =� 230 thousand]
465
2. From the following about firm 'Y', calculate 'Net Value Added at Market Price' by it:
Items (fin thousand!
(i) Sales 300
(iii) Net indirect taxes 30
(iv) Purchase of intermediate products 150
(v) Change in stock (-) 10
(vi) Purchase of machinery 100
[Ans. Net value added at market price by firm Y = f 120 thousand]
3. From the following data, calculate 'Gross Value Added at Factor Cost':
low
Items (f)
(i) Units of output sold 1,000
(ii) Change in stock 100
(iii) Subsidies 300
(v) Intermediate consumption 7,000
ee
(vi) Price per unit of output 10
rF
Fr
(vii) Rent 700
[Ans. Gross value added at factor cost = f 3,400]
4. Calculate 'Net Value Added at Factor Cost' from the following data:
or
Items (f ln crore)
sf
u
(i) Sales 1,760
k
Yo
oo
(iv) Intermediate cost 1,000
(v) Exports 150
B
(vi) Indirect taxes 40

re
[Ans. Net value added at factor cost = f 610 crore]

5. Calculate 'Sales' from the following data:
ou
ad
Items (fin lakh)

(i) Subsidies 100
Y

nd
Re
(iv) Intermediate consumption 2,000

Fi
(vi) Profit 750

(vii) Net value added at factor cost 2,500
[Ans. Sales = f 4,500 lakh]
Items (fin lakh)
(i) Subsidies 200
(iv) Sales 5,000

(vi) Profit 750
(vii) Net value added at factor cost 2,000
[Ans. Intermediate consumption = < 3,000 lakh]
7. From the following data, calculate 'Net Value Added at Market Price' by Firm A:
Items (< in crore)
(i) Sales 850
(iv) Purchase of machinery 300
(v) Depreciation 70
(vi) Purchase of intermediate products 450
[Ans. Net value added at market price by firm A = < 300 crore]
8. Calculate 'Value of Output' from the following data:
Items (< in lakh)
(i) Subsidy 10
(ii) intermediate consumption 150
(iii) Net addition to stocks (-) 13
(v) Excise duty 20
(vi) Net value added at factor cost 250
[Ans. Value of output = < 440 lakh]
Numericals related to Income Method

9. Calculate 'Operating Surplus' from the following data:
Items (< in crore)
(i) Rent 120
(ii) Profit 200
(iii) Domestic income 800
(iv) Mixed income 70
(v) Wages and salaries 350
(vi) Indirect tax 150
(vii) Subsidies 50
[Ans. Operating surplus = < 380 crore]
Items (< in crore)
(ii) Rent 200
(iii) Wages and salaries 750
(vi) Profit 300
(vii) Interest 100
Unsolved Numericals 467

(ix) Remittances from abroad 80
(x) Taxes on profits 60
[Ans. National income = f 1,380 crore]
11. From the following data, calculate 'Net National Product at Market Price':
Items (fin crore)
(i) Corporation tax 350
(ii) Compensation of employees 800
(iii) Mixed income of self-employed 900
(iv) Net factor income from abroad (-) 50
(vi) Rent 350
low
(vii) Profit 600
(ix) Interest 450
[Ans. Net national product at market price = f 3,300 crore]
12. Find (a) Net National Product at Market Price, and (b) Gross National Product at Factor Cost:
ee
Items (fin lal<h)
(i) Wages and salaries
rF 900
Fr
(ii) Rent 150
(iii) Net current transfers to abroad 10
or
(v) Royalty 50
(vi) Profit
sf 250
u
k
Yo
(ix) Social security contribution by employers 160
oo
(x) Social security contribution by employees 40
B
(xi) Interest 500

[Ans. (a) Net national product at market price = f 2,100 lakh
re
(b) Gross national product at factor cost = f 2,200 lakh]

13. Calculate 'Gross National Product at Market Price' from the following data:
ou
ad
Items {fin crore)

Y
(ii) Interest 500

(iii) Rent 700
nd
Re
(iv) Profits 800

(v) Employer's contribution to social security schemes 200
Fi
(vi) Dividends 300

(vii) Consumption of fixed capital 100
(ix) Net exports 70
(x) Net factor income to abroad 150
(xi) Mixed income of self-employed 1,500
[Ans. Gross national product at market price = f 5,700 crore]
14. Calculate 'Net National Product at Factor Cost' from the following:
Items (f ln crore)
(i) Profits 300
(ii) Wages and salaries 600

(iv) Rent 200
(v) Net factor income paid to abroad 50
(vi) Interest 300
(vii) Social security contributions by employers 100
[Ans. Net national product at factor cost = < 1,450 crore]
Items (< in crore)
(i) Net indirect taxes 500
(iii) Net factor income from abroad (-) 50
(v) Net retained earnings of private enterprises 200
(vi) Profit 800
(vii) Rent 600
(viii) Corporation tax 400
(ix) Interest 700
(x) Subsidy 200
[Ans. National income = < 4,550 crore]
Numericals related to Expenditure Method

16. Calculate GDP M P and NDP MP with the help of expenditure method from the data give below:
Items (< in crore)
(i) Corporate tax 50
(ii) Private final consumption expenditure 7,100
(iii) Fixed capital formation 3,000
(vi) Net indirect taxes 600
(vii) Government final consumption expenditure 2,200
(viii) Change in stock 800
(ix) Consumption of fixed capital 450
[Ans. GDP M P = < 12,800 crore
NDP M P = < 12,350 crore)
17. Calculate 'Net Domestic Product at Factor Cost' and 'Gross National Product at Market Price' from
the following data:
Items (< in crore)
(i) Indirect taxes 20
(iii) Net factor income from abroad 15
(vi) Net exports (-) 10

(vii) Subsidies 10
(viii) Net domestic capital formation 30
[Ans. Net domestic product at factor cost = < 310 crore
Gross national product at market price = < 360 crore]
18. Calculate 'National Income' from the following:
Items (< in lakh)
(i) Net change in stocks so
(ii) Government final consumption expenditure 100
(iv) Gross domestic fixed capital formation 200
low
(v) Private final consumption expenditure 500
(vi) Net imports 40
(vii) Depreciation 70
(x) Net capital transfers to abroad 25
ee
[Ans. National income = < 630 lakh]
rF
Fr
19. From the following data, calculate 'Net National Product at Market Price':
Items (< in crore)
(i) Private consumption expenditure 75,000
or
(ii) Government consumption expenditure 15,550
(iii) Gross capital formation
sf 4,500
u
(iv) Exports 6,000
k
(v) Imports 9,000
Yo
oo
(vi) Net factor income from abroad (-) 650
(vii) Depreciation 600
B
[Ans. Net national product at market price = < 90,800 crore]

re
20. From the following data, find out 'National Income':

Items (< in crore)
ou
ad

Y
(iii) Consumption of fixed capital 2,000

(iv) Gross domestic fixed capital formation 9,860
nd
(v) Exports 13,720

Re
(vi) Imports 15,000

Fi

(viii) Change in stock 2,560
(ix) Goods and Services tax 2,700
(x) Subsidy 100
[Ans. National income = < 45,490 crore]
Miscellaneous Numericals
21. From the following data, estimate (a) Net Indirect Taxes, and (b) Net Domestic Product at Factor Cost:
Items (< in crore)
(i) Net national product at market price 1,400
(ii) Net factor income from abroad (-) 20

(iii) Gross national product at factor cost 1,300
(v) National debt interest 18
[Ans. (a) Net indirect taxes = � 200 crore
(b) Net domestic product at factor cost = � 1,220 crore]
22. From the following data, calculate National Income by (a) Income Method, and (b) Expenditure Method:
Items (f ln crore)
(ii) Net capital formation 400
(iii) Change in stock 50
(v) Rent 200
(vi) Interest 150
(vii) Operating surplus 720
(ix) Employers' contribution to social security schemes 100
(x) Net exports 20
(xi) Net factor income from abroad (-) 20
(xii) Government final consumption expenditure 600
(xiii) Consumption of fixed capital 100
[Ans. National income (by income and expenditure methods) = � 2,600 crore]
23. From the following data calculate Net National Product at Factor Cost by (a) Income Method, and
(b) Expenditure Method:
Items (�in crare)
(i) Current transfers from rest of the world 100
(iii) Wages and salaries 3,800
(iv) Dividend 500
(v) Rent 200
(vi) Interest 150
(vii) Net domestic capital formation 500
(viii) Profits 800
(ix) Employers' contribution to social security schemes 200
(x) Net exports (-) 50
(xi) Net factor income from abroad (-) 30
(xii) Consumption of fixed capital 40
(xiii) Private final consumption expenditure 4,000
(xiv) Net indirect tax 300
[Ans. Net national product at factor cost (by income and expenditure methods) = � 5,120 crore]
24. From the following data relating to a firm, (a) estimate the Net Value Added at Market Price, (b) show
that Net Value Added at Factor Cost is equal to the sum of factor incomes.
Items (� in thousand!
(i) Salaries and wages 120
(ii) Interest payments 90
(iii) Dividends 30

(iv) Undistributed profits 20
(v) Rent payments 15
(vi) Increase in stocks 40
(vii) Imports of raw material 20
(viii) Indirect taxes 10
(ix) Depreciation of fixed capital 15
(x) Domestic sales 360
(xi) Exports 40
(xii) Domestic purchase of raw materials and other inputs 120
[Ans. (a) Net value added at market price = � 285 thousand
(b) Net value added at factor cost = Sum of factor incomes = � 275 thousand]
low
25. From the following data, estimate 'Gross National Product at Market Price':
Items {� in crore)
(i) Gross domestic product at factor cost 750
(ii) Corporation tax 20
ee
(iii) Net other current transfers from general government 110
(iv) Net indirect taxes
rF 130
Fr
(v) Net other current transfers from abroad 80
(vi) Net factor income from abroad (-)70
or
(vii) Saving of the private corporate sector 60
[Ans. Gross national product at market price = � 810 crore]
sf
u
26. From the following data, calculate (a) Domestic Income, and (b) National Income.
Items (�in crore)
k
Yo
oo
(ii) Interest 1,500
B
(iii) Undistributed profit and dividends 1,800

(iv) Rent 2,400
re
(v) Mixed incom of self-employed 9,000

ou
(vi) Net factor income from abroad 3,000

ad
[Ans. (a) Domestic factor income � 29,700 crore

=
Y
(b) National income = � 32,700 crore]

27. From the following data, calculate Gross National Product at Market Price by (a) Income Method, and
nd
(b) Expenditure Method:

Re
Items (f ln crore)
Fi

(ii) Profit 250
(iii) Mixed income of self-employed 300
(iv) Rent 80
(v) Interest 70
(vi) Private final consumption expenditure 700
(vii) Net domestic capital formation 120
(x) Government final consumption expenditure 350

(xi) Net indirect taxes 60
(xii) Net factor income from abroad (-) 10
[Ans. Gross national product at market price (by income and expenditure methods) = � 1,250 crore]
28. From the following data, find out (a) Gross Domestic Product at Market Price, and (b) National Income:
Items (f ln crore)
(iii) Consumption of fixed capital 7,680
(iv) Gross domestic fixed capital formation 12,565
(v) Exports (X) 12,860
(vi) Imports (M) 13,985
(viii) Change in stock 5,000
[Ans. (a) Gross domestic product at market price = � 54,225 crore
(b) National income = � 46,270 crore]
29. Calculate Gross National Product at Market Price by (a) Income Method, and (b) Expenditure Method:
Items (f ln crore)
(i) Net exports 10
(ii) Rent 20
(iv) Interest 30
(v) Dividends 45
(vii) Corporate tax 10
(viii) Government final consumption expenditure 100
(ix) Net domestic capital formation so
(x) Compensation of employees 400
(xii) Net indirect taxes 50
(xiii) Net factor income from abroad (-) 10
[Ans. Gross national product at market price (by income and expenditure methods) = � 560 crore]
30. From the following data, calculate National Income by (a) Income Method, and (b) Expenditure Method:
Items (f ln crore)
(i) Interest 150
(ii) Rent 250
(iv) Private final consumption expenditure 1,200
(v) Profits 640
(vi) Compensation of employees 1,000
(vii) Net factor income to abroad 30
(x) Consumption of fixed capital so
(xi) Net domestic capital formation 340
[Ans. National income (by income and expenditure methods) = � 2,010 crore]

AGGREGATE DEMAND, AGGREGATE SUPPLY
AND RELATED CONCEPTS
1. Find the value of C, when C= 50, Y= 500 and marginal propensity to consume is 0.2.
[Ans. C= 150)
2. Find saving, when S= (-) 100, Y= 500 and marginal propensity to save= 0.4.
[Ans. Saving= 100)
3. Find the values of marginal propensity to consume and marginal propensity to save from the
following data:
Income(�) Saving(�)
low
750 150
1,000 200
[Ans. MPC= 0.8; MPS= 0.2)

4. What will be the value of average propensity to save when
(i) C = 200 at Y = 1,000?
ee
(ii) S = 450 at Y = 1,200?
rF
Fr
[Ans. (i) APS= 0.8 (ii) APS= 0. 375)
5. Complete the following table:
or
Level of Income Consumption Expenditure Marginal Propensity Marginal Propensity
(�) (�) to Consume to Save
sf - -
u
1,000 900
1,200 1,060 - -
k
- -
Yo
1,400 1,210
oo
1,600 1,350 - -
B
[Ans. MPC: -, 0. 8, 0.75, 0.7; MPS:-, 0.2, 0. 25, 0.3]

re
Income Consumption Expenditure Marginal Propensity Average Propensity

(�) (�) to Consume to Save
ou
ad
0 20 - -
- -
Y
50 55
100 90 - -
- -
nd
150 125
Re
[Ans. MPC: -, 0.7, 0.7, 0. 7; APS: -,-0.1, 0.1, 0.16]

Fi

Income Marginal Propensity Saving Average Propensity Average Propensity
(�) to Consume (�) to Save to Consume
0 0.5 -80 - -
50 0.5 - - -
100 0.5 - - -
150 0.5 - - -
200 0.5 - - -
[Hint: C= C + MPC(Y); where, C= 80 at Y= 0 and MPC= 0.5.)
[Ans. Saving: - 80, - 55, - 30, - 5, 20; APS: -, -1.1, -0.3, -0.03, 0.1; APC: -, 2.1, 1.3, 1.03, 0.9)

SHORT RUN EQUILIBRIUM OUTPUT
1. If the value of multiplier is 4
(i) what will be MPC and MPS?
(ii) what will be marginal propensity to consume when marginal propensity to save is 0.2?
[Ans. (i) MPC = 0.75, MPS = 0.25
(ii) MPC = 0.8]
2. In an economy, investment expenditure is increased by � 700 crore. The marginal propensity to
consume is 0.9. Calculate the total increase in income and consumption expenditure.
[Ans. Increase in income = � 7,000 crore
Increase in consumption expenditure = � 6,300 crore]
3, In an economy, investment expenditure is increased by � 400 crore and marginal propensity to
consume is 0.8. Calculate the total increase in income and saving.
Increase in saving = � 400 crore]
4. In an economy, investment is increased by � 600 crore. If the marginal propensity to consume is 0.6,
calculate the total increase in income and consumption expenditure.
Increase in consumption expenditure = � 900 crore]
5. A � 200 crore increase in investment leads to a rise in national income by � 1,000 crore. Find out
marginal propensity to consume.
[Ans. MPC = 0.8]
6. An increase in investment leads to total rise in national income by � 500 crore. If marginal propensity
to consume is 0.9. What is the increase in investment? Calculate.
[Ans. Increase in investment = � 50 crore]
7. Given marginal propensity to save equal to 0.25, what will be the increase in national income if
investment increases by � 125 crore? Calculate.
[Ans. Increase in national income = � 500 crore]
8.. It is planned to increase national income by � 1,000 crore. How much increase in investment is
required to achieve this goal? Assume that marginal propensity to consume is 0.6. Calculate.
[Ans. Desired increase in investment = � 400 crore]
9. An increase in investment by � 400 crore leads to increase in national income by � 1,600 crore.
Calculate marginal propensity to consume.
[Ans. MPC = 0.75]
10. An increase in investment by � 500 crore leads to increase in national income by � 2,500 crore.
Calculate marginal propensity to consume and change in saving.
[Ans. MPC = 0.8; Change in saving = � 500 crore]
GOVERNMENT BUDGET AND THE ECONOMY

1. Total expenditure of a government budget is � 75,000 crore and total receipts is � 45,000 crore. How
much is the budget deficit?
[Ans. Budget deficit = � 30,000 crore]
2. Calculate Budgetary Deficit from following data:
Items (�in crore)
(i) Revenue expenditure 60,000
(ii) Capital expenditure 30,000

(iii) Revenue receipts 50,000
(iv) Capital receipts 25,000
[AnS:. Budgetary deficit = � 15,000 crore]
3. Find Fiscal Deficit from the information given below:
Items (fin lakh)
(i) Borrowing by the government 600
(ii) Revenue receipts 100
(iii) Capital receipts 750
(iv) Interest payment 150
[AnS:. Fiscal deficit = � 600 lakh]
low
4. Find Primary Deficit from the following data:
(i) Fiscal deficit 9,000
(ii) Interest payment by the government 900
[AnS:. Primary deficit = � 8,100 crore]
ee
5. In a government budget, primary deficit is � 10,000 crore and interest payment is � 8,000 crore. How
much is the fiscal deficit?
rF
Fr
[Ans. Fiscal deficit = � 18,000 crore]
BALANCE OF PAYMENTS
or
sf
1. The balance of trade shows a deficit of � 4,000 crore and the value of imports are � 10,000 crore. What
u
is the value of exports?
k
[AnS:. Value of exports = � 6,000 crore]
Yo
oo
2. The balance of trade shows a deficit of � 500 crore. The value of exports are � 400 crore. What is the
value of imports?
B
[Ans. Value of imports = � 900 crore]

re
3. Find Current Account Balance from the following data:

Items (fin lakh)
ou
(i) Balance of visible trade 9,000

ad
(ii) Export of services 9,000

Y
(iii) Import of services 3,000

[Ans. Current account balance = � 15,000 lakh]
nd
Re
4. Find the Balance on Non-factor Services from the following information:

Items (fin crore)
Fi
(i) Balance of visible trade 500

(ii) Income 200
(iii) Transfers 100
(iv) Current account balance 900
[Ans. Balance on non-factor services = � 100 crore]
5. If balance of trade shows a surplus of � 300 crore and receipt of unilateral payments is � 50 crore, how
much is the balance on the capital account of balance of payments?
[Ans. Capital account shows a deficit of � 350 crore]
Ill

PROJECT
WORK
Re
Fi ad
nd
Y
ou
Yo
re
B u
oo
ksf
rF
or
Fr
low
ee
Multiplier establishes a relationship between increase i n autonomous investment (�I) and i ncrease
in GDP (�Y) . It is expressed as under:
�y
K=
�I
( Here, K = Multiplier; �Y = Change in GDP; �I = Change in investment.)
Thus, multiplier is simply the ratio between �Y (change i n GDP) and �I (change in investment).
To illustrate, if investment i ncreases by � 5 crore, and consequently GDP i ncreases by � 20 crore, then :
�y 20
K = - = - = 4. It signifies that due to an increase in i nvestment (by � 5 crore), income
�I 5
i ncreases by a factor of 4 or that increase in GDP = 5 x 4 = � 20 crore.
Thus:
�I . K = �y
u u u
5 X 4 = 20
�y
K= K: Multiplier
M
Or, M .K = �Y � y : Change in GDP
M : Change in investment
Note: Since change in GDP is studied with respect to change in investment, it is called investment
m ultiplier.
- I n the words of Keynes , " I nvestment m u lti p l i e r tel l s us that when there is an i n crement of
aggregate i nvestment, i nco me w i l l i n c rease by an amount wh ich is K times the i ncrement
of i nvestment."
- In the words of Ku ri hara, "The m u lti pl ier i s the ratio of change i n i n come to the change
i n i nvestment."
Diagrammatic I l l u stration
Fig. 1 i l l ustrates the multiplier effect of change in autonomous i nvestment expend iture on GDP.
The economy attains equ i l i brium at point E where AS = AD. With increase i n autonomous investment
479
expenditure, AE line shifts to AE 1 . New equ i l i brium is at poi nt E 1 . GDP i ncreases from OY to OY*.
Change in GDP = OY* - OY = YY* = AE. Change in i nvestment is BE 1 . Clearly, AE > BE 1 . Implying that,
i ncrease i n GDP is the multiple of i ncrease i n investment expenditure
AE = C + I
low
..____.______________ x
ee
y
rF Y*
Fr
Y (lncome)/G DP
WHY SHOULD GDP I N CREASE MANY TI M ES MORE THAN TH E
or
I NCREASE I N I NVESTM ENT?
sf
u
It should be simple to understand it through an illustration:
k
Yo
Let us recall the multiplier equation:
oo
Y
K = t!i..
B
t!i.. I
re
Or, Lil . K = .'iY

Suppose prod ucers make an additional investment (iii) of � 1 00 crore in the economy duri ng the
ou
ad
year 201 8-19. What does it mean? It means additional expenditure by the producers to enhance their
production capacity. Where does this expenditure go? Obviously, expenditure by Mr. X becomes the
Y
i ncome of Mr. Y. Let us assume � 1 00 crore passes from X-set of individuals to Y-set of individuals. What
will the Y-set of individuals do with additional � 1 00 crore? Well , we all know that a part of i ncome is
nd
Re
saved and a part is spent. What part of the additional income is spent and what part is saved, depends on
the margi nal propensity to consume or marginal propensity to save of the Y-set of individuals. Suppose,
Fi
marginal propensity to consume is 0.5, implying margi nal propensity to save is also 0.5. (Because, we
know that propensity to save + propensity to consume = 1 .) Accordi ngly, half of � 1 00 crore will be spent
on consumption and the other half (� 50 crore) will be saved . Expenditure must become somebody's
i ncome. Accord ingly additional expenditure of � 50 crore becomes income, say of Z-set of people in the
economy. Thus, owing to additional investment of � 1 00 crore, there has been a sequence of increase
in i ncome, fi rst by � 1 00 crore, then by � 50 crore. This sequence continues till ; of every additional
i ncome is used as consumption expenditure and the other half is saved . Accord ingly, owi ng to an add itional
i nvestment expenditure (of � 1 00 crore) there is a series of consequential increase in i ncome, viz . ,
1 00 + ; ( 1 00) + ; (50) + ; (25), and so on. As elaborated in the subsequent section, this total

should come to 200. Implying that an additional investment (.M ) of � 1 00 crore causes an additional
i ncome (�Y) of � 200 crore on the assumption that propensity to consume is 0.5. It is to be understood
with emphasis that the value of multiplier (K which is 2 in this case as !;
= �� = 2) ultimately
will depend upon the value of marginal propensity to consume or the marginal propensity to save. So,
there is close relationship between the val ue of K and MPC. The following section substantiates this
relationship further.
RELATI O N BETWEEN MARG I NAL PROPEN SITY TO CONSU M E AN D M U LTI PLI ER

I n the words of Kurihara, "The value of multipl ier is i n fact determined by the margi nal propensity
to consu me." Higher the marginal propensity to consume, greater is the size of multiplier. On the
contrary, lower the marginal propensity to consume, smaller is the size of multiplier. People spend a
part of this increased income on consumption and they save the rest. How much of their i ncome people
would spend on consumption, depends on their marginal propensity to consume (MPC). If marginal
propensity to consume is high , they will spend high percentage of their income on consumption. Every
expenditure reflects a corresponding increase in income. Accordingly, a h igh expenditure owing to
h igh MPC would reflect itself as a high increase in income. Briefly, h igher the marginal propensity to
consume, greater the value of multiplier and hence, greater the i ncrease in i ncome. Implying a direct
relation between multiplier and marginal propensity to consume.
Provi ng the D i rect Relationship between M PC and K

We know that,
.::lY
�y = K . �I (as K = -) . . .(i)
ill
We have also known that in equilibrium,
S = I , so that
�S = �I . . . (ii)
.::ls
Recall that, MPS = , so that
.::lY
�S = MPS. �y . . . (iii)
Relating equation (ii) and ( i i i ) , we get
MPS . �y = �I . . . (iv)
Dividing both the sides by MPS, we get
1
�Y = -- . �I . . . (v)
MPS
Relating equation ( i ) and (v), we get
1
K . �I = -- . �I
MPS
1 1
Or, K = -- = ----
MPS 1 - MPC
Hence, the conclus ion: h igher the MPC, h igher the val ue of K; h igher the MPS, lower the
val ue of K.
Project: Multiplier and its Application i n the Indian Economy 481

Cross-Check
Let us take two different values of MPC as 0.2 and 0.4, and find the corresponding values of K.
1 1 1
K = ---- ---- = -- = 1 .25 . . .(i)
1 - MPC 1 - 0.2 0.8
1 1 1
and K = ---- --- = -- = 1 .67 . . . (ii)
1 - MPC 1 - 0.4 0.6
So, it is clear that h igher the val ue of MPC, higher the value of K.
Check the val ue of K, now using two different values of MPS as 0.2 and 0.4
1 1
low
K = -- = - = 5 . . .(i)
MPS 0.2
1 1
K = -- = - = 2.5 . . .(ii)
MPS 0.4
Evidently, higher the val ue of MPS, lower the value of K.
ee
I n the words of Hanson, "The m u lti pl ier is large or small according as the margi nal propensity to
rF
Fr
consume is large or smal l ." Followi ng table shows the value of K corresponding to the different values
of MPC.
or
Table 1 . Val ue of K Correspond ing to Different Values of MPC
sf
u
Marginal Propensity to Consume Va lue of M ultiplier
= llC )
k
{ M PC
Yo
llY
-
oo
1 1-
0 (lowest va l ue) K = 1 - M PC - -
1-0 -
1
B
re
1
- K=
1 1
= -- = 1.5
- 1 - ...!...
2
3 3 3
ou
ad
1 1
K= -- = 2
Y
1 1
2 1 - ...!...
2 2
nd
Re
1 -1 Higher
Some K= -=4 M PC
-
3 3 -1 i m plies
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4 a rbitra ry 1--
4 4 h igher K
va l ues
1 1
K= -- = 5
4 4 1
5 1--
5 5
1 1
K= = -- = 10
9
- 9 -1
10 - 1--
10 10
1
1 (h igh est va lue) K = -- = _!_ = ao
1-1 0

Table 1 shows that when MPC is zero, multiplier is unity ( 1 ). Simi larly, when MPC is un ity ( 1 ) ,
multiplier is i nfinity (Cl)). Between these two extremes, value of multiplier may b e determined anywhere
depending on the size of MPC. If MPC is unity, it implies that people spend all their income on
consumption . I n this situation, any increase in i nvestment would lead to an infinite increase i n national
i ncome. But in real l ife, as indicated by Keynes' Psychological Law, consumption does not i ncrease in
the same ratio as income; accordingly, the infinite value of multiplier is only a theoretical possibility.
WORKI N G OF TH E M U LTI PLIER OR M U LT I PLI ER PROCESS

Multiplier is a process. It works through the i nterplay of three macro variables, viz . , investment,
i ncome and consumption as under:
1 ....----,> J .._____,,> I
Multi plier Process
Change in I nvestment 1 Change i n Consu m ption Change i n I ncome
�--> 1::,.C :::=========:::::;>

Change i n i nvestment causes change i n income. As a result, there is change i n consumption .
Consumption expend iture of o n e person is a n income of the other. Hence, change i n consumption
leads to change in i ncome. This process continues till 11C as a consequence of 111 reduces to zero. Check
Table 2 for details.
Table 2 . Multiplier Process
Round Increase in Investment
(!::,.I)
I Induced Cha nge in
Consumption (!::,.C )
Cha nge i n Income
( !::,.Y )
(� crore ) [assumed M PC = 0.5) (� crore )
1::,.C = MPC X 1::,.y
(� crore )
1 100 - 100
2 - 0.5 X 100 = 50 50
3 - 0 .5 X 50 = 25 25
4 - 0.5 X 25 = 12.S 12.5
5 - 0.5 X 1 2.5 = 6.25 6.25
6 - 0.5 X 6.25 = 3 . 1 2 3.12
7 - 0.5 X 3 . 1 2 = 1.56 1.56
8 - 0 .5 X 1.56 = 0 . 78 0.78
9 - 0.5 X 0.78 = 0.39 0.39
10 - 0.5 X 0.39 = 0. 195 0 . 195
and so o n till l::,.C = 0
-
Tota l 100 200
Project: Multiplier and its Application in the Indian Economy 483

Tab l e 2 is based on the assu m ption that i nvestment has been i ncreased by � 1 00 crore and
MPC = 0.5. It offers followi ng observations on the multiplier process:
(i) As a result of i n itial i ncrease in i nvestment by � 1 00 crore, there is a change in income by � 1 00
crore. This is assumed to occur i n 1 st round of change.
(ii) On the assumption that MPC = 0.5, consumption in the 2nd round increases by 0.5 ( 1 00) =
� 50 crore. Accordingly, i ncome rises by � 50 crore i n the 2nd round.

(iii) I n the 3rd round of change, consumption i ncreases by 0.5 (50) = � 25 crore. Accord ingly income
rises by � 25 crore in the 3 rd round.
(iv) This process of increase in consumption as 21 of increase in income and additional consumption
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expenditure showing as additional income continues till increase i n consumption reduces to zero,
occurring nearly in the 1 0th round.
(v) Adding up the total change in income, we get � 200 crore.
!:J..Y 200
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(vi) 1'1Y being 200 i n response to 1'11 of 1 00, the multiplier value = 2 . [ K = 2
!:J.. I = 1 00 = ]
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Diagrammatic I l l u stration of M u lti plier Process
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Multiplier process is explained diagrammatically through Fig. 2 . This diagram is drawn on the
1
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assumption that MPC = .
2
k
Yo
y
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Y = AS
B
re
;:::. 250
ou
+
ad
':::!, AE 1
� 200
Y
·'=
nd
Re
w 1 50
Fi
1 00 45 ° l i n e s h ows equality
<( betwee n Y a nd AS.
so
X
0 so 1 00 1 50 200 250 300
Y (lncome)/GDP

I ncome is shown on X-axis and expenditure (C + I) on Y-axis. AE is aggregate expenditure curve:
AE 1 and AE 2 show lower and h igher levels of AE, respectively. I n itially the economy is i n equilibrium at
an income level of � 1 00 crore. Point 'A' is an equilibrium point, because at this point AS = AD. Now,
Lil of � 1 00 crore is planned . As a result, aggregate expenditure shifts from AE 1 to AE 2 . Because of
i ncrease in i nvestment by � 1 00 crore ( = AB), there will be an increase in income by � 1 00 crore ( = BC)
i n the 1 st round. In the 2nd round, consumers will spend � 50 crore ( = CD) on consumption resulting
i n an increase i n i ncome by � 50 crore ( = DE). I n the third round, the consumers will spend � 25 crore
( = EF) on consumption. As a result, i ncome will increase by � 25 crore ( = FG). I n the 4th round, the
consumers will spend � 1 2 . 5 crore ( = HG) on consumption . This will increase income by � 1 2 . 5 crore.
This process will conti nue till additional consumption expenditure reduces to zero. This occurs at point J
when the level of income reaches � 300 crore. Thus, we find that an investment of � 1 00 crore
ultimately leads to an i ncrease in i ncome by � 200 crore ( = 300 - 1 00), on the assumption that
MPC = 0.5. Accord ingly, income i ncreases by factor of 2 (of the increase i n i nvestment) and multiplier
!:J..Y 300 - 1 00 200
happens to be 2 . [ K =
l:J..I = 1 00 = 1 00 = 2 ]
REVERS E OPERATION O F M U LTI PLI ER

M u ltiplier is a double-edged sword . If an i njection of i nvestment (iii ) causes m u ltiplier-times
( K times) i ncrease in income, withd rawal of investment or d isi nvestment (-iii) will cause K times
decrease i n i ncome as well. So if, Lil of � 1 00 crore causes .'iY of � 200 crore on the assumption that
MPC = 0.5 (and therefore, K = 2 ) , then - Lil of � 1 00 crore should cause - .'iY of � 200 crore on the
same assumption that MPC = 0.5 (and therefore, K = 2).
Fig. 3 i l lustrates the reverse operation of m u lti plier.
;::;
.�
C+I +(-) M
Y (l ncome)/GDP
It is assumed that economy is i n a state of equilibrium at poi nt A when AS = AD. Equilibrium level
of income = OK. Investment is reduced by AB (so that Lil = - AB). Consequently, income reduces by CB in
the 1 st round (AB = CB); it further reduces by EF in the 2nd round, and finally (in all the rounds together)
reduces by KL which is surely greater than the initial reduction in investment (iii = - AB; tiY = - KL).

APPLICATION OFTHE MULTIPLIER PRINCIPLE IN THE I ND IAN ECONOMY
Should Growth not be a Quick Process in the Indian Economy where MPC is very high?
This question must be buggi ng the reader's mind at this stage. Why should I ndia continue to be
less developed for so long when investment generates a multiple rise in income? And , when MPC in
I ndia is fairly high (because poor people spend the bulk of their income on consumption). The followi ng
description should bring out the fact why multiplier process is grossly truncated (much less than fully
operational) i n the Indian economy. Accordingly, the principle of multiplier loses much of its validity
when stud ied in the Indian context.
Working of the multiplier process is based on the fundamental assumption that there exists excess
low
capacity in the economy. So that, when i nvestment rises and consequently, income rises and additional
i ncome is converted i nto additional consumption (implying add itional demand), the producers respond
by planning h igher level of output, utili sing the existing production capacity. But in I ndia, the basic issue
is not of utilisation of the existing production capacity, but of the lack of capacity itself.
Due to the presence of excess capacity, whenever consumption expenditure rises (implying
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i ncrease i n demand) there is a corresponding increase in production (implying increase in income).
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Excess capacity occurs due to lack of demand, which is a typical feature of developed economies.
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Accordingly, when demand rises, excess capacity is utilised , leading to a multiple rise in production and
GDP (income) till the excess capacity is exhausted. The problem in I ndia is of generation of capacity.
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It is the problem of capital formation. We do not have abundant capital stock to increase the level of
GDP, even when we have abundant labour force. Our labour force remains unemployed because of the
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lack of capital (production capacity). Accordingly, rise of demand consequent upon rise in expenditure
is not expected to cause a rise i n output. Instead, it may lead to h igher pressure of demand on the
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existing output. Leadi ng to inflationary spiral in the country.
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Does it mean that the multiplier process does not work at all i n the Indian economy? Does it mean
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that increase in expenditure (AD) is dangerous as it would always lead to i nflationary spiral? Answer
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is 'NO'. While full scale application of the multiplier principle is ruled out in the Indian economy, its
partial application is not denied . Indian economy exh i bits a typical characteristic: while there is always
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a lingering threat of overall i nflation, the industrial sector often suffers from the deficiency of demand.
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This sector is often confronted with deflation. The reason is this: having spent the bulk of their income
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on food and related essential items, the vast majority of the population in I ndia are left with meager
(small) i ncome for the purchase of industrial goods (related to comforts and luxury of l ife). Accordi ngly,
nd
demand for these goods remai ns subdued (low) even when there is overall i nflationary spiral in the
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economy. Such a situation is described by the economists as of 'stagflation'. Implying stagnation of

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the i ndustrial sector in the midst of over i nflationary spiral in the country. The situation of industrial
stagnation quite often implies the existence of excess capacity in the industrial sector. When aggregate
demand rises, it is this sector (loaded with excess capacity) which is expected to respond with h igher
level of output. And in this process, autonomous i nvestment is expected to generate multiplier effect
on the rise i n GDP (i ncome).
Briefly, multiplier effect i n the I ndia (like other less developed countries) works only partially and
is confined only to that production activity where deficiency of demand is a prominent feature.

1 . Defi ne m u lt i p l i er.
An s. M u lt i p l i e r is the ratio of change i n i ncome to the change i n i n vestment.
2 . What is t h e relat i o n s h i p between M PC a n d m u lt i p l ier?
An s. The va l u e of m u lt i p l i e r is d i rectly re lated to the va l u e of M PC. H igher M PC leads to hig her va l u e of
the m u lti plier.
3 . How does the m u lti p l i e r process work?
An s. M u lt i p l i e r process wo r ks t h rou g h the i nterplay of th ree macro va riables: i nvestment, i ncome a nd
cons u m ption.
I nvestment is a n expend iture a nd additio n a l expenditu re becomes additiona l i ncome i n the
economy. Si nce additional i ncome is split as additional cons u m ption a nd additio n a l saving (td =
!1C + !1S), every time the consu m ption rises, there is a rise i n expend itu re, i m plying a rise i n i ncome.
H i g her the M PC, g reater should be the com ponent of additional cons u m ption out of add itiona l
i ncome. Accord i n g ly, hig her should be the level of additional i ncome. Accord ing to this process,
if additio n a l i nvestment (!11) = 1 00, a nd M PC = 0.5 (or M PS = 0.5), then the tota l additional i ncome
generated i n the economy wou l d be = 1 00 x 2 00.

0_5 (M PS)
1 1 1
Or, 1 00 x 1 00 x _ = 1 00 x _ =
2 00.
_
1 M PC _
1 05 05
4. M u lti plier process is active on ly when there i s excess ca pacity i n the economy. Do you ag ree?
A n s . It is true that the m u lt i p l i e r process is active o n l y when there is excess capacity in the eco nomy.
When expenditure rises, it must lead to util isation of the excess ca pacity, so that output rises,
i m plying a rise in i ncome. In case there is no excess ca pacity, additio n a l expenditure wou l d only
lead to add itiona l demand without addition a l su pply. It wou l d be a situation of i nflationary spiral
without a ny rea l rise i n output.
5 . M u l t i p l ier process is only partia l l y a ct i ve i n less d eve l oped econom i es l i ke I n d i a . D o you a g ree?
An s. It is true that the m u lt i p l i e r process is o n l y pa rti a l ly active in less d eveloped countries l i ke I n d i a . It
is beca use i n these countries, the problem is not of util isation of excess ca pacity. I n stead it is the
problem of creation of prod uction ca pacity.
6 . M u l t i p l i e r a s a tool of eco n o m i c a n a lysis is more re l eva nt in the context of d ef l a t i o n rat h e r t h a n
i nfl ation . Expla i n how .
Ans . It is true that m u lti plier as a tool of economic a n a lysis is more releva nt i n the context of deflation
rather than i nflati o n . Beca use, existence of excess capacity ( u n util ised prod uction ca pacity) is a
necessa ry prereq uisite of the operational success of the principle of m u ltiplier. And, this condition
is fulfi l led only when the economy is batt l i ng deflation, not i nflati o n .
7. Why m u lt i p l ie r p r i n ci p l e i s of l i m ited v a l i d ity i n the I n d i a n econom y e v e n w h e n propen sity to
con su me i s h i g h ?
A n s . M u l t i p l i e r p r i n c i p l e is of l i m ited va l i d ity i n the I nd i a n eco nomy even when M PC is h i g h . T h i s
is bec a u se o f the ge nera l l a c k o f excess capacity i n the eco nomy. The problem i n the I nd i a n
economy is not a s m u c h o f u t i l isation o f t h e excess ca pac ity a s o f t h e ge neration o f more
ca pacity. We know, the m u l t i p l i e r process becomes a ctive o n l y when there is u n ut i l ised ca pacity
in the eco nomy.
Ill
low
I NTRODUCTION
' G D P growth' has emerged a s a household name. It is taken a s the synonym for national prosperity
and better quality of life. The politicians (and policy makers) all over the world refer to GDP growth
as an i ndex of 'good governance' of the economy. A rise in GDP makes them self-acclaimed good
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governors of the economy, and they would seek yet another term in the office as a matter of right. A
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common man is led to believe that his fortune is linked to GDP growth: improvement in GDP would
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certainly improve his fortune. The benefits of GDP growth are so forcefully presented that we remain
ignorant about its costs. One is led to believe that GDP growth is a universal remedy for all economic
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problems (like of poverty and unemployment) i nvolving zero costs (in terms of negative consequences).
This is a false propaganda, just to garner votes. Have we ever thought of environmental pollution
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as a direct consequence of GDP growth? Have we ever thought of social disintegration as a direct
consequence of GDP growth? Have we ever thought of depletion of our natural resources as a direct
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consequence of GDP growth? As students of economics, we must be aware of all such costs, besides
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the benefits of GDP growth . It is only with a deeper recognition of both the costs and benefits (of
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GDP growth) that we should accept GDP growth as a central element of the strategy of development.
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BENEFITS
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Let us fi rst attempt a brief description of the benefits of GDP growth. The principal benefits are
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as under:
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(1 ) H igher Level of Consum ption and Welfare: GDP refers to the production of final goods and
services in the economy during an accounting year. A rise in GDP would obviously lead to a
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rise in consumption basket of the residents of the country. On an average, each resident should
benefit (in terms of h igher level of consumption), provided population growth does not outstrip
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GDP growth. Since, level of welfare is d i rectly related to the level of consumption, a rise i n
consumption would lead to a rise i n t h e level o f welfare o f the residents o f a country.
(2 ) H igher Level of Employment: GDP growth is often linked with greater opportun ities of
employment. I n fact, there is one-to-one relationship between GDP growth and employment,
provided technology remains constant. However, one should not lose sight of the fact that presently
technology has emerged to be a more potent factor of growth than the other determinants. I n
fact, the developing countries are grappling with the problem of 'jobless growth'. There is GDP
growth without any perceptible rise in employment, because more and more efficient technology
is being used across all activities of val ue-addition (production). Thus, while focusing on GDP
growth , the overpopulated developing economies should not altogether ignore the significance of
labour-intensive technology.
488
{3) Higher Level of Potential Output: GDP growth leads to a shift in the level of potential output.
PPC {Production Possibility Curve) shifts to the right when growth is achieved through efficient
technology and/or greater employment of resources. A shift in PPC is certainly a sign of national
prosperity. It tends to meet aspirations of the people in terms of better job opportun ities and
h igher standard of l iving.
{4) Higher Level of Self-sufficiency: GDP refers to domestic production, or production withi n the
domestic territory of a country. A rise in GDP would obviously lead to a rise in self-sufficiency,
or a cut in imports. It reduces dependence on rest of the world. Accordingly, terms of trade (the
export price in relation to import price) tends to shift in our favour. This i ncreases the inflow of
foreign exchange. A rise in foreign exchange reserves (on account of rise in exports and fall i n
imports) enhances o u r credit rating in t h e i nternational market.
{5) Trickle-down Effect: H istorical experience of developed nations shows that GDP growth generates
'trickle-down' effect. Implying that the benefits of GDP growth gradually start flowing to poorer
sections of the society. Particularly, when the level of production activity rises, demand for labour
tends to rise. This causes a rise in the rate of employment. Eventually, the process of growth turns
' inclusive' in nature. When the fruits of growth are widely distributed , poverty is alleviated and
human development is enhanced . Enhancement of human development is reflected in terms of
h igher standard of l iving of the residents, h igher level of l iteracy and education, as well as h igher
expectancy of l ife (due to better access to medical facilities).
{6) Rise in Government Revenue: Rise in GDP enhances government revenue in terms of higher tax
receipts. This enables the government to increase expenditure on welfare of the residents. The
government can spend more money on healthcare and education. More and more poverty alleviation
programmes can be sponsored. Accordingly, the gulf between the rich and the poor can be reduced.
Greater the equality in the distribution of income and wealth, higher the degree of social harmony.
{7) Rise in Social Awareness: When consumption level rises (owing to rising GDP), people tend to
shift thei r focus from self-interest to social i nterest. Social awareness tends to rise. More and more
people are driven towards philanthropy. It enhances spi rit of togetherness and social dynamism.
The process of economic and social prosperity gets a long period momentu m .
Briefly, GDP growth , provided i t covers larger sections o f t h e society, leads to better quality of
l ife of the residents of a country. The standard of living rises, the level of literacy enhances and people
enjoy robust health. Allocation of resources becomes efficient, and h igher benchmarks of optimisation
are established .
COSTS
GDP growth is not free of costs, though these are not as commonly known as the benefits. The
principal costs of GDP growth are as under:
{1 ) Concentration of Economic Power: It is a well known fact that GDP growth has led to the
concentration of economic power. GDP growth has been triggered through globalisation of the
economies which has led to the growth of multinational corporations. Production activity (in most
economies) is being managed and controlled by these global enterprises. Accordingly, wealth is
getting concentrated , rather than being equitably distributed . 'Trickle-down' effect of growth
has remained only a theoretical prescription. While GDP growth is accelerati ng, poverty remains
unabated . In Ind ia, for example, the richest 1 per cent of Indians own 58.4 per cent of the
country's wealth . The richest 10 per cent of the Ind ians own 80.7 per cent of wealth . I ndia boasts
of being one of the fasting growing economies of the world. But, it is also true that India is the
Project: Cost and Benefit of GDP Growth 489

second most unequal economy i n the world. The worst still is that the inequality is trend i ng up
year after year. Implying that, the rich are getting richer and the poor are getting poorer.
Thus, unabated hu nger and deprivation of the mill ions i n the cou ntry is to be reckoned as the cost
of h igh G D P growth in the country.
(2 ) Environmental Pol l utio n : Envi ronmental pol l ution is a great risk factor associated with GDP
growth . Indeed , it is the core element of the cost of G D P growth. Air pollution (because of
industrial smoke or stubble-burn i ng), water pollution (because of industrial waste being driven
i nto the rivers), noise pollution (because of exponential growth of transportation) are linked with
GDP growth. Faster the GDP growth, faster is environmental pollution. According to one report
(by Centre for Science and Envi ronment TOI , Nov. 27, 2017), air pollution causes nearly 30 per
cent of premature deaths in the country.
low
Are we really aware of such costs of GDP growth? Add to this the environmental cost in terms of
acid rai n and the depletion of ozone layer.
(3) Depleti on of Reso u rces: Faster growth would lead to faster depletion of resources. Resources
are broadly classified as: (i) renewable ( li ke water and forests), and (ii) non-renewable (like
fossil fuels) . GDP growth m ight lead to the depletion of both the types of resources. I n case
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of renewable resources, depletion would occur if their consumption is faster than these can be
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replenished . And , in case of non-renewable, depletion is inevitable as these cannot be replenished .
Are we conscious of the fact that in India, water-table is constantly loweri ng and forest cover
is constantly shrinking. These deficiencies are an important trigger factor of natural calamities
or
which indirectly contribute to the cost of GDP growth. Likewise, if non-renewable resources are
excessively exploited in a bid to accelerate the process of growth, eventually a poi nt would come
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when such a momentum of growth becomes unsustainable. So that, faster growth now would
mean slower growth in the future. Implying that the present generation is beco m i ng prosperous
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at the cost of futu re generations.
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(4) Social Discontent: Excessive pursuit of materialism through GDP growth may lead to the
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emergence of less caring society. It is in such a society that social problems (such as suicides and
divorce) tend to trend up. People may be materially well-off, but devoid of the happi ness of l ife,
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once they are gripped by the greed to acq u i re more. A greed ridden society wou ld never be able
to achieve h igher level of satisfaction , no matter how big is the GDP size.
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I n developing economies like India, social discontent may also arise from the fact that GDP
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growth must lead to a cut i n current consumption . If the government is on a mission to scale up
GDP growth, it must be able to garner funds for extra investment. U ltimately, these funds are
to come either through voluntary savings or through forced savings (taxation). Either way the
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current consumption must suffer. The social d iscontent becomes evident (as in I ndia presently)
when the government resorts to 'fiscal discipline' by way of h igher taxation and lower subsidies.
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It is an ind ispensable cost of GDP growth.

Summing up, we can say that GDP growth should not be considered as panacea-a standard
remedy for all ills i n the economy. It generates its own ills. It involves costs which cannot be overlooked .
The costs are quite harsh, particularly when the gulf between the 'haves' and 'have-nots' is widened ,
when environmental pollution leads to sickness and disease, and when resource-depletion becomes a
challenge for future generations. Accordingly, it is suggested that the pursuit of GDP growth should
not become a fad for any government. GDP growth sans social justice makes no sense. GDP growth
sans sustainability over a longer period of time is meani ngful . And , GDP growth sans environmental
protection is just ridiculous. Not that the costs of GDP growth can be altogether eliminated . But, we
can certai nly strike a balance between the costs and benefits of GDP growth. Costs must be managed
and kept within the limits, even when it leads to a cut in the rate of growth.

1 . What is G D P g rowth?
An s . It refers to a rise i n rea l G D P, over a period of t i m e .
2 . How i s G D P d efined?
An s . G D P is defi ned a s t h e m a r ket va l u e (measu red at con sta nt prices) of the fi n a l goods a n d servi ces
prod uced in the economy d u ri n g an accou nting yea r.
3 . How does GDP g rowth lead to a rise i n sta n d a rd of l i ving?
An s . G D P g rowt h leads to a rise i n sta nda rd of living of the res idents of a cou ntry as it enha nces per
ca pita ava i l a b i l ity of goods a nd services.
4. What i s 'trick l e- down effect' of GDP g rowt h?
An s . I t refers to the perco l ation of the benefits of GDP g rowth ac ross a l l sections of the society. So that,
the g rowth process becomes ' i n c l usive' in natu re.
5 . B riefly state the benefits of G D P g rowth .
An s . Benefits of G D P g rowth a re as these:
(i) It leads to h i g her level of cons u m ption and welfa re.
(ii) It leads to hig her level of employment, i m plying hig her rate of pa rtici pation. H ig h e r rate of
pa rtici pation i m p roves the d istribution of i ncome. It becomes more eq u itable.
(iii) G D P g rowth causes a rise i n potentia l output. G D P g rowth leads to h i g her level of potenti a l
output, i m plying a forwa rd s h ift i n P P C o f a nation. T h i s is beca use, G D P g rowth is often
accompan ied with 'expa nsion of resou rces' a nd ' i n novative technology'.
(iv) GDP g rowth causes hig her level of self-sufficiency, as domestic prod uction rises a nd i m ports
a re red uced .
(v) G D P g rowth leads to trickle-down effect. I m plying d istri bution of the benefits of g rowth across
a l l sections of the society.
(vi) G D P g rowth i m p l ies a rise in govern ment revenue. It e n h a nces capacity of the govern ment to
spend on p u b l i c welfa re prog ra m mes.
(vii) GDP g rowth e n h a nces soc i a l awa reness, as higher levels of i ncome i nd u ce people to be more
p h i l a nthropic.
6 . State t h e prin c i pa l costs of GDP g rowth.
An s . The principa l costs of G D P g r owt h a re as these:
(i) It promotes ineq u a l ity of i ncome. The g u lf between the rich and the poor tends to widen.
(ii) It leads to environ menta l pol l ution, causing sickness, d isease a n d pre-mature deaths.
(iii) GDP g rowth causes depletion of resou rces. Depletion occu rs both i n case of renewa ble a nd
non-renewa ble resou rces. It red uces prod uction capacity of future generation.
(iv) GDP g rowth leads to problems of plenty. It heig htens extravag a n ce, g reed a nd selfish ness.
Socia l d iscontent rises, leading to soc i a l d isi nteg ration.
7. S h o u l d t h e p u rs u i t for GDP g rowth be g i ven u p i n view of its h ig h eco n o m i c a n d soc i a l costs?
An s . Not at a l l . The p u rsu it for G D P g rowth o n l y needs to be moderated . We m u st str i ke a b a l a nce
between the costs and benefits of GDP g rowth. I m plying that, we shou ld not pu rsue GDP g rowth
u n m i ndfu l of economic a nd soc i a l ineq u a l ity, u n m i ndfu l of environmenta l pol l ution and u n m i ndfu l
of the depletion of resou rces (meant for the fut u re generations). We should m a ke G D P g rowth a
susta i n a bl e process a n d a process that e n h a nces the rate of pa rtici pation a nd red uces the g u lf
between t he ric h a nd the poor
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Project: Cost and Benefit of GDP Growth 491
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I NTRODUCTION
Problem of unemployment in I ndia is very grave and grim. If unchecked , i t is likely to become still
more grim in the future. It poi nts to poverty of an ind ividual , and loss of human resource of a nation.
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Nature of unemployment in India is multi-dimensional. Open unemployment, underemployment,
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disguised unemployment are some of the important types of unemployment. Explosive rise in population,
defective education system, slow speed of industrialisation and use of labour-saving technology are
some of the important causes of unemployment. Jobless growth [a situation when GDP grows sans
or
(without) any growth in employment] is emerging to be a serious challenge in the I ndian economy.
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Social unrest (owing to lack of employment opportun ities) may become a serious threat to economic
growth if employables are not given employment.
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FOCUS OF STU DY
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The present study focuses on the following parameters of the problem of unemployment i n India:
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( 1 ) Concept of unemployment and related terms.

(2) Extent of unemployment.
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(3) Unemployment across rural and urban areas and across male and female population.
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(4) Unemployment across d ifferent states i n India.

(5) Contribution of primary, secondary and tertiary sectors to total employment.
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(6) Challenge of informalisation of workforce.

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(7) Challenge of jobless growth.

(8) Reasons for slow growth of employment opportun ities in Ind ia.
(9) Remedial measures.
( I ) Concept of Unemployment and Related Terms

U nemployment is a situation in which people are able to work and willing to work at the existing
rate of wage, but are not getting work. Thus, while calculating unemployment only those persons are
taken i nto account who are not getting work, even when they are ( i ) able to work, and (ii) willing to
work at existing wage rate. Those who are not capable of doing any work (old, i nfirm, sick people,
children, students, etc.) are not included among unemployed . Likewise, those who do not want to work
492
at all are also not included among the unemployed . The above concept of unemployment refers to
Labou r Force Approach . Under this concept, labourer is taken as an individual u n it and employment is
measured in terms of Standard Person Year (SPY). One Standard Person Year means a person working
8 hours per day for 273 days in a year. It means if a person gets work for minimum eight hours per day
and for minimum 273 days in a year, he is not unemployed .
Open unemployment, underemployment and disguised unemployment are important terms
related to unemployment.
Open unemployment includes all those persons who do not get employment at all during the
year. These persons are willing to work, have necessary calibre, ski ll, capability, but they are not able
to find work. U nderemployment refers to: (i) the situation when people get employment only for a few
months of the year, and (ii) the situation when people find jobs below their cal ibre and qualification.
Disguised unemployment is a state in which more people are engaged i n a job than needed . If some of
them are withdrawn from the job, total output will remain constant or may even rise.
(2) Extent of Unemployment

Table 1 shows the extent of unemployment i n I ndia.
Table 1. N u m ber of U nemployed Persons Registered with Employment Exchanges in I n d ia
(in million)
Year Number of Unemployed Persons
on the Live Register
1990-9 1 36.30
2000-0 1 42.00
2005-06 41.47
2010- 1 1 40. 1 7
2011-12 44.49
2012-13 46.80
2013-14 48.26
2015-16 44.85
[Source: Directorate Genera l of Employment and Tra i ning. M i n i stry of La bou r & E m ployment, Government of India.]
Observations
Table 1 offers the following observations:
(i) The number of unemployed persons registered with various employment exchanges is not
only enormous but also has tended to rise over time. In 1 990-91 , 36.30 million persons were
registered as job seekers. Th is number increased to 44. 85 m i l lion i n 201 5-16. This points
to a grim as well as alarmi ng situation.
(ii) Rising unemployment projects rising poverty. I nd ia has the h ighest number of 'absolutely
poor' (people below poverty l ine) in the world. Such a state eclipses GDP growth , no matter
how rapid it is.
Project: Problem of Unemployment in India 493

(3) Unem ployment across Ru ral and U rban Areas
Table 2 shows the rate of unemployment across rural and urban population in India. Rate of
unemployment is defined as ratio of unemployed persons to total labour force.
Table 2 . Rate of Unem ployment Across Rural and Urban Population i n India {201 7-1 8)
(in percentage)
Area Male Females Total
R u ra l Areas 5.8 3.8 5.3
U rban Areas 7.1 10.8 7.8
low
Total 6.2 5.7 6.1
[Source: Periodic La bour Force Su rvey Report, 2017-18)
Observations
(i) Contrary to the popular belief, female unemployment rate is lower i n rural areas (3.8) compared
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to urban areas ( 1 0.8). This is explained in terms of these facts:
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(a) Among most families in urban areas, job work for women is still governed by family decisions
rather than the ind ividual's own decision. Implying that even the avai lable opportun ities are
not actually uti lised .
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(b) H igher employment among women in rural areas is owi ng to widespread rural poverty.
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Female workers i n rural areas are largely engaged in low paid and less productive jobs just
to add to their fami ly i ncome.
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(ii) Overall rate of unemployment in India is higher among female population than the male population.
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This is because (a) education among women sti ll suffers from a social taboo, and (b) mobility of
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female workers for jobs is sti ll very restricted .

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(4) Unemployment across D iffe rent States

Table 3 reveals the rate of unemployment across different states in I ndia.
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Table 3. Unemployment Rate (per 1 ,000) across Different States in I ndia (year 201 1 -12)
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Rural U rban Rura l + U rban

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State
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Male Female Male + Male Female Male + Male Female Male +

Female Female Female
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(1) (2) (3) (4) (S) (6) (7) (8) (9) (10)
And h ra Pradesh 49 58 52 54 97 64 51 64 56
Arunachal Pradesh 19 22 20 37 86 47 23 28 24
Asam 49 89 54 58 73 60 so 87 55
Bihar 42 132 48 59 271 74 44 145 so
Chhattisga rh 59 30 48 93 81 89 66 38 56
Goa 73 8 57 31 101 47 53 so 52
G ujarat 25 39 29 14 24 16 21 35 24

Haryan a 42 67 46 41 63 44 42 66 45
H i machal Pradesh 27 15 22 23 77 36 27 19 23
J a m m u & Kas h m i r so 1 18 61 53 242 84 so 147 67
J h a rkhand 26 68 33 57 103 62 33 72 39
Ka rn ata ka 36 31 34 37 56 41 36 37 36
Kera l a 122 277 169 87 213 123 112 260 156
Mad hya Pradesh 36 21 33 45 49 46 38 26 36
M a h a rashtra 42 42 42 30 66 37 37 so 40
Manipur 31 44 34 58 119 74 38 63 44
Meghalaya 9 6 8 27 46 33 13 12 12
M i zoram 15 27 20 42 69 52 27 45 33
Naga l a n d 199 302 231 205 451 264 201 341 241
Odisha 88 85 87 64 28 58 84 77 83
Pu nj a b 56 33 52 43 48 43 51 38 49
Rajasthan 45 12 35 54 42 52 47 16 39
Sikkim 29 10 21 31 2 23 29 9 21
Ta m i l Nadu 106 121 111 63 85 68 86 109 93
Tri pura 123 326 170 142 586 276 126 381 188
Uttarakhand 54 43 51 43 243 71 51 71 56
Uttar Pradesh 56 27 51 62 55 61 58 32 54
West Benga l 81 93 83 64 88 68 76 91 79
All I ndia 55 62 57 49 80 55 53 66 56
[Source: Key Indicators of Employment and Unem ployment i n I n dia,
National Sa mple Su rvey O rganisation Report, June 2013)
Observations
(i) U nemployment rate is very h igh in the states of Nagaland, Tripura, Kerala, Tamil Nadu and Odisha.
U nemployment rate is low in Meghalaya, Sikki m , H imachal Pradesh, Gujarat and Mizoram.
(ii) H igh variation i n the rate of unemployment across d ifferent states reveals that the idea of balanced
regional growth is still a far cry in I ndia.
(5) Contri bution of Primary, Secondary and

Te rtiary (Service) Sectors to Total Employment
Primary sector includes agriculture and allied activities. Secondary sector includes industry,
construction, and related activities. Service sector i ncludes trade, transport, communication, banking,
insurance, entertainment, media research, tour and travels, hotels, information technology, etc. Table 4
reveals the contri bution of these sectors to total employment.

Table 4. Contribution of Primary, Secondary and Tertiary Sectors to Total Em ployment
(in percentage)
Year Primary Sector Secondary Sector Tertiary Sector
1950-5 1 73 10 17
1970-71 73 11 16
1990-91 67 12 21
2001-02 61 17 22
2006-07 50.2 20.4 29.4
low
2011-12 48.9 24.3 26.8
2015-16 46.2 21.8 32.0
2017-18 43.86 24.69 3 1.45
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[Source: Census Report, NSSO Su rvey]
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Observations
(i) Primary sector dominates in providing opportun ities of employment. I n the year 2017-1 8 ,
43 . 86 per cent o f employment was provided b y primary sector compared to 24.69 per cent and
or
3 1 .45 per cent respectively by the secondary and tertiary sectors. Dominance of primary sector
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suggests that the Indian economy conti nues to be largely a rural economy.
(ii) Though the dominance of primary sector remains unchallenged right since 1 950-51 , it has tended
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to taper off (decli ne) over time. From 73 per cent share in employment generation in 1 950-51 ,
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the primary sector had only 43 .86 per cent share in 2017-1 8. The decline has been constant
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over the years. This points to a gradual transformation of the Indian economy. There has been a
grad ual growth of the industrial and tertiary sectors, which is a sign of a developing economy.
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(iii) I n terms of employment generation, tertiary sector has grown a l ittle faster than the secondary
sector. This poi nts to the laggard growth of the industrial sector. It is because of this that the
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problem of unemployment in I ndia still conti nues to be d iabolic (huge) i n size.

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(6) Chal lenge of l nformal i sation of Wo rkforce

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Employment may broad ly be classified as: (i) formal sector employment, and (ii) informal sector
employment. Formal sector refers to organised sector of the economy. It includes all government
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departments, public enterprises and private establishments which h i re 10 or more workers.

I nformal sector refers to unorganised sector of the economy. It includes all such private enterprises
which hire less than 1 0 workers, besides farming and self-employment ventures. Those working in the
organised sector are called 'formal workers', and those working i n the unorgan ised sector are called
' informal workers'.
From the viewpoi nt of employment status, the underlyi ng d ifference between formal and informal
sectors (or between organised and unorganised sectors) is that workers in the formal sector are entitled
to social security benefits (such as provident fund, gratuity, pension, etc.) while workers in the informal
sector are not. While economic i nterest of the workers in formal sector is protected through various
labou r laws, there are hardly any protective laws for the informal sector (other than Minimum Wages

Act). To protect their economic i nterest, workers in the formal sector can form trade un ions; no such
unions exist i n the i nformal sector. I nformal sector workers are h ighly vulnerable to uncertainties of the
market. They are h i red when the market sentiments are good and are fired when there is economic
slowdown.
l nformalisation of workforce refers to a situation where percentage of workforce in the formal
sector tends to decline and that in the i nformal sector tends to rise . I n accordance with social i stic
pattern of society (as a central goal of Development Plann i ng launched i n 1 951 ), 'formal sector
employment' should have risen and ' informal sector employment' should have decl i ned over time.
Alas! J ust the opposite has happened i n the Ind ian economy. And it has happened not accidentally,
but as a consequence of the strategy of development since 1 991 . A series of economic reforms
were launched in 1 991 , with ' l i beralisatio n , privatisation and global isation' as their key elements.
Conseq uently, there is a sign ificant transformation from 'a controlled economy' to ' market economy'.
And , i n this process of transformation there has been a sign ificant drift towards i nformalisation of
workers. Market economy and i nformal isation of workers, perhaps, are strongly correlated to each
other. Presently, formal sector employment comes to merely 10 per cent of the total ; 90 per cent
of the workforce continues to be i nformal . This poi nts to growing vu lnerabil ity of the workforce to
uncertainties of the market economy.
A staggering number of 40 crore workers working in informal or unorganised sector of the economy
poin ts to growing vulnerability of the workforce to uncertain ties of the market.
Little wonder that informalisation leads to poverty, and therefore, to fragmen tation of social harmony
Closure of textile mills in Ahmedabad (offering employment to nearly 1,50,000 workers) and the
consequen t riots are a testimony to this assertion. According to one study, when mill workers were
rendered unemployed, their families took to casual jobs and many of them even took to suicides as
the ultimate solution to their hardships.
(7) Challenge of Jobless G rowth

Jobless growth is an emerging challenge of the Ind ian economy. Since the adoption of NEP (New
Economic Policy) in 1 991 , GDP growth i n I ndia has shown a substantial rise. But it has failed to be
accompanied with proportionate opportun ities of employment. Consequently, I ndia has seen growth
without employment. Our heavy rel iance on labour-saving technology is perhaps the principal reason
behind this situation. If growth rate is to be maintai ned , a capital-i ntensive technology cannot be
dispensed with . But if opportun ities of employment are to be generated , labour-i ntensive technology is
indispensable. But having i ntegrated our economy with the global economy where competition is the
central theme of economic decisions, there seems to be no choice but to stick to the use of labour
saving technology, which is certai nly more efficient than the labour-intensive technology. Thus, there
seems to be no respite from the challenge of jobless growth at least i n the near future.
(8) Reasons for Slow G rowth of Employment Opportu n ities i n I n d ia

Some of the important reasons for slow growth of employment opportun ities are as under:
(i) Trend towards Automation : I ncreased use of i nformation technology and capital-intensive
methods of production have hindered the growth of employment opportun ities. Electronic
delivery of services like e-banki ng, online reservation, e-governance, etc. , has reduced the
demand for workforce.

(ii) Lack of Vocational Education: Education i n I ndia is degree-oriented . There is a serious lack
of vocational education. More often than not, the degreeholders look for wage employment
rather than self-employment.
(iii) Poor Start-up Culture: Entrepreneurial initiative is h ighly lacking in our country. Even those
in business are more like risk averse rather than risk lovers.
Also, India's ran k in ' Ease of Doing Business' is very poor ( 1 00 i n the world). Excessive
formalities and complex procedure for setting up new business ventures discourage
entrepreneurship. All these factors contribute to slow growth of employment opportun ities.
(iv) I ncreasing Participation of Females: With i ncrease in female l iteracy and social change i n the
society, more and more females look for jobs. It has increased the number of job seekers in
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the economy contributi ng to unemployment.
(v) Slow Progress of Industrialisation: Growth of i ndustries in I nd ia has been slow. Special
emphasis has been laid on the development of the industries i n the five year plans, yet the
prospects of employment generation are not very encouragi ng. Moreover, in large-scale
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industries capital-i ntensive technology is used . It leads to lesser employment generation.
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(vi ) Decreasing Dependency Ratio: Dependency ratio is the ratio of dependent population to
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the working population . Dependent population i ncludes popu lation in the age-group of
0 to 14 years and above 60 years; working population includes popu lation in the age-group
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of 1 5 to 60 years. In Ind ia, dependency ratio is decreasing. This ratio was 0.8 in 1 991 , 0.73
in 2001 and is expected to be 0.59 i n 201 1 . Lower dependency ratio increases the supply of
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labour, further aggravating the problem of unemployment.
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(vii) Rapid Growth of Population: Continuous rise in population has been a grave problem of
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Ind ia. Rapid growth of population is the main cause of unemployment. Measures taken by
government to promote employment could not produce desired results because of i ncreased
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pressure of population .
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(viii) Lack of National Employment Policy: There has been no clearcut employment policy. Our
planners thought that unemployment problem will be automatically solved as a 'trickle
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down' effect of GDP growth . But it did not happen. The planners did not go in for serious
manpower planning. They have fai led to stri ke a balance between i ndustrial technology and
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opportun ities of employment. We have been following the western technology which never
matched the need and means of the Ind ian economy.
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(9) Remedial Measures

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Some of the remed ial measu res relating to the problem of u nemployment i n I nd i a are as
u nder:
(i) Use of automation should be restricted to h igh technology and critical areas.
(ii) Vocational education should be promoted i n place of degree-oriented education.
(iii) Entrepreneurship should be promoted by giving tax holidays, l iberal loans, consultancy, etc.
Procedural formalities for setting up busi ness ventures should be simplified .
(iv) Make i n I ndia programme should be strengthened to increase employment opportun ities
in manufacturing sector. Multi national companies should be encouraged to set up business
ventures in India.

(v) National Employment Policy should be framed to phase out unemployment in time bound
manner.
(vi) Exports should be promoted . It will increase d i rect and indirect employment of the persons
engaged in production, transportation, export, etc.
(vi i) Growth rate of population should be checked . So that the demand for jobs is contai ned over
a long period of time.
(viii) Labour-intensive sectors like food processi ng industry, gems & jewellery, footwear,
readymade garments, handlooms & handicrafts, etc., should be encouraged to generate
more employment opportun ities.
(ix) Personal care services like baby care, old age care, drivers, security, domestic services, etc. ,
should be organised for linking demand and supply of workers i n this regard .
Briefly, while GDP growth should be accelerated , focus should not be lost of the choice of
technology. Technology must suit the needs and means of the country. Thrust should be placed on
the labour-intensive technology to the extent possible. Also, environment should created where self
employment becomes a preferred choice rather than job seeking.
DATA BASE
This project is based on secondary data. The data is collected from published sources.
Following publications have been used as the principal sources:
(i) National Sample Survey Report (68th Survey) . Key Indicators of Employment and
Unemployment in I ndia.
(ii) Handbook of Statistics on Indian Economy, Reserve Bank of India.
(iii) Economic Survey Reports.
(iv) Census Reports.
(v) Five Year Plan Documents.
1 . What is u n e m p l oy m ent?
An s. U n e m p loyment refers to a situation when people a re not getting work even when they a re a b l e to
work a nd w i l l i ng to work at the existing wage rate.
2 . How is u n e m p l oyment d i fferent from underemp l oyment?
An s. U n e m p loyment occ u rs when people a re not getting wo rk at a l l even when they a re a b l e to work
a nd w i l l i n g to work at the existing wage rate. U nder-em ployment occu rs when people get work
only for a few weeks d u ri n g a month or a few months d u rin g a yea r. It a lso occu rs when people fa i l
to g et work at par with their s k i l l s or q u a l ifications.
3 . What i s i nformal i sation of wo rkforce?
An s. l nfor m a l isation of workforce is a process ind icati ng a dec l i ne in percentage of workforce i n the
formal sector (where rig hts of the workers a re protected accord ing to l a bo u r laws) and a rise i n
Project: Problem o f Unemployment in India 499

percentage of workforce i n the i nformal sector (where rig hts of the workers a re not protected
accord ing to labour laws).
4. E l u c id ate the concept of 'jobless g rowth ' .
An s . Jobless g rowth i s a serious emerg i n g c h a l lenge o f t h e I n d i a n economy. It i s a situation when G D P is
g rowing without a correspond i ng g rowth i n the opportun ities of em ployment. Rise i n GDP is d riven
excl usively by the i n novative tec h n iq ues of prod uctio n . This ma kes the d istri bution of i ncome
h i g h l y skewed (uneq ua l ) i n favo u r of richer sections of the society. The rich tend to become richer,
while the poor conti nue to suffer poverty and deprivation.
5 . The fact t h at more a n d more women a re see k i n g j o b has only com pou n ded the prob le m of
u n e m ployment. Do you agree with th is state m e nt?
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A ns . I n the context of the I n d i a n economy, it is true that a g rowi ng n u m ber of women have sta rted
seeking job. Conseq uently, u nem ployment is turning to be a serious situation. This situation needs
to be viewed i n the l i g ht of the fact that wage-employment for women was considered as a socia l
ta boo. Ca mpaign for 'women em powerment' has led to a spi ke i n su pply of women workers i n
a l l a reas o f prod uction activity. Conseq uently, a situation h a s emerged where job-seekers a re far
more i n n u m ber than the ava i la ble opport u n ities of em ployment.
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6 . Na rrate the reasons for u n e m ployment in I nd ia .
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A ns . The principal reasons of u nem ployment i n I ndia a re as these:
(i) Use of l a bou r-savi ng technology, or trend towa rds a utomation.
(ii) Lack of vocational education.
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(iii) Lack of entrepreneu rial i n itiative.
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(iv) C a m pa i g n fo r 'wo m e n e m powe r m e n t ' w h i c h h a s led to a s p i ke in s u p p l y of w o m e n
workers i n a l l a reas o f prod u ction activity.
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(v) S l o w pace of i n d u s t r i a l g rowth i m p l y i n g s l ow g e n e r a t i o n of t h e o p p o rt u n i t i e s of
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em ployment.
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7. S u g g est the possi b l e remedies to the prob l e m of u n e m p l oyment in I n d i a .

An s . The possible remedies t o the problem o f u nemployment i n I n d i a a re as these:
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(i) Use of a utomation should be ration a l ised .

(ii) Vocatio n a l ed ucation should be promoted .
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(iii) I nd ustri a l isation, pa rticu la rly the one which is l a bo u r-i ntensive, shou ld be enco u raged.
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(iv) Growth rate of popu lation should be checked, so that the supply of labour does not swe l l .
(v) National em ployment pol icy s h o u l d b e fra med t o phase o u t unem ployment i n t i m e bou nd
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m a n ner.
8 . What is wro n g i n the ed ucation syste m of I n d i a that l e a d s to u n e m p loyment?
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An s . There a re two serious flaws i n the education system of I n d i a , beca use of w h i ch u n e m ployment
tends to rise:
(i) Ed ucation system i n I nd i a is deg ree-oriented . It lacks the element of ski l l formation. Accord i ng ly,
most deg reeholders i n I ndia a re not 'em ploya bles'.
(ii) Tech n ica l tra i n i ng i nstitutes fa i l to i m pa rt entrepreneurial i n itiative to the tra i n ees, even when
they turn out to be good ski l l ed workers. Accord i ng ly, ski l led workers rem a i n job-seekers rather
than being 'self-employed'.
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Ti me Al lowed : 1½ H o u rs M axi m u m M a rks : 40
Instructions:
( i ) Al l the q uestions a re com p u lsory. M a rks for q u estions a re i n d i cated aga i n st each q uesti o n .
( i i ) Question n u m be r 1 -10 a re very short-a n swe r q uestions ca rryi ng 1 m a rk each . Th ey a re
req u i red to be a n swered i n one word or one sentence each .
( i i i ) Question n u m ber 1 1 - 1 2 a re short-a n swer q u estions ca ring 3 m a rks each . Answers to them
s h o u l d not norm a l ly exceed 60-80 words each .
( iv) Question n u m be r 13-15 a re a lso short-a n swe r q u estions carryi ng 4 m a rks eac h . Answe rs to
them s h o u l d not norma l ly exceed 80-100 words each .
(v) Question n u m ber 16-17 a re long a n swer q u estions carryi ng 6 ma rks each . Answe rs to them
s h o u l d not norm a l ly exceed 100-150 words each .
(vi ) Answers s h o u l d be brief a n d to the poi nt a n d the above word l i m it be a d h e red to as fa r as
poss i b l e .
SECTION-A (I NTRODUCTO RY MAC ROECO N O M I CS)

1. Va l u e of Money M u ltiplier (increases/decreases/rema i ns u ncha nged)
with a n i ncrease i n Cash Reserve Ratio. 1
(Fill up the blank with correct alternative)
Ans. decreases
2. Defi ne an i ntermed iate good .
Ans. An i ntermed iate good is that good which is used as raw materi a l or is pu rchased by the
firms for resa le.
3. Average Propensity to Consu me ca n never be 1
(Choose the correct alternative)
(a) positive (b) zero
(c) more than one (d) less than one
A ns. (b) zero
501
4. Name a ny two qua ntitative tools to control credit creation in a n economy.
Ans. (i) Repo rate, and (ii) Cash Reserve Ratio (CRR).
Or
What a re demand deposits?
Ans. Demand deposits of com mercial ba n ks a re those deposits which ca n be withdrawn
from the ba n k on demand or by writi ng a cheque a ny ti me.
5. The moneta ry policy genera l ly ta rgets to ensu re
(Choose the correct alternative)
(a) price sta bil ity in the economy
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(b) employment generation in the cou ntry
(c) sta ble foreign relations
(d) g reater tax col lections for the govern ment
Ans. (a) price sta bil ity i n the economy
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6. I n a n economy, brea k-even point and eq u i l i bri u m point may lie at the sa me level of
income, if ex-a nte investments a re
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(Fill up the blank with correct answer)
Ans. zero
or
7. State whether the g iven statement is true or fa lse:
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'Ma naged Floati ng Exchange Rate is decided by ma rket forces but rema ins within a
specific ra nge as decided by centra l ba n k'.
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Ans. True
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8 . The formula to calcu late Primary deficit is

B
(Fill up the blank with correct alternative)

re
Ans. Fisca l Deficit - I nterest Payments

ou
9. From the set of statements given in Col u m n I and Col u m n 1 1 , choose the correct pa i r
ad
o f statements: 1
Y
Column I I Column I I
nd
Re
(a) Export of softwa re to France (i) Debit side of current acco u nt

(b) Import of M ach inery fro m Ch ina (ii) Ca pita l Accou nt of Bala n ce of Payments
Fi
(c) Remittances to relative staying a b road (iii) Debit side of Current Account of Ba la nce of
Payments
(d) Investment by Apple phones firm in India (iv) Cre d it side of Current Accou nt of Ba lance
of Payments
Ans. (c) Rem itta nces to relative staying a broad-(iii) Debit side of Current Account of Bala nce
of Payments

1 0. Government expenditure on M i d - Day Mea l scheme ru n n i ng i n govern ment (state run)
schools is a type of expenditure in government budget.
(Fill up the blank with correct answer)
An s. reven u e
11. "India's GDP is expected to expand ZS% i n 2019-20: World Bank."
-The Economic Times.
Does the g iven statement mean that welfa re of people of I ndia i ncrease at the same
rate? Comment with reason . 3
An s. No. Genera l ly it is considered that a n increase i n G ross Domestic Prod uct (GDP) of a ny
economy ( I ndia i n this case) ensures i ncrease i n welfa re of the people of the country, but
there a re strong exceptions to this genera l isation. Fol lowi n g a re the reasons:
(i) If with every i ncrease in the level of G D P, d istri bution of GDP is getting more u neq ual,
welfa re level of the society may not rise.
(ii) Com position of GDP may not be welfa re-oriented even when the level of GDP tends
to rise. There is no d i rect i ncrease i n the welfa re of the masses if GDP has risen owing
l a rgely to the increase i n the prod uction of defence goods
( i i i ) Non-moneta ry exchanges rem a i n u n - recorded, to which extent GDP rem a i n s
underesti mated . To t h a t extent, r i s e i n welfa re is not reflected t h rough G D P.
1 2. Calculate the va lue of M a rg i n a l Propensity to Consume (M PC), if i n a n economy,
a utonomous consu m ption is t 500 crore, ex-a nte i nvestments a re t 4,000 crore and
eq u i l ibri u m level of i ncome of the economy is t 1 8,000 crore. 3
Ans. Given, a utonomous consu m ption (C) t 5 0 0 crore
=
Ex-a nte i nvestments (I) = t 4, 0 0 0 crore

Eq u i l i br i u m level of i ncome (Y) = t 1 8, 0 0 0 crore
At the eq u i l i b ri u m level,
Y= C+ I
O r, Y = C + M PC (Y) + I
1 8, 0 0 0 = 500 + M PC (1 8, 0 0 0 ) + 4, 0 0 0
1 8, 0 0 0 = 4, 5 0 0 + 1 8, 0 0 0 (M PC)
1 8, 0 0 0 (M PC) 1 8, 0 0 0 - 4, 5 0 0
=
1 8, 0 0 0 (M PC) = 1 3, 5 0 0
1 3· 5 0 0 = 0 .7 5
M PC =
1 8, 0 0 0
M a rg i n a l propensity to consume = 0 .7 5 .
Or
Suppose i n a hypothetica l economy, the savi ngs increase by t 20 crore when nationa l
i ncome increases by t 1 00 crore. Compute the additional i nvestments needed to atta i n
a n increase i n nationa l i ncome b y t 6,000 crore? 3
Ans. Given, i ncrease i n savi ngs (�S) = t 2 0 c rore
I ncrease i n i ncome (�Y) = t 1 0 0 crore
CBSE Sample Question Paper 503

We know that,
AS
M PS =
AY
20
= = 0 .2
1 00
When M PS = 0 .2, m u lt i p l ier (K) wi l l be
1
K = --
M PS
=- 1 =5
0 .2
low
We a l so know,
AY
K=
Al
5 = 6, 0 0 0
Al
ee
rF
G, O O O
Fr
AI = = 1 ,200
5
Hence, i nvestment of � 1,2 0 0 crore w i l l be needed to atta i n a n i nc rease i n natio n a l
or
i n come by � 6, 0 0 0 crore.
sf
u
13. Discuss a ny one of the fo l lowi n g fu nctions of a centra l ba n k :
( a ) A s government's ba n k
k
Yo
(b) Open market operations. 4
oo
Ans. (a) As Govern ment's Ba n k : Centra l ba n k acts as a ba n ker, agent a n d fi na ncia l advisor
B
to the government. As a ba n ker to the govern ment, it keeps the accou nts of a l l
re
government ba n ks a n d ma nages gove r n m ent treas u ries. T h e loans a re g ive n to

the government without a ny i nterest for short-term. It a lso transfers funds to the
ou
govern ment. As a n ag ent, it buys a n d se l l s secu rities, treas u ry bills on be h a l f of the

ad
govern ment. Fi n a l ly, it advises the government on eco nom ic, fi n a n c i a l a n d moneta ry
Y
matte rs, with a view to m a i nta i n i ng sta b i l ity in the eco no my.
( b) Open M a r ket Operat i o n s : Open m a r ket operations refe r to s a l e a n d p u rc h a se of
nd
Re
g ove r n m e n t secu rities i n the open m a r ket by t h e centra l ba n k of the country. By

sel l i n g t h e sec u rities, the centra l ba n k withd raws ca s h ba l a n ces fro m t h e syste m
Fi
a n d by buyi n g the sec u riti es, t h e centra l ba n k i nj ects cash ba l a n ces i nto the
syste m .
To i n c rease money supply (as d u ri n g deflation), secu rities a re p u rchased by the
centra l ba n k . On the other ha nd, to decrease money supply (as d u ri n g i nflation)
secu rities a re sold off by the centra l ba n k . Buyi ng the secu rities, the commerc i a l
ba n ks red uce their c a s h deposits a n d hence, their ca pacity t o c reate cred it. Sel l i ng
the secu rities, the commerc i a l ba n ks add to thei r cash reserves a n d e n h a nce thei r
capac ity to create credit.

14. "Foreign Institutional Investors (Flis) remained net seller in the Indian capital markets over
the last few weeks". -The Economic Times.
State and d iscuss the l i kely effects of the g iven statement on foreig n exchange rate with
reference to the I ndian Economy. 4
A n s. Sel l i ng of secu rities by Fo re i g n
y
I nstitutiona l I nvestors ( F l i s) i n the
I nd i a n ca pita l markets wi l l lead to
fa l l in the s u p ply of fo re i g n currency
i n the eco no my. It is a supply shock g'
"' R 1
that ca uses a backwa rd s h ift of ;:! R
supply cu rve of foreig n exchange for 0
the I n d i a n economy from S to S 1 as "'
51
i n Fi g . 1. Conseq uent ly, eq u i l i b ri u m D
exchange rate wi l l rise. M o re ru pees
a re to be paid fo r buyi ng a u n it o�-----��-----x
01 0
of fo re i g n cu rrency, lead i n g to De m a n d a n d S u pply of U S $
deprec iation of domestic c u r rency.
Or
'Many large Multinational Corporations (MNCs) have recently shifted their investments
from China and have started their production in India, thereby boosting the Make in
India plans of the Government'.
Presu m i n g other factors bei n g consta nt, d iscuss the effects of the g iven statement on
Foreig n Exchange rates with reference to the I n d i a n Economy. 4
A n s . I nvest ments by l a rge m u ltinational
y
corporations ( M N Cs) i n I nd i a wi l l
ensure g reater i n fl ow o f fo re i g n
exchange i n the economy, lead i n g
t o a n i ncrease i n the s u p p l y of g'
"' R i------,,-------'K
.c
fo re i g n c u r rency. It is a supply shock .lS R 1 I---'---�--!-�
that ca uses a fo rwa rd s h i ft of s u p ply
cu rve of fo reig n exchange for the
s
I nd i a n eco nomy fro m S to S 1 as in D
Fig . 2. Conseq uently, exc h a n g e rate
w i l l fa l l . Less ru pees a re to be pa id o '-------'-----'------x
0 01
fo r buyi ng a u n it of fo re i g n c u r rency, De m a n d a n d S u pply of U S $
lead i n g to a p prec iation of domestic
c u r rency.
1 5. Ela borate the objective of 'rea l location of resou rces' i n the government budget. 4
A n s . The g overnment rea l l ocates resou rces with a view to maxi m i s i n g soc i a l welfa re.
M a r ket econom ies a re bel ieved to a c h i eve o pti m u m a l location of resou rces t h ro u g h
the m a r ket forces o f s u p ply a n d d e m a n d . But, it l e a d s t o maxi m isation o f profits, not
necessa rily the maxim isation of soc i a l welfa re. Soc i a l welfa re often suffers as the m a r ket
eco n o m i es do not p roduce enoug h of p u b l i c goods which satisfy coll ective needs of

the society. Also, these econom ies fa i l to account for 'external ities' of p rod uction which
often lead to loss of soc i a l welfa re on account of envi ron menta l degradation (including
envi ro n m enta l pollution and excessive exploitation of the non-renewa ble resou rces).
Through its budgeta ry policy, the government m a kes sufficient p rovision for the supply
of p u b l i c goods ( l i ke law and order, defence, public a d m i n istration). It a l so add resses
envi ro n m enta l issues by offering s u bsid ies on the use of cleaner energy (C N G, LPG, sola r
a n d wind energy).
1 6 . (a) 'Rea l Gross Domestic Product is a better indicator of economic g rowth than Nominal
Gross Domestic Prod uct'. 4
Do you a g ree with the g iven statement? Su pport you r answer with a suitable
low
n u merical exa mple.
(b) Calculate 'Depreciation on Ca pita l Asset' from the fol lowi ng data : 2
Particu l a rs Amou nt (i n < crore)
(i) Capital va l u e of the asset 1,000
ee
(ii) Estimated life of the asset 20 yea rs
rF
Fr
(iii) Scra p va l u e Nil
A n s . (a) Yes, t h e g iven statement is correct. Rea l G ross Domestic Prod uct (G D P) is a better
i n d i cator of economic g rowth than N o m i n a l G ross Domestic Prod uct (G DP) . This is
or
beca use only rea l G D P shows the change i n the flow of goods and services i n the
sf
u
economy, as it is esti mated on the basis of consta nt price leve l .
The fol lowi ng ta ble i l l u strates h o w rea l G D P and nom i n a l G D P change i n relation to
k
Yo
change in price and output.
oo
Year Output Price Real G D P Nominal G D P
B
( U nits) (t crore) (t crore) (t crore)

re
2011-12 500 40 20,000 20,000 Situation-1

2018-19 500 so 20,000 25,000
ou
ad
2011-12 500 40 20,000 20,000 Situation-2

2018-19 600 40 24,000 24,000
Y
In situation-1 , rea l G D P [esti mated at the consta nt price (< 40 c rore] rem a i ns consta nt
nd
(< 20,000 crore) between the period 201 1 -1 2 and 201 8-1 9 even when n o m i n a l G D P
Re
rises from < 20,000 crore to < 25,000 crore. Rise i n nom i n a l G D P is owi ng t o the rise
Fi
i n price, not output. Th us, only the market va l u e of output rises, not the quantum of
output, I m plyi ng that there is no economic g rowth.
I n situation-2, output rises from 500 to 600 u n its even when price is consta nt
(< 40 crore). Accord i n g ly, rea l GDP rises from < 20,000 c rore to < 24,000 crore. This
i n d i cates economic g rowth, as people now have more goods and services to enjoy.
N o m i n a l G D P now coi ncides with rea l G D P, s i m ply beca use price is consta nt.
_ Capita l va l u e of the asset - Scra p va l u e
· t ·10n on C a p ·1 t a I A sse t -
(b) D eprec1a
Esti. mate d 1 .I fe o f t h e asset
< 1 ,000 crore - 0
20 yea rs
t 1 ,000 c rore
20 yea rs
= t 50 crore
Depreciation on ca pita l asset = t 50 crore.

Or
(a) 'Ci rc u l a r flow of i ncome i n a two sector economy is based on the axiom that one's
expenditure is other's i ncome.'
Do you a g ree with the g iven statement? Su pport you r answer with va l id reasons. 3
(b) Calculate Com pensation of Employees from the fol lowi ng data : 3
Pa rticu la rs A mount (in t crore)
(i) Profits after tax 20
(ii) I nterest 45
(iii) G ross domestic prod uct at m a r ket price 200
(iv) Goods and services tax 10
(v) Consu m ption of fixed ca pita l 50
(vi) Rent 25
(vii) Corporate tax 5
Ans . (a) Yes, the g iven statement is correct. I n a two sector economy (com prising fi rms
and households), the fi rms produce goods and services by h i ring factor services
from the households. In return for the use of factor services, the firms m a ke factor
payments to the households. Th us, expenditure by the fi rms on the p u rchase of
factor services becomes factor i ncome of the households. The factor i ncome ea rned
by the households is used to buy goods and services prod uced by the fi rms. Th us,
expenditure by the households becomes i ncome of the fi rms. Briefly, ci rcu l a r flow
of i ncome across households and fi rms is based on the axiom that expenditure by
the fi rms becomes i ncome of the households, and expenditure by the households
becomes i ncome of the firms.
(b) Com pensation of E m p l oyees
= G ross domestic p roduct at market price - Rent - I nterest - Profits (Profits after tax
+ Corporate tax) - Consu m ption of fixed ca pita l - Goods and services tax
= t 200 crore - t 25 crore - t 45 crore - (t 20 crore + t 5 crore) - t 50 crore - t 10 crore
= t 200 crore - t 25 crore - t 45 c rore - t 25 crore - t 50 crore - t 1 0 crore
= t 45 crore
Com pensation of em ployees = t 45 crore.
1 7. 'A n economy is operating at underemployment level of i ncome.' What is mea nt by the
given statement? Discuss one fisca l measu re and one moneta ry measure to tackle the
situation. 6
A ns. An economy is said to be operating at u nderem ployment eq u i l i bri u m level where AD = AS
but a l l those who a re a ble to work and w i l l i ng to work (at the existing wage rate) do not
get work.

Fi g . 3 exp l a i n s the situation y
AD = AS (Li ne of Reference)
of u n dere m ployment level of
i n come.
Undere m ployment level of
i n come occu rs owi ng to
deficient demand or the lack
of agg regate demand (AD). ,,..__�,__- Point of U n deremployment
Equ ili brium
In Fig 3, deficient demand is
eq u a l to FK. Accord i n g l y, this
low
L,
can be add ressed by way of I ncome/Output
i ncreasing AD.
Two i m porta nt measu res to ra ise AD and reach the situation of fu l l e m ployment a re as
u nder:
ee
(i) Pu blic expenditure on p u b l i c works, p u b l ic welfa re a n d p u b l i c i nvestment should be
rF
Fr
increased . A l l this w i l l act as a n i njection of demand i nto the system and is expected
to ind uce p rivate expenditu re. Accord i ng l y, aggregate demand is expected to rise
or
and the situation of fu l l em ployment eq u i l ibri u m wi l l be reached.
sf
(ii) Centra l ba n k should decrease the repo rate. It is the rate at which the centra l ba n k
u
lends money t o t h e commercia l ba n ks. A decrease i n repo rate lowers t h e market
k
Yo
rate of i nterest, p romoti ng demand for cred it. An expa nsion i n the demand for credit
oo
leads to a rise in aggregate demand. Accord i n g ly, the situation of fu l l e m ployment
B
eq u i l i br i u m will be reached.
Ill
re
ou
ad
Y
nd
Re
Fi

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Introductory

Syllabus Covered: Central Board of Secondary Education, Delhi

Medium: ENGLISH (Hindi medium is also available)

4323/3, Ansari Road, Darya Ganj, New Delhi-110002

Phone: 0129-7117719-48 lines, Fax: 0129-2250322

2. Some Basic Concepts of Macroeconomics ...............15

3. National Income and Related Aggregates ................51

4. Methods of Calculating National Income ................ 81

7. Aggregate Demand, Aggregate Supply and

8. Short Run Equilibrium Output ........................ 213

9. Problem of Deficient Demand

10. Government Budget and The Economy ................291

11. Foreign Exchange Rate...............................333

12. Balance of Payments ................................365

• CBSE Sample Question Paper, 2020 (Solved)

A Comparison with Neighbours 12

Part-C: Project Work 20 20

PART-A: INTRODUCTORY MACROECONOMICS

Unit-1: National Income and Related Aggregates (28 Periods)

Unit-2: Money and Banking (15 Periods)

Unit-3: Determination oflncome and Employment (27 Periods)

Unit-4: Government Budget and the Economy (15 Periods)

Unit-5: Balance of Payments ( 15 Periods)

Employment: Formal and informal growth; problems and policies.

Sustainable Economic Development: Meaning, Effects of Economic

Development on Resources and Environment, including global warming.

A Comparison with Neighbours ( 12 Periods)

I Mark 3 Marks 4 Marks 6 Marks

4. Analysing and Evaluating:

2. HOW MACROECONOMICS DIFFERS

(2) Economic Variables

(4) Degree of Aggregation

(5) Different Set of Assumptions

(7) Method of Study

(8) Micro-Macro Paradox

3. SCOPE AND SIGNIFICANCE OF

deals with the definition and estimation of national income and

its related aggregates like GDP (Gross Domestic Product) and

NDP (Net Domestic Product).

related to employment (or unemployment) in the economy.

context. It explains the causes of unemployment, and suggests

(3) Theory of Money: Creation of money (or creation of credit) by the

commercial banks is an important component of macroeconomics.

Power Points & Revision Window ------------

(vi) Policy formulation.

1. Objective Type Questions (Remembering & Understanding based Questions)

A. Multiple Choice Questions

B. Fill in the Blanks

Choose appropriate word and fill in the blank:

1. Aggregate demand is not a variable. (micro/macro)

State whether the following statements are True or False:

D. Matching the Correct Statements

rF (iv) A microeconomic activity

(a) Macro (i) Limited degree of aggregation of economic variables

(b) National income (ii) Central issue of macroeconomics

(d) Microeconomics (iv) Equilibrium in one market

(e) Determination of overall level of output (v) A macroeconomic variable

(a)-(iii), (b)-(v), (c)-(iv), (d)-(i), (e)-(ii)

E. 'Very Short Answer' Objective Type Questions

2 . Reason-based Questions (Com prehension of the Subject- matter)

3. H OTS & Applications

4. Analysis & Evaluation

1. What may happen if savings are encouraged in an economy?

I� �� BAN K ��,