CLASS 12

Introductory Macroeconomics

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 INDEX
TOPICS PAGES
1) INTRODUCTION 03-07

2) NATIONAL INCOME 08-28

ACCOUNTING
3) MONEY AND BANKING 29-35
4) DETERMINATION OF 36-46
INCOME AND
EMPLOYMENT
5) GOVERNMENT BUDGET 47-61
AND ECONOMY
6) OPEN ECONOMY 62-73
MACROECONOMICS

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 Chapter 1
Introduction
Economy
Economy refers to the whole collection of production units by which people earn their
living.

Economics
Economics refers to the study of how a society chooses to use its limited resources,
which have alternate uses, to produce goods and services and to distribute them
among different groups of people in order to satisfy unlimited human wants.

Economic Problem
‘Economic problem’ is the problem of choice involving satisfaction of unlimited wants
out of limited resources having alternative uses.
The root cause of all economic problems is ‘Scarcity’.
Scarcity in economics refers to the limitation of supply of a good in relation to its
demand.

Reasons for Economic Problem:

Economic problem arises due to:
Scarcity of resources: The supply of resources (i.e. land, labour, capital, etc) is
limited in relation to their demand and the economy cannot produce all what people
want. It is the basic reason for the existence of economic problems in all economies.

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These resources are available in limited quantities in every economy, big or small,
developed or underdeveloped. No economy in the world is rich in all the resources.
There would have been no problem if resources were not scarce.

2. Unlimited human wants: Human wants are never ending, i.e. they can never be
fully satisfied. As soon as one want is satisfied, another new want emerges. Wants of
the people are unlimited and keep on multiplying and cannot be satisfied due to limited
resources.
Human wants also differ in priorities, i.e. all wants are not of equal intensity. For every
individual, some wants are more important and urgent as compared to others. Hence,
people allocate their resources in order of preference to satisfy some of their wants.

3. Alternative uses of resources: Resources are not only scarce, but they can also
be put to various uses. It makes choice among resources more important. For
example, land can be used for farming, setting up a factory or a school etc. As a result,
the economy has to make a choice between the alternative uses of the given scarce
resources. If one resource can be put to only one use, there would be no problem of
choice.
Two features of resources:

• Resources are scarce and limited.

• Resources have alternative uses.

Two features of human wants:

• They are unlimited, i.e. they can never be fully satisfied.

• Human wants differ in priorities. Some wants are more basic and urgent and
may require immediate attention than the others.

Central Problems of an Economy

Problem of allocation of resources: Every economy faces the problem of allocating
the scarce resources having alternative uses to the production of different possible
goods and services in such a manner that it ideally meets the needs of the society. It
also involves the distribution of the goods and services produced among the
individuals within the economy in an optimal manner. ‘Problem of resource allocation
would not arise, if resources do not have alternative uses.’ If a resource can be put

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only to a specific use, then the problem of resource allocation would not arise. Central
problems are the economic problems faced by every economy. An economy has to
allocate its scarce resources after choosing from different potential bundles of goods
to be produced, select the technique of production and also decide as to how the
output, thus produced, should be distributed in the economy.
The central problems faced by an economy can be categorised under three heads:
1.What to produce and in what quantities
• This problem involves selection of goods and services to be produced and the
quantity to be produced of each selected commodity. It arises since resources are
limited in an economy and can be put to alternative uses.
• Producing more of one good usually means less resources will be available for the
production of other goods. For example, production of more cars is possible only by
reducing the production of other goods using similar resources.
• Production of more war goods is possible only by reducing the production of civil
goods. So, on the basis of the importance of various goods, an economy has to decide
which goods should be produced and in what quantities.
• The problem of 'What to produce' has two aspects:

• What possible commodities to produce: An economy has to decide, which

consumer goods (rice, wheat, clothes, etc.) and which of the capital goods
(machinery, equipment, etc.) are to be produced. In the same way, economy
has to make a choice between civil goods (bread, butter, etc.) and war goods
(guns, tanks, etc.).
• How much to produce: After deciding the goods to be produced, the economy
has to decide the quantity of each commodity that is selected. It means, it
involves a decision regarding the quantity to be produced, of consumer and
capital goods, civil and war goods and so on.

Guiding Principle: The guiding principle is to allocate resources in such a way that
gives maximum aggregate satisfaction.

2. How to produce (choice of technique of production)

• The central problem of ‘how to produce’ is the problem relating to the choice of
technique of production to be used for producing different goods and services. By
‘technique’, we mean what particular combination of inputs to be used for production.

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• A good can be produced using different techniques of production depending on the
availability of resources. Broadly, the choice is between the two types of techniques–
labour-intensive technique and capital-intensive technique.
• The technique which uses more labour and less capital (machines) is labour intensive
technique. The technique which uses more capital and less labour is capital intensive
technique.
Guiding principle: The guiding principle for the choice of technique is to adopt that
technique through which maximum output can be produced at minimum cost using the
least possible scarce resources.

3.For whom to produce (or the problem of distribution of output and incomes
between the members of the society)
• This problem relates to the distribution of produced goods and services among the
individuals within the economy, i.e. selection of the category of people who will
ultimately consume the goods, i.e. whether to produce more goods for the poor and
less for the rich or more for the rich and less for the poor.
• Since resources are scarce in every economy, no society can satisfy all the wants of
its people. Thus, a problem of choice arises.
• Goods are produced for those people who have the paying capacity. The capacity of
people to pay for goods depends upon their level of income. It means, this problem is
concerned with distribution of income among the factors of production (land, labour,
capital and enterprise), who contribute to the production process.
Guiding principle: The guiding principle is to ensure that the most urgent wants of
the society are fulfilled to the maximum possible extent.

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 Interdependence of Microeconomics and Macroeconomics
➢ Microeconomics depends on Macroeconomics. For example, demand for a
commodity is influenced by the taxation policies prevailing in the economy.

➢ Similarly, Macroeconomics depends on Microeconomics. For example, national

income is the sum total of factor incomes earned by all residents of an economy in a
fiscal year.

Opportunity Cost
Opportunity cost is defined as the value of the next best alternative
foregone.
For example: Suppose an individual is given three job offers namely A - which pays
`20,000 per month, B - which pays `18,000 per month and C - which pays `6,000 per
month, all other conditions remaining same. If he avails the best job offer which pays
him `20,000 a month, he foregoes the next best job offer of `18,000. Hence `18,000 is
the opportunity cost of choosing the best alternative.

Difference between Positive and Normative Economics

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 CHAPTER 2
National Income

Macroeconomics: It studies the behaviour of the economy as a whole. It studies

national aggregates like Aggregate Demand, Aggregate Supply, National Income etc.
It also studies national economic problems like inflation, unemployment, poverty and
the issues connected with economic growth and economic development.

• Main tools of Macroeconomics are aggregate demand and aggregate supply

(macroeconomic variables)
• Main subject matter of Macroeconomics is to determine income and
employment level of the economy.
• Examples of Macroeconomic studies – Estimation of national income,
Determination of income and employment level of the economy, Government
budget etc.

Basic concepts in Macroeconomics

National income accounting is a branch of macroeconomics of which estimation of
national income and related aggregates are a part. National income and related
aggregates are basically measures of production activity. Production activity of the
production units located within the economic territory is domestic product. Gross
domestic product, net domestic product are some examples. Whereas Production
activity of the residents of an economic territory is national product. GNP, NNP, are
some examples.

1.ECONOMIC TERRITORY
Economic (or Domestic) territory is the geographical territory administered by a
government within which persons, goods and capital circulate freely.
The above definition is based on the criterion ‘freedom of circulation of persons, goods
and capital’ Clearly, those parts of the political frontiers of a country where the
government of that country does not enjoy the above ‘freedom’ are not to be included
in economic territory of that country. One example is embassies. Government of India
does not enjoy the above freedom in the foreign embassies located within India. So,
these are not treated as a part of economic territory of India. They are treated as part
of the economic territory of their respective countries. For example, the U.S. embassy

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in India is a part of economic territory of the U.S.A. Similarly, the Indian embassy in
Washington is a part of economic territory of India.

Scope
Based on ‘freedom’ criterion, the scope of economic territory is defined to cover:

• Political frontiers including territorial waters and air space. ‘

• Embassies, consulates, military bases, etc. located abroad, but excluding those
located within the political frontiers.
• Ships, aircrafts etc. operated by the residents between two or more countries
• Fishing vessels, oil and natural gas rigs, etc. operated by the residents in the
international waters or other areas over which the country enjoys the exclusive
rights or jurisdiction.

(ii) RESIDENT
Resident Vs. Citizen
Note that citizen (or national) and resident are two different terms. This does not mean
that a citizen is not a resident, and a resident not a citizen. A person can be a citizen
as well as a resident, but it is not necessary that a citizen of a country is necessarily
the resident of that country. A person can be a citizen of one country and at the same
time a resident of another country. For example, A NRI, Non-resident Indian is citizen
of India but a resident of the country in which he lives. A large number of Indian
nationals have settled in U.S.A., Australia, etc. as residents (and not as nationals) of
these countries. For India, they are Non-residents Indians (NRI) but continue to remain
Indian nationals. Citizenship is basically a legal concept based on the place of birth of
the person or some legal provisions allowing a person to become a citizen. On the
other hand, resident ship is basically an economic concept based on the basic
economic activities performed by a person.
A resident, whether a person or an institution, is one whose centre of economic
interest lies in the economic territory of the country in which he lives or is
located.
The ‘centre of economic interest’ implies two things:

• the resident lives or is located within the economic territory and

• the resident carries out the basic economic activities of earnings, spending and
accumulation from that location.

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Implications
National product includes production activities of residents irrespective of
whether performed within the economic territory or outside it. In comparison,
Domestic product includes production activity of the production units located
in the economic territory irrespective of whether carried out by the residents or
non-residents.

From Domestic Product to National Product

The concept of domestic product is based on the production units located within
economic territory, operated both by residents and non-residents. The concept of
national product is based on residents, and includes their contribution to production
both within and outside the economic territory. Normally, in practical estimates,
domestic product is estimated first. National product is then derived from the domestic
product by making certain adjustments.
National product is derived in the following way:

In practical estimates the ‘residents’ contribution outside the economic territory is

called ‘factor income received from abroad’. The ‘non-residents’ contribution inside the
economic territory is called ‘factor income paid to abroad’. Therefore,

‘Factor income received from abroad’ is added to domestic product because this
contribution of residents is in addition to their contribution to domestic product. ‘Factor
income paid to abroad’ is subtracted because this part of domestic product, does not
belong to the residents. By subtracting ‘factor income paid’ from ‘factor income
received’ from abroad, we get a net figure ‘Net factor income from abroad’ popularly
abbreviated as NFIA.

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 Net Factor Income from Abroad (NFIA)
It refers to the difference between factor income earned by the normal residents of the
country from the rest of the world in the form of wages and salaries, rent, interest and
profits (dividends and retained earnings) and similar payments made to the normal
residents of other countries (i.e. non-residents) within the domestic territory.
Net Factor Income from Abroad = Factor Income from Abroad - Factor Income
paid Abroad.

Components of NFIA:
Net compensation of employees
Net income from property and entrepreneurship
Net retained earnings of resident companies abroad

Significance of NFIA: It is the difference between the national aggregates and the
domestic aggregates. The national concept is inclusive of NFIA whereas the
domestic concept excludes it.

National Income = Domestic Income + NFIA

Difference between Domestic Income and National Income:

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 Intermediate Products and Final Products
Goods and services purchased by a production unit from other production units with
the purpose of reselling or with the purpose of using them completely during the same
year are called intermediate products. The expenditure on them is called intermediate
cost or intermediate consumption. Goods and services purchased for consumption,
i.e., for satisfaction of wants, and for investment are called final products. Expenditure
on them is called final expenditure.

Difference between Final Goods and Intermediate Goods:

Difference between Consumption/ Consumer Goods and Capital

Goods:

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The same good can be a consumption good and capital good depending upon
the end (ultimate) use of the good. For example: Car purchased by a household
is a consumption good since it is purchased for the direct satisfaction of wants
by the consumer whereas car purchased by a taxi driver/ firm is a capital good
since it is purchased for the production (investment) purpose.
All capital goods are producer goods but all producer goods are not capital
goods. Single use producer goods like raw materials, coal, wood etc. which are
completely used up in production process are known as intermediate goods
whereas durable use producer goods like plant, machinery etc. which are
repeatedly used in the production process for several years are called capital
goods.
A commodity can be an intermediate as well as final good depending upon its
nature of use (purpose for use). If good is used for either consumption or
investment, it is a final good. However, if it is used for resale or ‘used up’ for
further production in the same year, it is an intermediate good. For example:
Bread purchased by a household is a final (consumption) good as it is used for
consumption purpose whereas bread purchased by a restaurant owner to make
sandwiches is treated as an intermediate good as it is completely used up in
the production process. If the same bread is purchased by a bakery shop for
further sale to the consumers then also it is treated as an intermediate good as
it is used for resale in the same year.
Not all purchases by production unit from other production units are
intermediate products because not all of them are either completely used up or
resold in the same year. For example, machines, tools vehicles, buildings etc.
purchased are not intermediate goods. They are final goods i.e. fixed assets/
capital goods, durable use producer goods purchased by production units for
own use i.e. for investments.
Government services (education, health etc.) are treated as final goods and
therefore included in the estimation of national income.
All goods and services acquired by consumers for their own use are treated as
final goods. Similarly, all durable goods acquired by producers are also treated
as final goods/ capital goods (part of capital formation).
Durable goods like trucks, aircrafts, weapons of destruction like tanks
purchased by the government for military purposes are treated as raw materials
i.e. intermediate goods, used for providing defence services.
Goods meant for resale in the year of production itself by dealer are
intermediate goods. However, at the end of the year when these goods remain
unsold, they constitute unsold stock and are considered as addition to the stock
or inventory investment which is treated as part of final goods.

Difference between Stocks and Flows

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 Difference between Factor Income and Transfer Income

Investment or Capital formation

It refers to the addition made to the stock of capital of the economy during a period of
time.

Components of Investment:
There are two components of investment:
(i) Investment in fixed capital i.e. durable producer goods is called fixed
investment and

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 (ii) Investment in stocks of raw materials, semi-finished goods and finished
goods (inventories) is called inventory investment, also called change in
stock.
For example:
Gross Investment = Gross fixed investment + Inventory investment/ Change
in stock.
Change in stock (Change in Inventories) = Closing stock – Opening stock.

Investment can be looked up in two forms:

Gross Investment and

Net Investment.
A distinction is made between Gross Investment and Net Investment on the basis
of depreciation.

Gross Investment – Net Investment = Depreciation

Depreciation
It refers to fall in the value of fixed assets due to normal wear and tear, passage of
time and foreseen (expected) obsolescence.
• By normal wear and tear, we mean, fall in the value of fixed assets due to normal
use in production resulting in decrease in the production capacity of fixed assets.
• The value of fixed assets also decreases with passage of time, even if they are not
being put to use in the business. Natural factors like rain, wind, weather etc. contribute
to fall in their value.
• The value of fixed assets decreases due to expected obsolescence i.e. due to
change in technology or change in demand for goods and services.
Significance of Depreciation:
It is used to differentiate between gross and net value of the same aggregates. The
term gross is inclusive of depreciation whereas the term net excludes it.
Gross value = Net value + Depreciation

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 Capital loss
It refers to loss in value of fixed assets due to unforeseen obsolescence, natural
calamities (like floods, earthquakes), thefts, accidents etc. No such provision is made
in case of capital loss as it is an unexpected loss. It hampers the production process.

Gross vs. Net Investment

1.Gross Investment: It refers to the total addition to the existing stock of capital during
a given period of time before making allowance for depreciation. (Capital stock
consists of fixed assets and unsold stock. Fixed assets include plant, machinery,
equipments etc. and unsold stock include unsold stock of finished and semi-finished
goods as well as raw materials. It is also called inventories.) Gross investment is
inclusive of depreciation.
2.Net Investment: It refers to the actual addition made to the capital stock of an
economy during a given period of time after making allowances for depreciation. Net
Investment is a measure of the net availability of new capital after taking into account
the wear and tear and foreseen obsolescence of the existing capital.

Net Indirect Taxes (NIT)

It is the difference between Indirect taxes paid by the producers and subsidies
received by them from the government.

NIT = Indirect Tax – Subsidies

Indirect Taxes: It refers to those taxes which are imposed by the government on
production and sale of goods and services, in which ‘liability to pay’ and ‘burden of tax’
lies on different persons. For example: GST.
Subsidies: These are the financial assistance given by the government to the firms/
enterprises on the production of certain commodities. It is given to promote exports or
to encourage production of certain goods and services or to sell goods at a price lower
than the market price. The effect of indirect tax is to increase the market price of the
product whereas the subsidies reduce the market price of goods.
Significance of NIT:
NIT is the difference between Factor Cost and Market Price. Aggregates expressed
in market price are converted into their factor cost by deducting NIT from it and vice-
versa.

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 Market Price Vs Factor Cost
Market Price refers to the price at which product is actually sold in the market. It
includes the indirect taxes and excludes the subsidies.
Factor Cost refers to the amount paid to factors of production for their contribution in
the production process.
Market Price = Factor Cost + Indirect Tax – Subsidies
Indirect tax is subtracted from and subsidies are added to the domestic product
at market price to arrive at domestic product at factor cost. The market price of a
good includes indirect taxes levied on good but does not include the subsidy, if any,
paid by the government. The indirect tax, paid by the buyer is deducted because it
ultimately goes to the government and not to the production units. Subsidy is opposite
of indirect tax. It is paid by the government to production units, and is over and above
the market price. This adds to the value of contribution of production units. Therefore,
it is added to the market price.
Net Exports (Exports – Imports): It refers to the difference between exports and
imports of goods and services. Exports are included in the estimation of National
Income because it is an expenditure on domestic product of a country by foreign
countries. Even though it is an expenditure by the non-residents, it is a final
expenditure. Imports are the expenditure on domestic products of foreign countries.
Private Final Consumption Expenditure, Government Final Consumption Expenditure,
Gross Domestic Capital Formation, all contain import components (a portion each of
these expenditures consist of imports). Since it is not possible to identify expenditure
on imports in these components individually. Therefore, a single estimate of imports
by the country as a whole is deducted from exports as it is an expenditure on domestic
product of foreign countries. This neutralises import element in PFCE, GFCE and
GDCF.

Domestic product at Factor Cost:

Out of what buyers pay, the production units have to make payments of indirect taxes,
if any. Sometimes production units receive subsidy on production. This is in addition
to the market price which production units receive from the buyers. Therefore, what
production units actually receive is not the ‘market-price’ but ‘market price - indirect
tax + subsidies’ This is what is actually available to production units for distribution of
income among the owners of factors of production.
Therefore, market price - indirect tax (I.T.) + subsidies = Factor payments (or factor
costs).

GDP – Net Indirect Tax = GDPFC

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Net Domestic Product at Factor Cost:
If we make adjustment of both the net I.T and depreciation (also called consumption
of fixed capital) we get one more aggregate called Net Domestic Product at Factor
Cost (NDPFC).

NDPFC+ Indirect Tax – Subsidies + Depreciation = GDPMP

The three crucial adjustments required for deriving one aggregate from the other are:
• Gross - Depreciation = Net
• Market price - Indirect Tax + Subsidies = Factor cost
• Domestic + NFIA = National

Circular Flow of Income

It refers to cycle of generation of income in the production process, its
distribution among the factors of production and finally, its circulation from
households to firms in the form of consumption expenditure on goods and
services by firms.

Circular Flow of Income in a Two Sector Economy:

Two sector model consists of production sector/ firms and household sector.
Households are the owners of factors of production and supply factor services to firms.
The firms in return make factor payments, So, factor payments flow from firms to
households. Household spend the entire income on purchase of goods and services
produced by firms. Thus, consumption expenditure flows from households to firms,
completing the circular flow of income.

Types of
Circular Flows

Real Flow Money Flow

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Types of Circular Flows:
Real Flow (Physical/ Product flow): It refers to flow of factor services from
households to firms and the corresponding flow of goods and services from
firms to households.
Money Flow (Income/ Nominal flow): It refers to flow of money in the form of
factor payments from firms to households. and the corresponding flow of
consumption expenditure from households to firms for purchase of goods and
services produced by the firms.

Total production of goods and services by firms = Total consumption of goods

and services by households
Factor payment by firms = Factor income of households
Total consumption expenditure by households = Total income of firms
Real flow = Money flow
Leakages refer to withdrawal of money from the circular flow. They are those flow
variables which reduce the flow of income. For e.g. Savings, Taxes imposed by the
government, Imports etc.

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Injections refer to the introduction of income into the circular flow. They are those
flow variables which increase the flow of income.in the process of production/ in the
process of income generation in an economy. For e.g. Investments, Government
expenditure, Exports etc.

Phases of Circular Flow of National Income

Production

Distribution

Expenditure

In Production (Income Generation Phase), firms produce goods and services with
the help of factor services. Production of goods and services by firms causes
generation of income.
In Income Distribution Phase, factor income (wages, rent, interest and profits) flow
from firms to households according to their contribution to production.
In Expenditure Phase, the income received by factors of production is spent on the
goods and services produced by firms. In this way, income generated in production
units reach back to the production units and make the circular flow complete.
Conclusion:
Value of output produced = Value of income distributed = Value of expenditure
incurred in the economy. Accordingly, there are three methods of estimating National
Income: Value added method, Income method and Expenditure method.

Industrial Classification

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It general practice all the production units of the economic territory are grouped into
three broad groups: Primary sector, Secondary sector and Tertiary sector.
• Primary Sector consists of all production units producing goods by exploiting natural
resources like land, water, subsoil assets etc.
• Secondary Sector consists of all production units which are engaged in
transforming one physical good into another physical good.
• Tertiary Sector consists of all production units producing services.

METHODS OF ESTIMATION OF NATIONAL INCOME (NNPFC) AND OTHER

RELATED AGGREGATES:
There are three methods of estimation of national income: production (value
added), income distribution and final expenditure methods.
1.Production Method (Value Added Method): It refers to the method of calculating
national income which takes into account, the actual contribution of each producing
unit in the production process in an economy. Value added refers to the difference
between the total value of output of a firm and the value of intermediate consumption.
Value Added = Value of Output – Intermediate Consumption
Value added is a measure of contribution of a production unit to domestic product. It
is, in fact, the addition to the value of raw materials (intermediate goods) by a firm by
virtue of its production activities. It is the contribution of an enterprise to the current
flow of goods and services.

Problem of Double Counting

It means counting the value of a product more than once in the estimation of
National Income. The problem of double counting arises when the value of
intermediate goods is counted in the estimation of national income along with the value
of final goods and services. A commodity passes through various stages of production
before reaching the final stage. When value of output is taken at each stage, it is likely
to include cost of inputs more than once. This leads to the problem of double counting.
It results in the overestimation of national income.

Two ways to avoid the problem of double counting –

a) Consider only the value of final goods and services in the estimation of national
income.

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b) Consider the value added instead of value of total output produced in the estimation
of national income.
Precautions to be taken while estimating national income using Value added
method:

o Value of intermediate goods should not be included in the estimation of national

income because value of these goods is already included in the value of final
goods. If they are included again, it will lead to double counting.
o Own account production means output produced by production units for self-
consumption and investment should be included. For example, output
produced by farmers for self-consumption. Imputed value of production of
goods for self-consumption should be included as they contribute to the current
output. These goods are like those produced for the market; they are not simply
sold because of their need by the producers themselves.
o Imputed rent of the owner-occupied houses should be included in national
income because all houses have rental value, no matter they are self-occupied
or rented one.
o Imputed value of free services produced by general government and private
non-profit institutions serving households must be taken into account. If it is not
done, it will lead to underestimation of total output consequently of national
income.
o Output of only newly produced goods i.e. goods produced in the current year
should be included in the total output of that year. Sale and purchase of second
hand goods and property should not be included because they were included
in the year in which they were produced. They do not add to the current flow of
goods and services (i.e. not a part of the current year production). However,
any commission or brokerage on sale or purchase of such goods will be
included in the national income as it is a productive service.

2.Income Distribution Method:

In this method we first estimate factor incomes paid out (i.e. distributed) to the owners
of factors of production by the various industrial sectors. The sum of such factor
payments equals Net value Added at Factor Cost (NVAFC) by that sector. Then we
take sum total of NVAFC by all the sectors to arrive at NDPFC (Domestic Income). The
components of NDPFC are:
1. Compensation of employees
2. Rent and royalty
3. Interest
4. Profits

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5. Mixed income of self employed
System of National Accounts 1993, a joint publication of the United Nations and the
World Bank, has elaborated the following components of Income method:
(i) Compensation of employees (COE): It is defined as the total remuneration in
cash or in kind, payable by an enterprise to an employee in return for work done by
the latter during the accounting period. The main components of compensation of
employees are:

o Wages and salaries in cash: include daily, weekly or monthly etc. payments in
cash including allowances such as house rent, conveyance allowances for
travel to and from work, bonuses etc. Wages and salaries in kind: include goods
and services provided by the employers to employees for satisfaction of wants
of employees and their families like rent free accommodation, vehicles for
personal use, imputed interest of interest free loans etc.
o Social security contributions by the employers include contribution of employers
towards social security schemes like casualty insurance, provident fund,
gratuity and pension provisions etc. which benefit employees.
(ii) Rent is defined as the amount receivable by a landlord from a tenant for the use
of land.
(iii) Royalty is defined as the amount receivable by the landlord for granting the
leasing rights of sub-soil assets.
(iv) Interest is defined as the amount payable by a production unit to the owners of
financial assets in the production unit. The production unit uses these assets for
production and in turn makes interest payment, imputed or actual.
(v) Profit is a residual factor payment by the production unit to the owners of the
production unit. It is the reward to the entrepreneur for his contribution to the
production of goods and services. It has three components.

o Corporate tax,
o Dividend and
o Retained earnings/ Undistributed Profits.

Profits = Corporation Tax + Dividends + Retained earnings

(vi) Mixed income of self-employed – There are cases where total factors payment
is estimable but not its different components. This problem arises mainly in case of
self-employed people like doctors, chartered accountants, consultants, etc, and
unincorporated enterprises (like retail traders, small shopkeepers, etc.). This factor
payment is popularly called ‘Mixed income of the self-employed’. It is used for any
income that has elements of more than one type of factor income. Mixed income arises

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for productive services of self-employed persons, whose income includes wages, rent,
interest and profit and these elements cannot be separated from each other.

NDP FC = Compensation of employees + Rent and royalty + Interest + Profit +

Mixed income (if any).
There is another term used in factor payments. It is ‘operating surplus’. It is defined
as the sum of rent and royalty, interest and profits. In that case:
NDP FC = Compensation of employees + Operating surplus + Mixed income of
self employed.

Precautions to be taken while estimating national income using Income method:

A. National income includes only factor payments, i.e. payment for the services
rendered to the production units by the owners of factors. Any payment for
which no service is rendered is called a transfer, and not a production activity.
Gifts, donations, charities etc are main examples. Since transfers are not a
reward for production activity it should not be included in national income.
B. Capital gain refers to the income from the sale of second hand goods like old
cars, old house, machinery, buildings etc. These transactions are not a current
production activity of the owners of these goods, they do not add to the current
flow of goods and services in the economy. So, any income arising to the
owners of such things is not a factor income hence not included.
C. Income arising from the sale of financial assets like shares, bonds, debentures,
government securities etc. will not be included as these transactions are not
related to the production of goods and services. Any profit arising from the sale
of these is capital gain which is not treated as factor payment. These financial
assets are mere paper claims and involve a change in title only. (However, any
commission or brokerage paid is the payment for services and must be included
in factor payments.)

3.Expenditure Method:
This method measures national income as sum total of final expenditures incurred by
all the four sectors of the economy. Final expenditures are expenditures on goods and
services for consumption and investment. This sum equals GDPMP. These final
expenditures are on the output produced by production units located within the
economic territory of the country. Its main components are:

24
 o Private final consumption expenditure (PFCE): This is the sum of final
consumption expenditure by households and private non-profit institutions
serving households.
o Government final consumption expenditure (GFCE): This equals the
imputed value of services produced and provided by general government free
to the people.
o Gross domestic capital formation (GDCF): This equal the expenditure
incurred on acquiring goods for investment by production units located within
the domestic territory.

Gross domestic capital formation = Gross domestic fixed capital formation +

Change in stocks.

o Net Exports (X-M): This is the difference between export and imports of goods
and services.
Precautions to be taken while estimating national income using Expenditure
method:
o By definition the method includes only final expenditures, i.e. expenditure on
consumption and investment. Intermediate expenditure is already a part of final
expenditures. So, including intermediate expenditure like that on raw materials,
etc, will mean double counting. It may lead to overestimation of national income.
Therefore, proper identification of expenditure on intermediate products is
necessary.
o Expenditure on second hand goods should not be included as it does not lead
to any addition to the current flow of goods and services (they have already
been accounted during the period of their production; they are not part of
current production). However, any commission or brokerage paid in such
transactions are treated as final expenditure because it is a payment for the
services purchased.
o Expenditure on financial assets in the form of expenditure on buying shares,
bonds, debentures, government securities etc will not be included as they are
simply paper claims. It only leads to transfer of money from one person or
institution to another person or institution. But any brokerage or service charged
or paid in buying financial assets is treated as expenditure on buying services.

Difference between Nominal National Income (National Income at

Current Prices) and Real National Income (National Income at
Constant Prices):

25
Difference between Nominal GDP (or GDP at Current Prices) and
Real GDP (or GDP at Constant Prices):

Determination of Nominal GDP and Real GDP: Nominal GDP and Real GDP can
be determined in the following manner:

26
GDP Deflator: GDP Deflator measures the average level of prices of all goods and
services that make up the GDP. It is used to eliminate the effect of price changes and
determine the real change in physical output.

GDP and Welfare

GDP (Real GDP) is used as an index of welfare of the people. Welfare means sense
of material well-being among the people. It is influenced by many factors like
consumption level, the types of goods and services consumed (economic factors),
environmental pollution, law and order situation (noneconomic factors) etc. Higher
GDP is generally taken as greater welfare of the people. However, GDP may not be
taken as a satisfactory measure of economic welfare due to certain limitations. These
are:
1. Does not include the rate of growth of population: Real GDP indicates overall
performance of the country. But Real GDP does not consider the changes in the
population of a country. The prosperity of the country is better judged by the per capita
real GDP. The per capita real GDP equals total real GDP divided by population. An
increase in per capita real GDP indicates increase in per capita availability of goods
and services. If rate of growth of population is higher than the rate of growth of real
GDP, then it will decrease the per capita availability of goods and services, which will
adversely affect the economic welfare.
2. Does not reflect distribution of GDP: There is inequality in the distribution of
income in the economy. GDP does not take into account changes in inequalities in the
distribution of income. If with increase in per capita real income or GDP, the inequality
in the distribution of income/ GDP increases i.e. rich becoming richer and poor
becoming poorer, then it may lead to decline in welfare (because utility of a rupee of
income to the poor is more than to the rich). In such a situation, if welfare rises, it may
rise in less proportion as compared to rise in per capita GDP.
3. Does not include non-economic or non-monetary exchanges: There are many
goods and services which contribute to economic welfare but are not included in the
GDP. For example: services of housewives and other family members (leisure time
activities) etc. These are non-monetary exchanges i.e. those exchanges and activities
which are left out from the estimation of GDP or National Income on account of non-
availability of data and problem of valuation. Since these activities do not command a
price i.e. no price is attached to them, although they contribute to economic welfare.
4. Composition of GDP: GDP includes different types of products like clothes, food
articles, police and military services, house etc. Some of these products contribute
more to the welfare of the people like food, clothes etc. whereas other products like
police services and military services etc. may comparatively contribute less and may
not directly affect the standard of living of the people. Thus, if GDP increases, the
increase in welfare may not be in the same proportion. Therefore, how much is the

27
economic welfare, it should depend more on the types of goods and services produced
and not simply how much is produced.
5. Contribution of some products in GDP may be negative: GDP include all final
goods whether it is milk or liquor, some goods included in GDP measurement may
reduce economic welfare. For example, liquor, cigarettes etc. because of their harmful
effect on health. GDP includes only the monetary value of the products and not their
contribution to welfare. Therefore, economic welfare depends not only on the volume
of consumption but also on the type of goods and services consumed. This should be
considered while drawing conclusion about economic welfare from GDP.

28
 CHAPTER 3
MONEY AND BANKING
Money is anything that is generally acceptable as a medium of exchange,
measure of value, store of value and as a standard of deferred payments.

Money Supply:
It refers to the total stock of money held by public at a particular point of time in an
economy.
• It is a stock concept because it is measured at a particular point of time.
Components of Money Supply:
o Currency (paper notes and coins) held by the public (outside the banks): and
o (Net) Demand deposits of the public with the commercial banks.

Basic Measure of Money Supply – most liquid form:

M1= C (Currency held by the public) + DD (net demand deposits with
commercial banks)
• Currency and coins with public: It consist of paper notes and coins held by the
public that can be legally used to make payments of debts or other obligations.
• Demand deposits of commercial banks: Demand deposits are the deposits of
commercial banks from which money can be withdrawn on demand by the depositor
using cheque.
Only in case of India: C+DD+ OD (other deposits with RBI only in case of India)
Other Deposits with RBI: It include deposits held by the RBI on behalf of foreign banks
and governments, World Bank, IMF, etc. However, it does not include deposits of the
Indian government and commercial banks with RBI.
Other than demand deposits there are time deposits which have a fixed term or
maturity period after which they can be withdrawn. E.g: Fixed deposit.
The currency issued by the central bank can be held by the public or by the commercial
banks and is called the ‘high powered money’ or ‘reserve money’ or ‘monetary
base’. Demand deposits are created by the commercial banks and are called Bank
money.

BANKING
29
Central Bank: It is an apex body that controls, operates, regulates and directs the
entire banking and monetary structure of the country.
Commercial Bank: Commercial bank is an institution which performs the functions of
accepting cheque able deposits and providing loans and making investments, with the
aim of earning profits and has the power to create money using demand deposits. E.g.
Punjab National Bank, Canara Bank etc.
All banks are financial institutions but all financial institutions are not banks.
Banks should accept cheque able deposits and give out loans.

Functions of Central Bank

1.Currency Authority (Bank of Issue):
a) Central bank has the sole authority for issue of currency in the country. In India RBI
has the sole right of issuing paper currency notes (except one-rupee note and coins
which are issued by Ministry of Finance). Withdrawal and putting currency into
circulation is also the responsibility of RBI.
b) All the currency issued by the RBI is its monetary liability, i.e. central bank is obliged
to back the currency with assets (which consists of gold coins, gold, foreign securities
etc.) of equal value.
c) Advantages of this functions are:
o It leads to uniformity in note circulation.
o It gives the central bank power to influence money supply and ensures public
faith in the currency system.
o It enables the government to have supervision and control over the central bank
with respect to issue of notes. It helps in stabilizing the internal and external
value of currency.

2. Banker to the government:

RBI acts as a banker, agent and financial adviser to the central and the state
government.
• As a banker it carries out all banking business of the government.
o Government maintains its cash balances in the current account with RBI.
o RBI accepts receipts and make payments on behalf of the government and
carries out other banking operations for the government.
o The Central Bank also provides short-term credit to the government so that the
government can meet any shortfalls in receipts over disbursements. The
government carries on short term borrowings by selling ad-hoc treasury bills to
the central bank.

30
• As an agent the central bank also has the responsibility of managing the public debt.
This means that the central bank has to manage all new issues of government loans.
• As a financial advisor the central bank advises the government from time to time on
economic, financial and monetary matters.

3. Banker’s bank and supervisor:

As a banker to the banks, the central bank functions in three respects:
o Custodian of cash reserves: Commercial banks are required to keep a certain
percentage of their deposits with the central bank. In this way the central bank
acts as a custodian of cash reserves of commercial banks. (The sole aim of
these reserves is to enable central bank to provide financial assistance to
commercial banks in times of financial emergency).
o Central bank is the lender of the last resort: When commercial banks fail to
meet their financial requirement from other sources, they approach the central
bank to give loans and advances as the lender of last resort. The central bank
helps them through discounting approved securities and bills of exchange.
o Clearing house function: All commercial banks have their accounts with the
central bank. Therefore, the central bank can easily settle claims of various
commercial banks against each other, by making debit and credit entries in their
accounts.
o Central bank as a supervisor, supervises regulates and controls the activities
of commercial banks. The regulation of banks may be related to their licensing,
branch expansion and mergers of banks. The control is exercised by periodic
inspection of banks and the returns filed by them.

4. Custodian of foreign exchange reserves:

The central bank acts as the custodian of the country’s stock of gold and reserves of
foreign exchange. This function enables the central bank to exercise a reasonable
control on foreign exchange. As all foreign exchange transactions must be routed
through RBI. It helps the bank in stabilizing the external value of currency and pursuing
a coordinated policy towards the balance of payments situation of the country.

5.Controller of money supply and credit: Central bank controls money

supply by using various quantitative and qualitative instruments.

Quantitative instruments
Aim at controlling the volume of credit and money supply in the economy.
a) Bank rate: The rate at which the central bank lends money to commercial
banks for its long-term needs is known as bank rate.
31
• An increase in bank rate increases the cost of borrowing from the central bank. As a
result, commercial banks will increase the rate of interest at which they lend to public
(lending rate) thereby making credit costlier. This discourages the public to borrow
from commercial banks, which reduces the flow of credit or money supply in the
economy.
• A decrease in bank rate will have the opposite effect.
b) Legal reserve requirement: Commercial banks are legally required to maintain
reserves on two accounts)
Cash Reserve Ratio (CRR): It refers to the percentage of the net demand and
time deposits that commercial banks are legally required to keep as cash
reserves with RBI.
➢ An increase in CRR means that commercial banks have to keep a higher
percentage of their deposits as reserves with RBI which reduces the credit
availability with them. This decreases their lending capacity which in turn
decrease the flow of credit or money supply in the economy.

➢ A decrease in CRR will have the opposite effect.

Statutory Liquidity Ratio (SLR): It is the percentage of net demand and time
deposits which commercial banks are legally required to keep in the form of
designated liquid assets (such as govt. securities) with themselves.
➢ An increase in SLR reduces the ability of banks to give credit and hence
reduces lending and the flow of credit or money supply in the economy.

➢ A decrease in SLR will have the opposite effect.

Open market operations: It refers to buying and selling of government securities

or bonds by the central banks from or to the commercial banks or public.
➢ Sale of securities by the central bank will reduce the reserves with commercial
banks when the bank gives the central bank a cheque for the securities which
will reduce the banks ability to create credit and reduce lending in the economy
and therefore decrease the money supply in the economy.
➢ In order to expand the flow of credit in the economy central bank purchases
securities from the commercial banks and in return gives the banks a cheque
drawn on itself in payment for the securities.
When the cheque clears, the central bank increases the reserves of the bank by the
particular amount thereby increasing their ability to create credit and lend more and
therefore money supply increases in the economy.

32
Repo (Repurchase) rate: It is the interest rate at which the commercial banks
can borrow from the central bank to meet their short-term needs.
➢ An increase in the repo rate will make borrowings from central bank costlier, as
a result banks will lend to public at a higher lending rate. Thus, borrowings will
be discouraged as credit is costlier leading to decrease in money supply in the
economy.
➢ A decrease in repo rate will have the opposite effect.

Reverse repo rate: It is the interest rate which the commercial banks get for
depositing their surplus funds with the central bank.
➢ Raising RRR gives incentives to the commercial banks to park their funds with
RBI. This reduces credit availability with the commercial banks and adversely
affect their lending capacity leading to decrease in money supply.
➢ Lowering RRR discourages the commercial banks from parking their funds with
the central bank. This will increase credit availability with the commercial banks
and their credit creation power leading to increase in money supply.

Qualitative instruments
Margin requirement: It is the difference between the amount of loan and the market
value of the security offered by the borrower against the loan. By changing the margin
requirement reserve bank can alter the amount of loans made against securities by
the bank.
➢ To expand money supply in an economy margin requirement is reduced which
means more loan is given against the same value of security which encourages
borrowing and therefore increases the flow of credit or money supply in the
economy.
➢ To reduce money supply in an economy margin requirement is increased which
means less loan is given against the same value of security which discourages
borrowing and therefore decreases the flow of credit or money supply in the
economy.

Difference between Central Bank and Commercial Bank:

33
 Money Multiplier / Credit creation by commercial banks
Credit creation refers to the process of creation of credit by the commercial
banks with the help of an initial deposit and given LRR.
Assumptions:
➢ The amount of initial deposit (assumed to be `1000)
➢ The LRR or legal reserve ratio (assumed to be 20%)
Legal Reserve Ratio is the fraction of deposits that the banks have to keep
compulsorily in the form of cash with the central bank or designated liquid assets like
govt securities with themselves. These may be in the form of CRR or SLR.

Principle:
a) All transactions are routed through the banks.
b) All banking system is treated as a single ‘Bank’

Working:
1) Suppose the initial deposits in the banks are Rs.1000. Since LRR is 20%, it means
that the banks can lend out the remaining 80% to the borrowers i.e. Rs 800. It does
so by opening an account in the name of the borrower.
2) If the borrowers withdraw the entire amount and make payments using Rs.800.
Since all transactions are routed through the banks, the money comes back to the
banks in the form of deposits by the receivers of this money. This increases the

34
deposits by Rs.800. Thus, the total credit created now increases to 1000 + 800 =
Rs.1800.
3)The bank then uses the Rs.800 to lend after keeping reserves worth 20% i.e. Rs.160
and lends the remaining Rs.640 as fresh loans to borrowers which again comes back
as deposits in the accounts of the receivers of this money. Hence total credit created
now equals Rs. 1000 + 800 + 640 = Rs.2440.
This continues and in each round, the deposit creation is 80% of the previous round.
These increases become smaller and smaller and continue till all of the initial deposit
equals the total cash reserves

Note on Demonetisation
Demonetisation was a new initiative taken by the Government of India in November
2016 to tackle the problem of corruption, black money, terrorism and circulation of fake
currency in the economy. Old currency notes of Rs 500 and Rs 1000 were no longer
legal tender. New currency notes in the denomination of Rs 500 and Rs 2000 were
launched. The public were advised to deposit old currency notes in their bank account
till 31 December 2016 without any declaration and up to 31March 2017 with the RBI
with declaration.
Legal tender is money declared legal by a government or backed by law of the
land. (can be legally used to make payments).

35
 CHAPTER-4
Determination of Income and Employment

Aggregate Demand (AD)

It refers to the total value of final goods and services that all sectors of the economy
taken together are planning to buy at a given level of income during a period of time.
It is the planned (ex-ante) demand. In other words, Aggregate demand is equal to the
total expenditure on consumption and investment that all sectors of the economy (i.e.
households, firms, government and ROW taken together) plan to undertake at each
income level during a given period of time.

Components of Aggregate Demand:

1. Private consumption expenditure (C): It refers to the planned expenditure on final
consumer goods and services by households at a level of income during a given period
of time. This demand is influenced by the disposable income of the household.
2. Investment expenditure
(I): It is the planned expenditure on new capital goods by producers during a period of
time. These capital goods are in the form of machinery, buildings, equipments,
inventory etc. Investment comprises expenditure on:
➢ fixed capital business assets like machinery, equipment, buildings, etc.
➢ inventory and
➢ residential construction. In Keynes theory, investment expenditure is assumed
to be autonomous (I) i.e. it is not influenced by the level of income.
3. Government Expenditure (G): It is the planned consumption expenditure of
general government on providing free services to the people. The free services
provided by the general government include the services of law and order, defence,
education, health, sanitation, roads etc.
4. Net exports (X – M): It is the planned net expenditure by foreigners on goods and
services produced in the country during a given period of time. It is equal to the
difference between value of exports and value of imports.

AD = C + I + G + (X – M)

36
AD in Keynesian framework, in case of two sector economy (households and firms) is
the sum of consumption demand and investment demand i.e. AD is a function of only
consumption expenditure and Investment expenditure. Hence,

AD = C+I
Ex-ante and Ex-post Ex-ante simply mean intended (or planned or expected or
desired). Ex-ante variable is the planned or expected value of the variable. For
example, Ex-ante investment means amount of investment which all the firms plan
(intend) to invest at different levels of income in the economy at the beginning of the
period. It is also known as planned investment. Similarly, ex-ante savings refers to the
savings intended/ expected to be made during the year.
Ex-post means actual or realised at the end of the year. Ex-post variable is the
actual or realised value of the variable For example, Ex-post investment means actual
investment made in an economy during a financial year at the end of the period.
Similarly, ex-post savings refers to the actual or realised savings during a year.
All the variables in the theory of income determination are ex-ante variables.

Aggregate Supply (AS)

It refers to the value of final goods and services planned to be produced by all the
production units in the economy taken together during a period of time. It refers to the
planned aggregate output in the economy.
Aggregate supply is same as national income.
The value of total output of goods and services (i.e. Aggregate supply) is equal to the
factor cost planned to be incurred on producing this output, which producers expect to
recover during the period. The cost includes expenditure on wages, rent, interest and
profits by all production units. The sum of these factor incomes (wages, rent, interest
and profits received by factors of production) at the national level is termed as national
income. Therefore, the value of aggregate supply and national income are same.
Aggregate supply is also equal to national output.

Aggregate supply = National income = National output

Components of AS (or National income):

The main components of AS are: Consumption (C) and Savings (S)
As the major proportion of national income is spent on consumption of goods and
services and the balance is saved. i.e. income is either consumed or saved. Therefore
Aggregate supply = National income = Consumption + Savings

37
 Consumption Function
It refers to the functional relationship between consumption and national
income.
The consumption expenditure we are discussing here is ex-ante i.e. planned
consumption expenditure which households are planning to consume during a given
period of time.
• It shows the consumption expenditure at different levels of income in an economy.

Autonomous consumption vs Induced consumption

Propensity to consume
It refers to the proportion of income spent on consumption. It has two aspects: APC
and MPC.
1. Average Propensity to consume (APC): It refers to the ratio of consumption
expenditure (C) to the corresponding level of income (Y). It is a measure of total
consumption expenditure as a proportion of total income.

38
Important points about APC
➢ APC can be greater than one as long as consumption is greater than income
(before the break-even point, at lower income levels)
➢ APC is equal to one when income is equal to consumption (at break-even
point).
➢ APC can be less than one when consumption is less than income (beyond the
break-even point).
➢ APC can never be zero as consumption can never be zero. Even at zero level
of income there is some consumption which is called autonomous consumption.
➢ APC falls with increase in income because the proportion of income spent on
consumption keeps on falling with increase in income.

2. Marginal Propensity to consume (MPC): It refers to the ratio of change in

consumption expenditure (∆C) to change in income (∆Y). In other words, it is the
change in consumption per unit change in income.

Important points about MPC

➢ The value of MPC varies between 0 and 1 as we know that income is either
spent on consumption or saved. However, • if the entire additional income is

39
 consumed i.e. ∆Y = ∆C, then MPC = 1. • if the entire additional income is saved
i.e. ∆C = 0, then MPC = 0.
➢MPC (b) refers to the slope of consumption curve which measures the rate of
change in consumption on per unit change in income. In the above schedule
MPC is constant (0.80) and due to constant MPC the consumption curve is a
straight line, i.e. consumption function is linear.’

Savings
Savings is that part of income that is not consumed.

Saving function: It refers to the functional relationship between savings and

income.

Propensity to save:
It is the proportion of income saved. It has two aspects: APS and MPS
1.Average Propensity to consume (APS): It refers to the ratio of savings (S) to the
corresponding level of income (Y).

Important points about APS

➢ APS can never be one or more than one as savings can never be equal to or
more than income.
➢ APS can be zero at break-even point when income is equal to consumption and
savings are zero.
➢ APS can be negative or less than one when income is less than consumption
and there will be savings in the economy (at income level lower than the break-
even point).
➢ APS can be positive or greater than zero when income is more than
consumption and there will be positive savings in the economy (at income level

40
 higher than the break-even point).  APS rises with increase in income. This
means that as income increases, the proportion of income saved increases.

2. Marginal Propensity to consume (MPS): It refers to the ratio of change in saving

(∆S) to change in income (∆Y). In other words, it is the change in savings per unit
change in income.

Important points about MPS

➢ The value of MPS varies between 0 and 1. However if entire additional income
is consumed i.e. ∆S = 0, then MPS = 0 and if entire additional income is saved
i.e. ∆S = ∆Y, then MPS = 1.
➢ MPS (1-b) refers to the slope of saving curve. It is measured as the ratio
between ∆S (additional saving) and ∆Y (additional income).
In the above schedule MPS is constant (0.20) and due to constant MPS saving curve
is a straight line, i.e. saving function is linear.

Relation between APC and APS: The sum of APC and APS is equal to one.

APC + APS = 1

Investment
Investment is defined as addition to the stock of physical capital (such as machines,
buildings, roads etc., i.e. anything that adds to the future productive capacity of the
economy) and changes in the inventory (or the stock of finished goods) of a producer.

Types of investment:
1. Induced investment

41
 • It refers to the investment which depends upon profit expectations and is
directly influenced by income level.
• It is income elastic i.e. as income increases it also increases.
• It is done by private sector.

2. Autonomous investment

➢ It refers to the investment which is not affected by change in the level of

income and is not induced by profit motive i.e. it is independent of the level
of income.
➢ It is income inelastic i.e. It remains same irrespective of any change in
income.
➢ It is generally done in the government sector.

Investment Multiplier (k):

Investment multiplier is defined as the increase in national income as a multiple of a
given increase in investment. It is a measure of the effect of change in investment on
the national income. In other words, k is the ratio of increase in national income (∆Y)
due to an increase in investment (∆I) i.e.

Multiplier and marginal propensity to consume:

The value of multiplier depends upon the value of marginal propensity to consume.
The concept of multiplier is based on the principle that one person’s consumption
expenditure is income of the other. When investment is increased, it also increases
the income of the people. People spend a part of this increased income on
consumption. However, the amount of increased income spent on consumption
depends on the value of MPC.

42
 ➢ In case of higher MPC people will spend a large proportion of increased income
on consumption. Higher the expenditure on consumption, higher the increase
in income of producers of goods and services. As a result, in such a case the
value of multiplier will be more.
➢ In case of lower MPC, people will spend less proportion of increased income
on consumption. In such a case the value of multiplier will be comparatively
less.

There exists a direct relationship between MPC and the value of multiplier. Higher the
value of MPC, more is the value of multiplier. Hence greater is the increase in income.
Similarly, lower the value of MPC, lesser is the value of multiplier. Hence less is the
increase in income.

There exists an inverse relationship between MPS and the value of investment
multiplier. Higher the value of MPS, lower will be the value of multiplier and lower the
value of MPS the higher is the value of multiplier. Hence more will be the increase in
income because lower the value of MPS implies lower savings, higher is the
consumption expenditure and consequently, higher the income of producers of
consumer goods and services. As a result, the value of multiplier will be more.

Involuntary unemployment: Involuntary unemployment occurs when those who

are able and willing to work at the going wage rate do not get work. It is distinguished
from Voluntary unemployment which refers to that part of population which are able to
work but voluntarily prefer not to work even though suitable work is available for them.

Full Employment: When the entire labour force of the country is in employment,
it is called full employment. Labour force comprises of people who are able to work
and willing to work.

Full employment level of income: It is that level of income where all the factors
of production are fully employed in the production process.
Full employment level of income is that level of income where all the factors of
production are fully employed in the production process The equilibrium level of output
may be more or less than the full employment level of output. If it is less than the full
employment of output, it is due to the fact that demand is not enough to employ all
factors of production. This situation is called the situation of deficient demand. It leads
to decline in prices in the long run. On the other hand, if the equilibrium level of output
is more than the full employment level, it is due to the fact that the demand is more

43
than the level of output produced at full employment level. This situation is called the
situation of excess demand. It leads to rise in prices in the long run.

Excess demand/ Inflationary gap

If aggregate demand is for a level of output/ income more than the full-employment
level, then a situation of excess demand exists. In other words, excess demand refers
to the situation when aggregate demand (AD) is more than aggregate supply (AS)
corresponding to full employment level of output in the economy.
The situation of excess demand give rise to inflationary gap; which causes a rise in
the price level or inflation. The inflationary gap is the amount by which actual aggregate
demand exceeds the aggregate demand required to establish full-employment
equilibrium. The inflationary gap is a measure of the amount of the excess of
aggregate demand.

Measures to correct Excess Demand / Inflationary gap

The problem of excess demand arises when AD > AS corresponding to full
employment income level. To correct this situation aggregate demand has to be
reduced till it becomes equal to AS. The overall objective is to achieve full employment
equilibrium in the economy. This can be done using various fiscal and monetary policy
measures.

A. Fiscal measures
Fiscal policy It refers to the policy concerning revenue and expenditure of the
government in order to achieve economic objective. During excess demand
government takes following measures to reduce aggregate demand:

➢ Reduce government expenditure - During excess demand government

should curtail/ reduce its expenditure on public work programmes (on its
administration and welfare activities, like police, military, courts, education,
sanitation etc.). This may reduce the purchasing power in the hands of the
people which may in turn decrease aggregate demand in the economy and be
helpful in correcting excess demand.
➢ Increase in taxes - During excess demand the government may raise the rate
of taxes and even impose new taxes. Increasing taxes may reduce the
disposable income of the people which may in turn reduce their consumption
expenditure. This may decrease aggregate demand in the economy and thus
help in correcting excess demand situation.

B. Monetary measures
Monetary policy It refers to the policy of the RBI (central bank of India) to influence
credit and money supply in the economy to achieve economic objectives. To reduce

44
aggregate demand during excess demand the central bank aims to reduce availability
of credit in the economy through its various monetary policy measures:

Increase in Bank rate Bank rate is the rate of interest at which the central
bank lends money to commercial banks for its long-term needs. During excess
demand the central bank increases bank rate., which raises the cost of
borrowings from the central bank. It forces commercial banks to increase their
lending rates thereby making credit costlier. As a result, demand for loans for
investment and other purposes decrease, leading to decrease in aggregate
demand in the economy.
Open market operations (Sale of securities) It refers to buying and selling of
government securities or bonds by the central bank from or to the commercial
banks or public. During excess demand the central bank sells government
securities to the public and commercial banks. This decreases the credit
availability with commercial banks. It adversely affects lending capacity of
commercial banks. This reduces consumption and investment demand which
in turn reduces aggregate demand in the economy.
Increase in Legal Reserve Requirements (LRR)
Commercial banks are obliged to maintain legal reserves. An increase in such
reserves is a direct method to reduce the availability of credit. There are two
components of legal reserves.

➢ Cash Reserve Ratio (CRR): It refers to the percentage of the net demand and
time deposits that commercial banks are legally required to keep as cash
reserves with RBI.
➢ Statutory Liquidity Ratio (SLR): It is the percentage of net demand and time
deposits which commercial banks are legally required to keep in the form of
designated liquid assets (such as govt. securities).
During excess demand the central bank (RBI) increases LRR (CRR or/ and SLR). This
reduces the funds available for credit creation with commercial banks. This in turn
reduces lending capacity of commercial banks. Thus, borrowings from banks fall
leading to decrease aggregate demand in the economy.

Increase in Repo rate It is the interest rate at which the commercial banks can
borrow from the central bank to meet their short-term needs. During excess
demand the central bank increases the repo rate which makes borrowings by
commercial banks costly. This forces commercial banks to increase their
lending rates. This discourages borrowings leading to fall in aggregate demand
in the economy.
Increase in Reverse repo rate It is the rate of interest at which commercial
banks can park their surplus funds with the central bank, for a relatively shorter
period of time. During excess demand the central bank increases reverse repo
rate. This gives incentives to the commercial banks to deposit their surplus
funds with the central bank/ RBI. This reduces liquidity with the commercial
45
 banks and thereby adversely affect their credit creating power. Consequently,
borrowings from banks will fall leading to decrease in aggregate demand in the
economy.

Deficient demand / Deflationary gap

If aggregate demand is for a level of output/ income less than the full-employment
level, then a situation of deficient demand exists. In other words, deficient demand
refers to the situation when aggregate demand (AD) is less than aggregate supply
(AS) corresponding to full employment level of output in the economy.
The situation of deficient demand give rise to ‘deflationary gap’, which causes the
economy’s income/ output/ employment to decline, thus pushing the economy into an
under-employment equilibrium. Deflationary gap is the gap by which actual aggregate
demand falls short of the aggregate demand required to establish full employment
equilibrium.

Measures to correct the situation of Deficient Demand/

Deflationary gap:
The problem of deficient demand arises when AD < AS at full employment income
level. To correct this situation level of AD has to be increased till it becomes equal to
AS. The overall objective is to achieve full employment equilibrium. The government
takes following measures to increase aggregate demand in the economy:

Fiscal Measures

Increase in
Decrease in
government
taxes
expenditure

46
 Chapter - 5
Government Budget and the Economy

Government Budget:
Government Budget is the annual financial statement of estimated receipts and
expenditures of the government over a fiscal year.
Fiscal Year: It is a financial year which runs from 1 April to 31 March.

Objectives of Government Budget:

1. Allocation of Resources
• The government through its budgetary policy reallocates resources so that social
(public welfare) and economic (profit maximization) objectives are met.
• The government can influence allocation of resources through:

✓ Tax concessions or Subsidies: Government can give tax concessions,

subsidies etc. to private producers to encourage production of such goods
and services which are beneficial for the society. For e.g.: Government can
encourage the use of Khadi products by providing subsidies. Similarly, the
government can discourage the production of certain goods such as harmful
consumption goods (like liquor, cigarettes etc.) by imposing heavy taxes.
✓ Directly producing goods and services: Areas where private sector
initiative is not forthcoming i.e. the areas where private sector is not
interested due to lack of profits or due to huge investment involved,
government can directly undertake the production of goods and services.

• There are many other activities like water supply, sanitation etc. which are
necessarily undertaken by the government in public interest.
• Government provides certain goods and services which cannot be provided by the
market mechanism i.e. by exchange between individual consumers and producers,
known as public goods. For example − national defence, roads, government
administration, public park etc. These are those goods which are collectively
consumed and one person’s consumption of a good does not reduce the amount
available for consumption for others and so several people can enjoy the benefits.

47
 Public Goods
• Public goods are those goods which are collectively consumed and have two
important features – they are non-rivalrous i.e. One person’s consumption of a good
does not reduce the amount available for consumption for others and so several
people can enjoy the benefits and they are non-excludable, which implies that there is
no feasible way of excluding anyone from enjoying the benefits of the good. These
make it difficult to collect fees for their use and private enterprise will in general not
provide these goods. Hence, they must be provided by the government. Examples of
public goods include law enforcement, national defence, street lighting and public
parks.
• Even if some users do not pay, it is difficult and sometimes impossible to collect fees
for the public good. These non-paying users are known as ‘free-riders’.

2. Redistribution of Income
• The government sector affects the personal disposable income of households by
making transfers and collecting taxes. It is through this that the government can
change the distribution of income and bring about a distribution that is considered ‘fair’
by society. This is the redistribution function.
• The government can reduce income inequalities (or redistribute income) by:
✓ Imposing higher rates of tax on the income of the rich and the goods consumed
by rich. It will reduce their disposable income.
✓ Government can spend more amount on providing free services to poor like
education, medical treatment etc. or subsidising them. This will raise disposable
income of the poor. In this way gap between the rich and poor can be reduced.
✓ The redistribution objective is sought to be achieved through progressive
income taxation, in which higher the income, higher is the tax rate. Firms are
taxed on a proportional basis, where the tax rate is a particular proportion of
profits.
✓ It aims at making sure that income is not concentrated among the few rich as
income disparities make GDP a poor measure of economic welfare.

3.Bringing Economic Stability

• Economic Stability means absence of large-scale fluctuations on the economic
indicators like prices, employment levels, etc. as such fluctuations create uncertainty
in the economy.

48
• Economic stability induces investments and increases rate and growth of
development.
• The government can exercise control over these fluctuations in income and
employment in the economy through taxes and expenditure. For e.g. In inflationary
conditions (rising prices, when there is excess demand), the government can
discourage spending by imposing higher taxes and reducing its own expenditure which
is also called Surplus budget policy. In deflationary conditions (i.e. times of
depressions, when there is deficient demand) government can encourage spending
by reducing taxes, providing tax concessions, subsidies and increasing its expenditure
also called Deficit budget policy.

Budgetary policy during inflation and deflation

✓ When demand exceeds available output, it may give rise to inflation. In such
situations, restrictive conditions may be needed to reduce demand. The govt
can reduce expenditure and impose higher taxes to reduce disposable incomes
and purchasing power and hence reduce aggregate demand in the economy.
i.e. it can use a surplus budget where total budgetary receipts exceed total
budgetary expenditures of the government.
✓ Similarly, when demand fall short of available output, it may give rise to
deflation. In such a situation government can encourage spending (aggregate
demand) by reducing taxes and increasing its expenditure which will increase
disposable income and purchasing power of the people in the economy. i.e. it
can use a deficit budget where total budgetary expenditures exceed total
budgetary receipts of the government.

3. Economic Growth
✓ The government aims to increase the production of goods and services across
various sectors of the economy namely primary, secondary and tertiary and
achieve a sustainable increase in the real GDP of an economy. It aims at
improving the standard of living of the people and welfare of its people.
✓ The government makes various provisions in the budget to raise the overall rate
of savings and investment in the economy to achieve a high economic growth
rate. For this the government provides tax rebates and other incentives for
production activities.
✓ Spending on infrastructure in the economy, promotes the economic activities
across different sectors.

49
4. Management of Public Enterprises:

• The budget policy of the government shows how the government tries to increase
the rate of growth through public enterprises.

• The budget helps the government to manage such public enterprises which are
of the nature of natural or state monopolies. For example: Railways, Electricity and
Water supply which are established and managed for social welfare of the public.

• The government manage such enterprises through budget by making various

provisions and providing them with financial help.

Difference between Public Goods and Private Goods

50
 Public Provision vs Public Production
• Public provision - Public provision means that they (goods) are financed through
the budget and can be used without any direct payment.
• Public production - When goods are produced directly by the government it is
called public production. Public goods may be produced by the government or the
private sector.

Structure/ Components of Government Budget

The two main components of budget are:
1. Revenue Budget
2. Capital Budget

RevenueBudget
• It consists of revenue receipts and
revenue expenditure.
• These receipts and expenditures are of
current financial year, related to day to day
functioning of the government.

Capital budget
• It consists of capital receipts and capital
expenditure.
• These receipts and expenditures are
related to assets and liabilities of the
government.

51
Components of budget can also be categorized according to
receipts and expenditure:
I. Total Budgetary Receipts: It refers to the estimated money receipts of the
government from all sources during a given fiscal year. It is broadly classified as
Revenue receipts and Capital receipts.

1. Revenue Receipts

✓ Revenue receipts are those receipts which neither create any liability nor lead
to any reduction in assets of the government.
✓ They are regular and recurring in nature and government receives them in
normal course of activities.
✓ Types of Revenue Receipts: Tax and Non- Tax Receipts.
Tax Receipts: It refers to the receipts from taxes and other duties imposed by the
government. E.g. Income tax, GST etc.
Tax is a compulsory payment made by the people and firms to the government
without reference to any direct benefit in return.

Types of
taxes

Direct tax Indirect tax

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Indirect taxes are compulsory payments but they can be avoided by not entering into
those transactions which call for such taxes whereas direct taxes cannot be avoided
as they directly affect the income level and purchasing power of the people as they
are imposed on their income and property.
Non-Tax Receipts: Receipts of the government (Current Income) from all other
sources other than those of tax receipts are termed as Non-Tax Revenue Receipts. It
includes –
1. Interest received on loans given by government to state government, union
territories, private enterprises and general public
2. Profits of Public Sector Undertakings like Railways, LIC etc. (Profits received
from sale proceeds of the products of public enterprises)
3. Dividends received by government from its investment in other companies
4. Fees and Fines collected by the government E.g. License fees
5. Gifts and Grants received by the government from foreign countries, foreign
government or international organisations.

2. Capital Receipts:

53
• It refers to those receipts which either create a liability or cause a reduction in the
assets of the government.
• They are non-recurring and non-routine (irregular) in nature.

Examples of Capital Receipts –

I. Borrowings and other liabilities (Government borrows funds from the public/
market, RBI, foreign government and internal institutions like IMF, World Bank
to meet its excess expenditure) − It increases liability of the government.
II. Disinvestment (raising funds by selling shares or equity holdings of the PSUs
by the government in the market) − It leads to reduction in assets of the
government.
III. Recovery of loans (Government grants various loans to state government, UTs
and other parties which leads an increase in the financial assets of the
government) − When the government recovers these loans from its debtors, its
financial assets decline.
IV. Small saving deposits (It refers to the funds raised from public in the form of
post office deposits, Kisan Vikas Patra, NSC – National Saving Certificate, PPF
etc.) − They lead to an increase in the liability of the government.

Types of Capital Receipts

1. Debt creating Capital Receipts - These are the capital receipts which increase
liability of the government and which government needs to repay along with interest.
For example: Net borrowing by government at home, borrowings from RBI, loans
received from foreign governments.
2. Non-Debt creating Capital Receipts - Non-debt creating capital receipts are those
receipts which are not borrowings and therefore, do not give rise to debt. Examples
are recovery of loans and the proceeds from the sale of shares of PSUs i.e.
disinvestment, as it leads to the reduction in assets of the government.

54
II. Total Budgetary Expenditure: It refers to the estimated expenditure of the
government expected to be incurred under various heads during a given fiscal year. It
is broadly classified into two groups – Revenue expenditure and Capital expenditure.

55
1.Revenue Expenditure:

✓ It refers to those expenditures which neither create any asset nor causes any
reduction in any liability of the government.
✓ It is regular/ recurring in nature. It is incurred on normal functioning of the
government and provision of various services.
✓ Examples: Payment of salaries to the government employees, pensions,
interest payment, expenditure on the administrative services, defence services,
health services, subsidies, grants to the state government etc.

2.Capital Expenditure:

✓ It refers to those expenditures which either create (or increase) an asset or

cause a reduction in the liabilities of the government.
✓ It is non-recurring (or irregular) in nature.
✓ It adds to the capital stock of the economy and increases its productivity through
expenditures on long period development programmes like construction of
metro, flyovers etc.
Examples:
(a) Repayment of loans/ borrowings – It reduces liability of the government.
(b) Loans and advances given to states and union territories – It increases asset of
the government.
(c) Expenditure on building roads, flyovers, factories (construction of Metro) – It
increases asset of the government.
(d) Expenditure of government on purchase of property or assets like buildings,
machinery etc. – It increases asset of the government.

Types of Budget

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 Types of Deficit
Budgetary Deficit: It refers to the excess of total expenditure (both revenue and
capital) over total receipts (both revenue and capital).

Budgetary Deficit = Total Expenditure – Total Receipts

Revenue Deficit

Fiscal Deficit

Primary Deficit

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(i) Revenue Deficit: The revenue deficit refers to the excess of government’s revenue
expenditure over revenue receipts.
Revenue deficit = Total Revenue Expenditure – Total Revenue Receipts
The revenue deficit includes only such transactions that affect the current income and
expenditure of the government. When the government incurs a revenue deficit, it
signifies that
• government’s own revenue is insufficient to meet the normal functioning of
government departments and provision of services.
• Current incomes of the government are less than the current revenue of the
government.

Measures to reduce Revenue deficit:

Either curtail expenditure or increase tax and non-tax receipts.

(ii) Fiscal Deficit: The Fiscal Deficit in a government budget refers to the excess of
government’s total expenditure over its total receipts excluding borrowings.
Fiscal Deficit = Total Expenditure – (Total Receipts – Borrowings)
It indicates the total borrowing requirements of the government from all sources during
the budget year. It shows the amount by which an economy’s expenditure exceeds its
receipts excluding borrowings.
The fiscal deficit will have to be financed through borrowing. Thus, from the financing
side:
Gross fiscal deficit = Net borrowing at home + Borrowing from RBI + Borrowing
from abroad.

Net borrowing at home includes that directly borrowed from the public through debt
instruments (for example, the various small savings schemes) and indirectly from
commercial banks through Statutory Liquidity Ratio (SLR).

✓ Borrowings by the government increases liabilities of principle amount and

interest payments. Interest payments leads to increase in revenue deficit which
in turn leads to increase in fiscal deficit. Thus, in order to cover up past debts,
more loans need to be taken up by the government leading to debt trap.
✓ Borrowings from RBI through deficit financing leads to increase in money
supply in the economy and creates inflationary pressure.

58
 ✓ Borrowings from rest of the world (foreign countries and international
organisations) leads to foreign dependence and their interference in our
economic policies.
✓ Increased future liability hampers future growth and development prospects of
the country.

Measures to reduce Fiscal deficit:

Increase taxes, reduce government expenditure like subsidies etc.

Relationship between Fiscal deficit and Revenue Deficit

Revenue deficit is a part of fiscal deficit (Fiscal Deficit = Revenue Deficit + Capital
Expenditure - non-debt creating capital receipts). A large share of revenue deficit
in fiscal deficit indicates that a large part of borrowing by government is being used to
meet its consumption expenditure needs rather than investment.

(iii) Primary Deficit: It refers to the difference between fiscal deficit of the current year
and interest payments on the previous borrowings.
Primary Deficit = Fiscal Deficit – Interest Payments
Net interest liabilities consist of interest payments minus interest receipts by the
government on net domestic lending.
The borrowing requirement of the government includes interest obligations on
accumulated debt. Primary Deficit indicates how much borrowings are required by the
government to meet expenses other than the interest payments. Thus, it focuses on
present fiscal imbalances i.e. borrowing on account of current expenditures exceeding
revenues.

✓ A low or zero primary deficit indicates that the interest payments constitute a
majority of the borrowings taken by the government and the past interest
payments have forced the government to borrow. Thus, in case of zero primary
deficit Fiscal deficit = Interest payments i.e. All borrowings are going
towards payment of interest on past loans.

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 GST: One Nation, One Tax, One Market
Goods and Service Tax (GST) is the single comprehensive indirect tax, operational
from 1 July 2017, on supply of goods and services, right from the manufacturer/ service
provider to the consumer.

✓ It is a destination based consumption tax with facility of Input Tax Credit in the
supply chain.
✓ It is applicable throughout the country with one rate for one type of
goods/service.
✓ It has subsumed a large number of Central and State taxes and cesses.
✓ It has replaced large number of taxes on goods and services levied on
production/ sale of goods or provision of service.

Cascading of tax
As there have been a number of intermediate goods/services, which were
manufactured/provided in the economy, the pre-GST tax regime-imposed taxes not
on the value added at each stage but on the total value of the commodity/service with
minimal facility of utilisation of Input Tax Credit (ITC). The total value included taxes
paid on intermediate goods/services. This amounted to cascading of tax. Under GST,
the tax is discharged at every stage of supply and the credit of tax paid at the previous
stage is available for set off at the next stage of supply of goods and/or services. It is
thus effectively a tax on value addition at each stage of supply. In extend principles of
‘value- added taxation’ to all goods and services.

Taxes Subsumed
It has replaced various types of taxes/cesses, levied by the Central and State/UT
Governments.

Central Taxes
Some of the major taxes that were levied by Centre were Central Excise Duty, Service
Tax, Central Sales Tax, Cesses like KKC and SBC.

State Taxes
The major State taxes were VAT/Sales Tax, Entry Tax, Luxury Tax, Octroi, Taxes on
Advertisements, Entertainment Tax, Taxes on Lottery /Betting/ Gambling, State
Cesses on goods etc. These have been subsumed in GST.
60
Treatment of Petrol/liquor and Tobacco in GST Five petroleum products
have been kept out of GST for the time being but with passage of time, they will get
subsumed in GST. State Governments will continue to levy VAT on alcoholic liquor for
human consumption. Tobacco and tobacco products will attract both GST and Central
Excise Duty. Under GST, there are 6 (six) standard rates applied i.e. 0%, 3%,5%,
12%,18% and 28% on supply of all goods and/or services across the country.

GST is the biggest tax reform in the country since independence and was rolled out
on the mid-night of 30 June/1 July, 2017 during a special midnight session of the
Parliament. The 101th Constitution Amendment Act received assent of the
President of India on 8 September, 2016.
The amendment introduced Article 246A in the Constitution cross empowering
Parliament and Legislatures of States to make laws with reference to Goods and
Service Tax imposed by the Union and the States. Thereafter CGST Act, UTGST Act
and SGST Acts were enacted for GST. GST has simplified the multiplicity of taxes on
goods and services.

Expected Benefits:
1. The laws, procedures and rates of taxes across the country are standardised.
2. It has facilitated the freedom of movement of goods and services and created a
common market in the country. It is aimed at reducing the cost of business operations
and cascading effect of various taxes on consumers.
3. It will reduce the overall cost of production, which will make Indian products/services
more competitive in the domestic and international markets.
4. It is also expected to result into higher economic growth as GDP is expected to rise
by about 2%.
5. Compliance will also be easier as all tax payment related services like registration,
returns, payments are available online through a common portal www.gst.gov.in.
6. It has expanded the tax base, introduced higher transparency in the taxation
system, reduced human interface between Taxpayer and Government and is
furthering ease of doing business.

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 CHAPTER 6
OPEN ECONOMY MACROECONOMICS

Foreign Exchange:
Foreign exchange refers to all the currencies other than domestic currency of a given
country. For e.g. India’s domestic currency is Indian Rupee and all other currencies
other than Indian rupee like US Dollar ($), British Pound, etc are foreign exchange/
currency for India.

Foreign Exchange Rate (or Exchange Rate):

Foreign exchange rate refers to the rate at which one currency is exchanged for the
other. In other words, it represents the price of one currency in terms of another
currency. For example, if the exchange rate is 1$ = 70, this implies that we have to
pay 70 Rupees to obtain 1 US $ (It represents price of 1 US $).
Foreign exchange rate means the units of domestic currency that must be paid to
obtain a unit of foreign currency. It is also called conversion rate – the rate at which
one currency can be converted into another currency.

Foreign Exchange Market

Foreign exchange market refers to the market in which national currencies are traded
for one another.

Types of Foreign Exchange Rate Systems

1.Fixed Exchange Rate System

✓ It refers to a system in which exchange rate for a currency is fixed by the

government.
✓ Such a rate doesn’t vary with changes in demand and supply of foreign
currency. Only the government has the power to change it as the
government decides the conversion rate.
✓ To achieve stability, the government undertakes to buy foreign currency
when the exchange rate becomes weaker and sell foreign currency when
the exchange rate gets stronger.

62
 ✓ For this the government has to maintain large reserves of foreign currencies
to maintain the exchange rate at the level fixed by it.

When the value of domestic currency is tied to the value of another currency, it is
known as ‘Pegging’.
When the value of currency is fixed in terms of some other currency or in terms of
gold, it is known as ‘Parity value’ of currency.

2.Flexible (or Floating) Exchange Rate System

✓ It refers to a system in which exchange rate is determined by the market

forces of demand and supply of foreign exchange/ currency in the foreign
exchange market.
✓ It is also known as market exchange rate as this rate varies with changes in
demand and supply of foreign currency. There is no government
intervention in the foreign exchange market.
✓ There is a well organised foreign exchange market in a country having
floating exchange rate system.

3.Managed Floating Exchange Rate

It refers to a system in which exchange rate is determined by the market forces of

demand and supply of foreign exchange and the central bank influences the
exchange rate through intervention in the foreign exchange market.
The central bank tries to influence the exchange rate by entering the market as
bulk buyer or seller.
✓ When central bank finds floating rate too high, it starts selling foreign
exchange from its reserves to bring down the foreign exchange rate.
✓ When central bank finds floating rate too low, it starts buying foreign
exchange to raise the foreign exchange rate. The central bank does it in the
interest of importers and exporters. Thus, managed floating is also known
as Dirty Floating Rate.
The central bank intervenes in the foreign exchange market to restrict the
fluctuations in the exchange rate within certain limit. The aim is to keep the
exchange rate close to desired targeted value.
For this the central bank maintains reserves of foreign exchange to ensure that
the exchange rate stays within the desired targeted value

63
 It is a hybrid of fixed and floating exchange rate systems and in this system the
central bank is a key participant to stabilise the value of currency in case of
extreme appreciation or depreciation.

Sources of Demand for Foreign Exchange (or Outflow of

Foreign Exchange):
The demand for foreign exchange comes from those who need it to make payment in
terms of foreign currency.
People (domestic residents) demand foreign exchange for the following
reasons:

✓ Importing goods and services from other countries (i.e. goods & services). ‘
✓ Transfer payments made abroad in the form of gifts, donations, cash
remittances to families, etc.
✓ Factor payments made abroad in the form of profits, dividends, interest,
compensation of employees, etc.
✓ Investments made abroad in financial and physical assets.
✓ Lending money and for making repayments to foreign countries.
✓ For undertaking foreign tours vii. To speculate on the value of foreign currency
– People demand for foreign exchange when they want to make gains from
appreciation of currency.

Sources of Supply of Foreign Exchange (or Inflow of

Foreign Exchange):
The supply of foreign exchange comes from those people who receive it in terms of
payments for their goods and services which they have sold to these countries.
Foreign currency flows into the home country due to the following reasons:

✓ Exporting goods and services by a country.

✓ Transfer payments received from abroad in the form of gifts, donations, cash
remittances by families, etc.
✓ Factor income received from abroad in the form of profits, dividends, interest,
compensation of employees, etc.
✓ Investments from abroad in financial and physical assets made by the
foreigners (or ROW) in the home country.

64
 ✓ Borrowing money and receiving repayments from foreign countries. vi.
Speculation – Supply of foreign exchange comes from those who want to
speculate on the value of foreign exchange.

Depreciation vs Devaluation of Domestic Currency

• Depreciation of domestic currency is defined as fall in the value of domestic currency
in terms of foreign currency due to the market forces of demand and supply of foreign
exchange. In other words, it means that the country has to pay more units of domestic
currency to obtain one unit of foreign currency.
• It takes place in the flexible exchange rate system where the change in foreign
exchange rate in terms of domestic currency is determined by the forces of demand
and supply of foreign exchange in the foreign exchange market.
• For example, when price of foreign exchange rises from 1$ = 65 to 1$ = 70, there is
depreciation of rupee. This means that by spending the same one US Dollar in India
now foreigners are able to purchase 70 worth of commodities (more) as compared to
65 worth of commodities earlier. This implies that domestic goods have become
cheaper for foreigners. As a result, demand for domestic goods by foreigners will
increase leading to increase in exports.

➢ Devaluation of Domestic Currency refers to decrease in the value of domestic

currency in terms of foreign currency by the government.
➢ It is done deliberately by the government under the fixed exchange rate system,
when the government decides to raise the price of foreign currency in terms of
domestic currency.
➢ Due to devaluation, exports become cheaper for foreigners and imports costlier
as now with same unit of foreign currency, foreigners are able to buy more of
domestic goods.

When foreign exchange rate rises depreciation/ devaluation of Rupee (domestic

currency) takes place. This encourages EXPORTS from a country as exports
become cheaper for the foreign nationals and foreign currency can now buy
more of domestic goods.

Appreciation vs Revaluation

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 In a flexible exchange rate system, when the price of domestic currency
(rupees) in terms of foreign currency (dollars) increases, it is called Appreciation
of the domestic currency (rupees) in terms of foreign currency (dollars).
Appreciation of domestic currency refers to increase in the value of domestic
currency in terms of foreign currency due to the market forces of demand and
supply of foreign exchange.
It takes place in the flexible exchange rate system.
In this case domestic currency becomes more valuable as less of it is required
to buy the same unit of foreign currency.
For example, if the price of foreign currency falls in the foreign exchange market
from 1$ = 70 to 1$ = 65, this implies appreciation of domestic currency i.e.
Indian rupee, making domestic goods costlier for foreigners as now they are
able to purchase 65 worth of commodities (less) by paying 1 US Dollar as
compared to 70 worth of commodities earlier.
Hence exports become costlier leading to decrease in exports. (On the other
hand, foreign goods may become cheaper for Indians as more of such goods
can be purchased by spending the same amount of domestic currency, leading
to increase in imports.)

➢ Revaluation refers to increase in the value of domestic currency in terms of

foreign currency by the government (RBI)
➢ It is done purposely by the government. Under the fixed exchange rate system
when the government deliberately lowers the price of foreign exchange it is
called revaluation of domestic currency.
➢ In this situation exports become costlier and imports become cheaper.

When foreign exchange rate falls appreciation/ revaluation of Rupee (domestic

currency) takes place. This makes foreign goods cheaper in domestic country
as more of such goods can now be purchased with same amount of domestic
currency. So, it leads to increase in IMPORTS.

Relation between price of foreign exchange and demand for

foreign exchange:
There is an inverse relation between price of foreign exchange and demand for that
foreign exchange in terms of domestic currency. The higher the price, lower is the
demand for foreign exchange, and lower the price the higher is the demand. Suppose
the foreign exchange rate falls from 1$ = 75 to 1$ = 70. This implies that to buy 1 US
Dollar worth of goods from U.S.A., now an Indian has to pay 70 (less) as compared to

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75 earlier. This means that American goods have now become cheaper for Indians
leading to increase in demand for them. This raises the demand for US Dollars. Thus,
the lower the price of US Dollar (or fall in price of foreign exchange/ fall in foreign
exchange rate), the higher is the demand for US Dollar. Similarly, a rise in price of
foreign exchange will make foreign goods costlier as now it takes more rupees to buy
same 1 US Dollar worth of goods from U.S.A. This reduces the demand for foreign
goods as well US Dollars leading to decrease in imports (imports becomes costlier).

Relation between price of foreign exchange and supply of

foreign exchange:
There is a direct relation between price of foreign exchange and supply of that foreign
exchange. The higher the price, higher is the supply of foreign exchange, and lower
the price, lower is the supply of foreign exchange. For example, If the foreign exchange
rate falls from 1$ = 75 to 1$ = 70. This implies that earlier foreigners (Americans) could
buy 75 worth of goods from India by paying 1US Dollar and now it can buy goods
worth 70 only by paying same unit of US Dollar. This means that Indian goods have
become costlier for foreigners (U.S.A.).
Therefore, they will buy less of Indian goods. In other words, demand for Indian goods
by U.S.A. will decrease. As a result, supply of US Dollars to India will decrease. Thus,
lower the price of US Dollar, lower is its supply. Similarly, a rise in price of foreign
exchange will reduce the foreigner’s cost (in terms of US Dollars) while purchasing
products from India, other things remaining constant. In other words, it makes Indian
goods cheaper for the U.S.A. as now a U.S.A. resident (foreigner) is able to buy more
Indian goods by paying same unit of US Dollar. Therefore U.S.A. buys more Indian
goods. This increases the supply of US Dollars to India. Hence, the higher the price of
US Dollar, more is the supply.

Balance of Payments
Balance of Payments is the accounting statement of a country’s sources (inflows) and
uses (outflows) of foreign exchange with respect to rest of the world.

➢ Sources/ supply of foreign exchange (causing inflow of foreign exchange) are:

exports, transfers from abroad, incomes from investment abroad, foreign
investments, borrowings from abroad etc.
➢ Uses of / demand for foreign exchange (causing outflow of foreign exchange)
are: imports, transfers to abroad, incomes paid on foreign investments,
investments abroad, lending abroad etc.

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 Structure of Balance of Payments Account
➢ The BOP account has two sides: the credit side and the debit side. The credit
side records the inflows (sources) of foreign exchange while the debit side
records the outflows (uses) of foreign exchange.
➢ There are two main accounts in the BOP — the current account and the capital
account.

Current Account
Current Account records all inflows and outflows of foreign exchange arising
from foreign trade, transfers and factor incomes with no effect on foreign
exchange assets and liabilities of the economy with respect to rest of the world.

Components of Current Account:

1. Merchandise/Trade in goods: It includes exports and imports of goods.
2. Invisibles/ Trade in services: It includes factor income and non-factor income
transactions. It includes (i) exports and imports of services, (ii) transfer from and
to abroad and (iii) income from and to abroad.
➢ Services include tourism, transportation, insurance, etc
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 ➢ Transfers/ unilateral or unrequited transfers comprises of all receipts and
payments between residents and non-residents for which the provider does not
receive a quid pro quo (any goods or services) in return. It includes both official
(i.e. government) and private transfers like gifts, grants, donations, cash
remittances by families.
➢ Income comprises of investment income in the form of interest, rent, profits/
dividends and compensation of employees.

Balance of Trade (BOT)

Balance of Trade is defined as the difference between the value of exports and value
of imports of goods of a country in a given period of time. Balance of Trade = Exports
of goods – Imports of goods Export of goods is entered as a credit item in BOT,
whereas import of goods is entered as a debit item in BOT. It is also known as Trade
Balance.

a) BOT is said to be in Balance when exports of goods are equal to the imports of
goods. BOT can be positive or negative.
b) Positive BOT also called Surplus BOT or Trade surplus will arise if country’s exports
of goods is more than imports of goods.
c) Negative BOT also called Deficit BOT or Trade deficit will arise if a country’s exports
of goods is less than imports of goods.

Balance on Current Account

It is defined as the difference between the sum of credits on current account and the
sum of debits on current account.
Balance on current account = Sum of credits on current account - Sum of debits
on current account.

• Current Account is in balance when receipts on current account are equal to the
payments on the current account.
• Current Account Surplus (CAS) is a situation that arises when the receipts on
current account is more than the payments on current account. It indicates net inflow
of foreign exchange. In simple words, Current Account Surplus arises when the value

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of exports of goods and services is more than the value of imports of goods and
services. CAS signifies that the nation is a lender to other countries (or ROW)
• Current Account Deficit (CAD) is a situation that arises when the receipts on
current account are less than the payments on current account. It indicates net outflow
of foreign exchange. In simple words, Current Account Deficit arises when the value
of exports of goods and services is less than the value of imports of goods and
services. CAD signifies that the nation is a borrower from other countries (or from
ROW). This is unfavourable for the economy since it reflects that the country does not
have enough foreign exchange to finance its international payments.

Balance on Current Account has two components:

1. Balance of Trade or Trade Balance
2. Balance on Invisibles

1. Balance of Trade (BOT) is the difference between the value of exports and value
of imports of goods of a country in a given period of time.
2. Balance on Invisibles/ Net Invisibles is the difference between the value of
exports and value of imports of invisibles of a country in a given period of time.
Invisibles include services, transfers and flows of income that take place between
different countries. Services trade includes both factor and non-factor income. Factor
income includes net international earnings on factors of production (like labour, land
and capital). Non-factor income is net sale of service products like shipping, banking,
tourism, software services, etc.

Capital Account
Capital account records all inflows and outflows of foreign exchange arising from
changes in foreign exchange assets and liabilities of the economy with respect to rest
of the world.

Components of Capital Account

1. Borrowings and lending to and from abroad All transactions relating to borrowings
from abroad by private individuals, institutions, government etc. and loan repayments
by foreigners are recorded as credit items All transactions of lending to abroad by
private individuals and institutions, government etc. and repayments of foreign loan
are recorded as debit items

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2. Investments to and from abroad Investments by ROW in shares of Indian
companies, in Indian branches of foreign companies, in real estate, etc. are recorded
as credit items. Investments by Indian residents in shares of foreign companies, in
foreign branches of Indian companies, in real estate abroad, etc are recorded as debit
items.

Investments to and from abroad’ includes two types of investments :

➢ Foreign Direct Investment (FDI): It refers to purchase of an asset, such that

it gives direct control to the purchaser over the asset. For example, purchase
of land and building.
➢ Portfolio Investment: It refers to purchase of an asset, such that it does not
give any direct control over the asset to the purchaser. For example, purchase
of shares. It also includes Foreign Institutional Investment (FII).

3. Change in Foreign Exchange Reserves: The foreign exchange reserves are the
financial assets of the government held in the central bank. A withdrawal from the
reserves leads to decrease in financial assets and is recorded on the credit side. Any
addition to these reserves is increase in foreign financial assets, and is recorded on
the debit side.

Balance on Capital Account

It is defined as the difference between the sum of credits on capital account and
the sum of debits on capital account.
Balance on capital account = Sum of credits on capital account - Sum of debits
on capital account.

• Positive balance of capital account/ Surplus in capital account means value of

credit or inflows (decrease in Foreign Assets and increase in Foreign Liabilities) is
greater than value of outflows or payments (decrease in Foreign Liabilities and
increase in Foreign Assets). This is unfavourable for the economy or leads to a fall in
Net Asset (Foreign Assets – Foreign Liabilities) position of the economy with respect
to rest of the world.
• Negative balance of capital account/ Deficit in capital account means value of
credit or inflows (decrease in Foreign Assets and increase in Foreign Liabilities) is less
than value of outflows or payments (decrease in Foreign Liabilities and increase in
Foreign Assets). This is favourable for the economy or leads to a rise in Net Asset
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(Foreign Assets – Foreign Liabilities) position of the economy with respect to rest of
the world.

In addition to current account and capital account, there is one more element in BOP,
known as ‘Errors and Omissions’. It is the balancing item, which reflects the inability
to record all international transactions accurately.

Autonomous vs Accommodating Transaction

BOP is always balanced only in an accounting sense since any surplus (or deficit) in
the current account is balanced by an equal amount of deficit (or surplus) in the capital
account. But a BOP deficit (or surplus) occurs when autonomous payments exceed
autonomous receipts (or autonomous receipts exceed autonomous payments).

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 Official Reserve Transactions
Official Reserve Transactions refer to transactions by the central bank that cause
changes in its official reserve of foreign exchange. Such transactions take place when
a country withdraws from its stock of foreign exchange reserves to finance deficit in its
overall balance of payments (BOP). A country with surplus in its overall BOP leads to
rise in foreign exchange reserves.
Significance: Official Reserve Transactions are very important as they help to bring
a balance in the country’s overall balance of payments. So, such transactions act as
accommodating item in BOP.

NOTE
• ‘change in reserves’ is recorded in the BOP account and not ‘reserves’.
• The country could use its reserves of foreign exchange in order to balance any deficit
in its balance of payments. The reserve bank sells foreign exchange when there is a
deficit. This is called official reserve sale. The decrease (increase) in official reserves
is called the overall balance of payments deficit (surplus). The basic premise is that
the monetary authorities are the ultimate financiers of any deficit in the balance of
payments (or the recipients of any surplus).
• RBI can use these reserves in influencing the foreign exchange rate. For example:
RBI can start selling foreign exchange from its reserve raising the supply of foreign
exchange in the market for foreign exchange. Demand for foreign exchange remaining
unchanged it will bring down foreign exchange rate.

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