Macroeconomics

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Macroeconomics
Meaning of Macroeconomics
The term macroeconomics derived from Greek word ‘makros’ which means large. Thus
macroeconomics is defined as that branch of economics which studies economic activities at
the level of an economy as a whole. For example, aggregate demand, aggregate supply,
national income etc.
Scope of Macroeconomics
A. Theory of national income – It studies generation of national income by output
method, income method and expenditure method.
B. Theory of employment – It is concerned with the determination of level of
employment in the economy. Here we study consumption function, saving function,
full employment, unemployment etc.
C. Theory of money – It explains functions of money, components of money supply.
Banking also play an important role in understanding various aspects of
macroeconomic problems like inflation, deflation etc.
D. Theory of general price level – Problem regarding inflation, excess demand or
deficient demand are studied with the help of macroeconomic variables.
E. Theory of economic growth – It studies fuller utilization of resources and their
growth to achieve the objective of economic growth ultimately.
F. Theory of international trade – It studies economic transactions between two or
more countries, BOP position of the country, determination of exchange rate etc.
Four Sectors of the Economy
(i) Household sector – This sector includes consumers who are using goods and
services. The consumer are also the owners of the factors of production.
(ii) Producers sectors – This sector includes producers who are engaged in
producing goods and services. This sector hire factors of production.
(iii) Government sector – This is acting as a welfare agency. For example
maintaining law and order, defense, and other services of public welfare.
(iv) The external sector – It buys goods and makes payment for it to the producer
sector. It sells and receives payment from the producer sector. This sector
receives factor services in exchange for factor payments from the household
sector. It also receives and gives transfer payments to household sector.
Difference between Microeconomics and Macroeconomics
S.N. Microeconomics S.N. Macroeconomics
1. It is the study of individual economic
units of an economy.
1. It is the study of the economy as a
whole and its aggregates.

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2. It deals with individual income, price or
output etc.
2. It deals with economy-wide aggregates
like national income, general price
level etc.
3. Its central problem is price
determination and allocation of
resources.
3. Its central problem is determination of
level of income and employment.
4. Its main tools are demand and supply
of particular commodity.
4. Its main tools are aggregate demand
and aggregate supply of the economy
as a whole.
5. It helps to solve the central problem of
what, how and for whom to produce.
5. It helps to solve the central problem of
full employment of resources in the
economy.
6. It discuss how equilibrium of a
consumer, a producer or an industry is
attained.
6. It is concerned with the determination
of equilibrium level of income and
employment.
7. Price determination, consumer’s
equilibrium or producer’s equilibrium
etc.
7. National income, unemployment,
inflation or national savings.
Difference between the classical school and the Keynesian school
Classical School – Economists like Adam Smith, James Mill, Marshall, Malthus, A.C. Pigou and
David Ricardo advocated for a free economy. A free economy always achieves equilibrium with
fuller utilization of resources. Unemployment, if it occurs, will disappear automatically.
Keynesian School – Unemployment will not disappear automatically. The government must
intervene. It should undertake investment expenditure to generate opportunities of
employment. Equilibrium with full employment is not an automatic phenomenon.
Types of Goods
A. Final Goods – These are those goods which are used for final consumption or for
investment. These goods consists of both producer goods and consumer goods.
B. Intermediate Goods – These are those goods which are purchased by one production
unit from other production and meant for production or for resale. For example, raw
material
Consumption Goods
These are those goods which are directly used for the satisfaction of human wants. These
are not used in the production of other goods. For example, milk, cloth etc.
Followings are the final users of consumption goods –
i. Consumer households

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ii. General government or government as a welfare agency
iii. NGOs
Types of Consumption Goods
a. Durable Goods – These are those goods which can be used for several years and are of
relatively high value, for example- car, television etc.
b. Semi-durable Goods – These are those goods which can be used for a period of one
year or slightly more, for example – clothes, furniture etc.
c. Non-durable Goods – These are those goods which are used in a single act of
consumption, for example – milk, petrol etc.
d. Services – These are those non-material goods which directly satisfy human wants, for
example – teacher, doctor etc.
Capital Goods
Capital goods are those goods which are used in the process of production for several years
and which are of high value. These goods are fixed assets of the producers, e.g. – plant and
machinery
All producers’ goods are not capital goods. Why?
Producers’ goods include (i) goods used as raw material, like wood used to make furniture
and (ii) goods used as fixed assets like plant and machinery. Capital goods include only fixed
assets of the producers. These are durable-use producer goods. On the other hand, goods
used as raw material are single-use producer goods. These are not repeatedly used in the
process of production. Accordingly, all producer goods are not capital goods.
Concepts of Investment
Investment is a process of capital formation, or a process of increase in the stock of capital.
It increases productive capacity of the producers, i.e.
𝑰 = 𝒅𝑲
Fixed Investment – It refers to increase in the stock of fixed assets of the producers during
an accounting year. Expenditure of the producers on the purchase of fixed assets or capital
goods like plant and machinery causes fixed investment.
Gross Investment (Capital Formation) – Expenditure on the purchase of fixed assets or on
inventory stock during the year is called gross investment. Components of gross investment
are –
Gross Fixed Investment – It is increase in the stock of fixed assets. It is estimated by adding:
Gross value of machinery and equipment and
Construction of building, business premises

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Inventory Investment – At a point of time, producers have with them the stock of
(i) Finished goods (unsold goods)
(ii) Semi-finished goods (goods which are in the process of production)
(iii) Raw material
Depreciation of Fixed Assets
Components of Investment (Gross)
I. Net value of machinery and equipment
II. Construction of Business premises, building etc.
III. Depreciation of Fixed assets – It is the loss in the value of capital goods or fixed
assets due to –
a. Normal wear and tear
b. Normal Rate of Accidental Damage
c. Expected Obsolescence – It refers to loss in the value of fixed assets due to –
i. Change in Technology
ii. Change in demand
Net Investment – The difference between gross investment and depreciation is called net
investment.
Depreciation Reserve Fund – It is a provision of funds to cope with depreciation losses.
Capital Loss – Loss of value of fixed assets owing to unexpected obsolescence is called capital
loss.
Stock – A stock is a quantity measurable at a particular point of time, e.g., 1st April 2015, 9 a.m.
etc. It has no time dimension. Examples – population, wealth, water in a tank.
Flow – A flow is quantity measurable over a specified period of time, e.g., months, weeks, hours
etc. It has time dimension. Examples – birth rate, income of person, expenditure etc.
Circular Flow of Income – It refers to flow of money and goods between the major sectors of an
economy. There are three types of the circular flow –
A. Production of goods
B. Generation of income/ the phase of Distribution
C. Phase of Disposition/ Expenditure
Real Flow – Under real flows of income, households render factor services to the firms and the
firms produce goods and services to pay factor services.
A variable isof twotypes,viz,stockvariable andflow variable.

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Money Flow – Under money flows of income, all payments by firms to the households for their
factor services and by the households to the firms for the purchase of goods and services are
made in terms of money.
Leakage – A leakage or withdrawal consists of any part of income generated in producing the
national output which is not passed on within the system. Savings, payment for inputs and
taxes.
Injection – An injection is an addition to the circular flow. This addition does not arise from
consumers current income. Examples – investment, payments for exports and government
expenditure.
Significance of the study of circular flow of income
(i) Knowledge of interdependence
(ii) Identification of injection and leakage
(iii) Estimation of national income
(iv) Level and structure of economic activity
Assignment for Basic Concepts of Macroeconomics
1. Name the four sectors of the economy.
2. Give two examples of macroeconomic variables.

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3. What do you understand by consumption goods?
4. Give two example of capital goods.
5. Define real flow.
6. What is money flow?
7. What is meant by circular flow of income?
8. What is capital loss?
9. As a student of Economics, how would you distinguish between capital goods and
capital stock?
10. Distinguish between intermediate goods and capital goods.
11. What are the difference between gross investment and net investment?
12. Make a difference between factor income and transfer income.
Application and Value Based Questions
1. Giving reasons, classify the following into intermediate and final goods –
(i) Machine purchased by a dealer and (ii) A car purchased by a household
2. As a student of Economics, how would you distinguish between capital goods and
capital stocks?
3. The Government asserts that MNREGA is to be related to asset creation. How do you
evaluate this statement?
4. Should purchase of wheat in the wholesale market treated as the purchase of final
good?
5. What is the principle of circular flow of income and product?
6. If depreciation reserve fund is not maintained, production capacity in the economy
would tend to reduce. Do you agree?
7. Imports create leakage in the circular flow of income. Do you agree? How in your
opinion the leakages can be corrected? (Value Based)
NCERT QUESTIONS
1. Why should the aggregate final expenditure of an economy be equal to the aggregate
factor payments? Explain.
Ans. The sum of final expenditures in the economy must be equal to the income
received by all the factors of production. It is because that the revenues earned by all
the firms put together must be distributed among the factors of production as salaries &
wages, profits, interest and rent in the economy as their services are exchanged for
factor payments.
2. What are the four factors of production and what are the remunerations to each of
these called?
3. Distinguish between stock and flow.
4. Describe the four major sectors in an economy according to macroeconomic point of
view.

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National income and its related aggregates
Normal Residents of a Country
National income is a useful yardstick to measure the annual economic performance of the
economy. Thus national income is defined as the sum total of factor income earned by the
residents of a country during a fiscal year.
A normal resident is a person or institution who generally resides in a country and whose centre
of economic interest lies in that country.
Following are include in normal institution of a country –
(i) A person may be a normal resident of one country even when he is a citizen of the
other. Example – if an Indian is living in Britain for more than one year and his centre
of economic interest lies in that country.
(ii) Indians employed in WHO, IMF etc.,
(iii) Officials, diplomats and members of the armed forces of a foreign country are
treated as the normal residents of the country to which they belong and not of the
country in which they are working.
Domestic Territory of a Country
It includes the followings -
(i) Territory lying within the political frontiers including territorial waters of a country.
(ii) Ships and aircraft operated by residents of the country across different parts of the world.
(iii) Fishing vessels, oil and natural gas rigs and floating platforms operated by the residents of
the country in the international waters or engaged in extraction in areas in which the country
has the exclusive right of exploitation.
(iv) Embassies, consulates and military establishments of the country located abroad.
Gross Income – It is estimated, inclusive of depreciation. Net national product does not include
depreciation.
Factor Cost – Factor cost refers to all factor payments made by the producing unit to the
factors of production for rending productive services in the production of goods and services. It
is free from the impact of subsidies or indirect taxes.
Market Price includes the impact of subsidies which tend to lower it and impact of indirect
taxes which tend to raise it.
MP = FC + NIT
Factor Payments – Factor payments are the incomes received by the owners of factors of
production for rendering their factor services to the producers.

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Factor Payment (Income) Transfer Payment (Income)
1. It comprises rent, wages, interest and
profit.
1. It comprises gifts, subsidies, donations,
scholarships etc.
2. It is received in return for rendering
productive services.
2. It is received without providing any
good or service in return.
3. It is an earned income. 3. It is an unearned income (receipt
concept)
4. It is bilateral payments. 4. It is unilateral payment.
5. It is included in national income. 5. It is not included in national income.
Transfer Payments – Factor payments are one-sided payments. These are like charity or grant
from one sector to other sector.
𝑓𝑎𝑐𝑡𝑜𝑟 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 − 𝑛𝑜𝑛 𝑓𝑎𝑐𝑡𝑜𝑟 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
National Income is the market value of final goods and services produced in the economy
during the period of an accounting year.
Net Factor Income from Abroad (NFIA)
It is the difference between factor incomes (rent, interest, wages & profits) earned by normal
residents of a country from rest of the world and factor income earned by non-residents in the
domestic territory of the country. It may be positive or negative.
National Disposable Income refers to the net national income at the market price available to a
country for disposal. It is the sum total of national income, net indirect taxes and current
transfer from the rest of the world.
𝑵𝒂𝒕𝒊𝒐𝒂𝒍 𝑫𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝑰𝒏𝒄𝒐𝒎𝒆
= 𝒏𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝒊𝒏𝒄𝒐𝒎𝒆 + 𝒏𝒆𝒕 𝒊𝒏𝒅𝒊𝒓𝒆𝒄𝒕 𝒕𝒂𝒙𝒆𝒔 +
𝒏𝒆𝒕 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒕𝒓𝒂𝒏𝒔𝒇𝒆𝒓 𝒇𝒓𝒐𝒎 𝒕𝒉𝒆 𝒓𝒆𝒔𝒕 𝒐𝒇 𝒕𝒉𝒆 𝒘𝒐𝒓𝒍𝒅

pg. 9
Gross National Disposable Income
= Net National Disposable Income +Current replacement cost
 Factor Income from Net Domestic Product Accruing to Private Sector (IDPAPS)
IDPAPS is that part of net domestic product at factor cost which is generated in the form of
compensation of employees, operating surplus and mixed income in private sector.
IDPAPS = NDPFC – Income from property and entrepreneurship accruing
to the government departmental enterprises – Savings of non-
departmental enterprises of government
1. Private Sector
2. Public Sector
Income from net domestic product accruing to private sector is that part of NDPFC which
accrues to the private sector.
Private Income
It is the income of the private sector obtained from any source, productive or otherwise and
the retained income of the corporation.
Public Sector
According to CSO, public sector companies (i) Government administrative department (ii)
Department enterprises like railways, post and telecommunication and (iii) Non-departmental
enterprises like HMT, IOC.
𝑷𝒓𝒊𝒗𝒂𝒕𝒆 𝑰𝒏𝒄𝒐𝒎𝒆
= Factor income from NDP accruing to private
sector
+ net factor income from abroad
+ interest on national debt
+ current transfer from the rest of world
+ current transfer from the government
Personal Income
= private income
- Undistributed profits
- Corporation tax
Personal Disposable Income

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= personal income
- Direct personal tax
- Miscellaneous receipts of the government administrative department or
miscellaneous fees and fines paid by the households
GDPMP = SUM TOTAL OF MARKET VALUE OF GOODS AND SERVICES IN A DOMESTIC
TERRITOTRY
GDPFC = GDPMP – NIT
GNPMP = GDPFC + NFIA
GNPFC = GDPMP + NFIA - NIT
NDPMP = GDPMP - D
NDPFC = GDPMP – D – NIT
NNPMP = GDPMP – D + NFIA
NNPFC = GDPMP – D – NIT + NFIA
Distinguish between
1. IDPAPS and Private Income
S.N. IDPAPS Private Income
1. It is income of private sector from
domestic product only.
It is income of private sector from all
sources.
2. It includes only factor incomes. It includes factor incomes as well as
transfer income.
3. It is a domestic concept as it does
not include net factor income from
abroad.
It is a national concept as it includes
NFIA.
4. Interest on national debt is not
included in it.
Interest on national debt is included in it.
5. IDPAPS = NDPFC – Income from
domestic product accruing to
public sector or government
sector.
Private Income = IDPAPS + NFIA + Current
transfer from government + Current
transfer from abroad + Interest on
National debt
2. Private Income and National Income
s.n. Private Income National Income
1. It includes both the factor incomes
and transfer incomes.
It includes only factor incomes.
2. It includes income generated in
private sector only.
It includes factor income generated in
both the private sector and public
sector.

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3. Interest on national debt in
included.
Interest on national debt is not
included.
Questions for National Income and Related Aggregates for 1 mark
1. Define national income at market price.
2. What is meant by consumption of fixed capital?
3. What is meant by externalities?
Ans. Externalities refer to good and bad impact of an activity by a firm or an individual
caused to others for which no price or penalty is paid.
4. What is a GNP deflator?
Questions for 3 or 4 marks –
1. Difference between national income and domestic income.
2. What is meant by normal residents of a country?
3. Explain the concept of domestic territory of a country.
4. What is difference between planned and unplanned inventory accumulation?
Ans. Planned change in inventory refers to change in stock of inventories occurring in a
planned way whereas unplanned inventory refers to change in stock of inventories
occurring in an unplanned way.
5. Distinguish between national income and private income.
6. Distinguish between GDPMP and NDPFC.
1. From the following data, find out personal disposable income –
Items (₹ in crore)
Corporation tax 68
Miscellaneous receipts of the government 24
Undistributed profits of corporations 8
Direct taxes 88
Private income 5496
2. Calculate private income from the following data
Items (₹ in crore)
National debt interest 30
Gross National Product at market price 300
Current transfers from government 20
Net indirect taxes 40
Net current transfer from the ROW (-) 10
Net domestic product at factor cost accruing to govt. 50
Consumption of fixed capital 70

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3. Suppose the GDP at market price of a country in a particular year was ₹1,100 crore. Net
factor income from abroad was ₹100 crore. The value of indirect taxes – subsidies was
₹150 crore and national income was ₹850 crore. Calculate the aggregate value of
depreciation.
4. The Government in India has launched a scheme of cash transfers to the people below
poverty. Would you consider these transfer as a part of domestic income of the
country?
5. Calculate intermediate consumption from the following data –
Items ₹ in lakhs
(i) Value of output 200
(ii) Net value added at factor cost 80
(iii) Sale tax 15
(iv) Subsidy 5
(v) Depreciation 20 (Ans. ₹90 lakhs)
6. Find out private income from the following data –
Items ₹ in crores
(i) Income from domestic product accruing to private sector 254
(ii) Net current transfer paid to rest of the world 4
(iii) Net current transfer from govt. administrative dept. 10
(iv) National debt interest 10
(v) Net factor income from abroad - 3 (Ans.
267)
7. From the following data, calculate private income –
Items ₹ in crores
(i) Income from domestic property accruing to private sector 4,000
(ii) Savings of non-departmental public enterprises 200
(iii) Current transfer from govt. administrative dept. 150
(iv) Savings of private sector 400
(v) Current transfers from rest of the world 50
(vi) Net factor income from abroad - 40
(vii) Corporation tax 60
(viii) Direct personal taxes 140 (Ans. 4160)
8. Calculate (a) NDPFC and (b) private income from the following –
Items ₹ in crores
(i) Domestic product accruing to govt. 300
(ii) Wages and salaries 1000
(iii) Net current transfer to abroad - 20
(iv) Rent 100
(v) Interest paid by production units 130
(vi) Interest on national debt 30
(vii) Corporation tax 50

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(viii) Current transfers by government 40
(ix) Contribution to social security secures by employers 200
(x) Dividend 100
(xi) Undistributed profits 20
(xii) Net factor income to abroad 0 (Ans.1600 &
1390)
9. Find the following values with the help of information given below –
(a) Gross Domestic Product at Market Price
(b) Net National Product at Factor Cost
(c) Personal Income
Items ₹ in crore
(i) Net domestic product at market prices 80,500
(ii) Net indirect taxes 9,000
(iii) Income accruing to Govt. from domestic product 2,000
(iv) Net factor income from abroad - 250
(v) Current transfers to households 2,500
(vi) Depreciation allowances 5,000
Ans. GDPMP = NDPMP + Depreciation
= 80,500 + 5,000 = 85,500
NNPFC = GDPMP + NFIA – DEPRECIATION – NIT
= 85,500 – 250 – 5,000 – 9,000
= 71,250
Personal Income = NNPFC + Current transfer from households – Govt. income
= 71,250 – 2,500 – 2,000
= 66,750
NCERT QUESTIONS
1. What is the difference between planned and unplanned inventory accumulation?
Ans. Planned Inventory – It refers to change in the stock of inventories which has been
planned. In a situation of planned inventory accumulation, firm will plan to raise
inventories. It is positive for the firm.
Unplanned Inventory – It refers to change in the stock of inventories which has occurred
unexpectedly. In a situation of unplanned inventory accumulation, due to unexpected fall in
sales, the firm will have unsold stock of goods. It is negative for the firm.

pg. 14
2. Write down the three identities of calculating the GDP of a country by the three
methods. Also briefly explain why each of these should give us the same value of GDP.
3. Suppose the GDP at market price of a country in a particular year was ₹1,100 crore. Net
factor income from abroad was ₹100 crore. The value of indirect taxes – subsidies was
₹150 crore and national income was ₹850 crore. Calculate the aggregate value of
depreciation.
Ans. GNPFC = GDPMP + NFIA – NIT
= 1100 + 100 – 150 = 1050
Depreciation = GNPFC - NNPFC
= 1050 – 850 = 200
4. In a single day, Raju, the barber, collects ₹500 from haircut; his equipment depreciates
in value by ₹50. Raju pays sales tax worth₹30, takes home ₹200 and retains ₹220 for
improvement and buying of new equipment. He further pays ₹20 as income tax from his
income. Based on this information, complete Raju’s contribution to the following
measures of income – (a) GDPMP (b) NNPMP (c) NNPFC (d) Personal
Income (e) Personal Disposable Income
Ans. GDPMP = 500
NNPMP = GDPMP+ NFIA – Depreciation
= 500 + 0 – 50 = 450
NNPFC = NNPMP – NIT
= 450 – 30 = 420
Personal Income = NNPFC – Retained Earning
= 420 – 220 = 200
Personal Disposable Income = Personal Income – Direct Tax
= 200 – 20 = 180

pg. 15
Calculating National Income
Product Method/ Output Method? Value Added Method
Product method or value added method is that method which measure domestic income by
estimating the contribution of each producing enterprise to production in the domestic
territory of the country in an accounting year.
GVOMP = Sales + ∆ in Stock
GVOMP = PRICE X OUTPUT + ∆ IN STOCK
GVAMP/GDPMP = GVOMP – Intermediate Consumption
NVAFC = GVAMP – Depreciation – Net Indirect Taxes
Value of Output = Sales + Change in stock
(GVAMP)Value Added = Value of output – Value of intermediate goods
NVAMP = GVAMP – Depreciation
Value Addition is the difference between value of output of an enterprise and the value of its
intermediate consumption.
Value of Output = sales + ԃStock
Intermediate Consumption – It refers to the value of non-factor inputs.
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑺𝒕𝒐𝒄𝒌 = 𝑪𝒍𝒐𝒔𝒊𝒏𝒈 𝑺𝒕𝒐𝒄𝒌 − 𝑶𝒑𝒆𝒏𝒊𝒏𝒈 𝑺𝒕𝒐𝒄𝒌
Computation of Net Value Added at Factor Cost (NVAFC)
Gross Value of Output at Market Price
Minus
↓
Intermediate Consumption
↓
Gross Value Added at Market Price
Minus
↓
Consumption of Fixed Capital
(Depreciation)
↓
Net Value Added at Market Price
Minus
↓
Net Indirect Taxes (Indirect Taxes –
Subsidies)
↓

pg. 16
Net Value Added at Factor Cost
Problem of Double Counting – It is the problem of estimating the value of goods and services
more than once. If certain items are counted for more than once resulting in over estimation of
national product to the extent of the value of intermediate goods included, this will cause the
problem of double counting.
Precautions in the Estimation of National Income by Product Method
The following precautions should be taken while estimating national income by product
method -
(i) The sale and purchase of old goods and property should not be included in national
income.
(ii) The output of intermediate goods should not be included in national income.
(iii) The value of goods retained for self-consumption should be included in national
income.
(iv) Imputed rent of owner-occupied buildings should be included in national income.
(v) Only the value of final goods should be included in national income.
Income Method
It is also called distributed share method or factor payment method. According to this method,
national income is measured in terms of factor payments to the owners of factors of production
during an accounting year.
Classification of Factor Incomes
It is also called distributed share method or factorpayment method. According to this
method, national income is measured in terms of factor payments to the owners of
factors of production during an accounting year.
Classification of Factor Incomes
Compensation of Employees
(i) Wages and salaries in cash – Remuneration in cash includes wages & salaries, DA,
bonus, city compensatory allowance, HRA, leave travelling allowance etc.
(ii) Payment in kind – includes rent free quarter, free water and electricity, free uniform,
free services of vehicles, amount of interest on interest-free loans etc.

pg. 17
(iii) Employers’ contribution to social security schemes – consists of contribution to life
insurance, casualty insurance, provident fund etc.
(iv) pension on retirement
Operating Surplus –
1. Rent and Royalty – Rent is a factor income earned from lending the services of land,
building whereas royalty is the income earned by landlord for granting leasing rights of
subsoil assets.
♣ Imputed Rent – The rent of owner-occupied houses is called imputed rent.
♣ Royalty – subsoil (deposits of coal, iron, natural gas etc.) and use of patents, copyrights
etc.
2. Interest – Interest is the price for the funds borrowed.
3. Profit
Profit – Dividends, Corporate profit tax and undistributed profit
Profit – Profit is the residual factor payment to owners of production units. Thus, profits
are the income of the factor input called entrepreneurship for organizing production and
undertaking attendant risks. It is reward that owners of firms get being in business and
taking risk involved therein.
Corporate (Profit) Tax – The net profit of a corporate enterprise is used mainly for three
purposes –
(i) corporate tax,
(ii) dividend and
(iii) Reserve fund (undistributed profit).
Profit tax is a direct tax levied by the Government on the profit of a company. The
company pays it out of its total profit. Profit tax, thus, is a part of domestic income since
it is actually earned by the company. Profit tax is also called corporate tax.
Dividend – It is that part of profit of a corporate enterprise which it pays to its
shareholders in accordance with numberof shares held by the letter. By the virtue of
owing shares, the shareholders become owners of the company.
Undistributed Profit – A company, after paying profit tax and distributing dividend out of
its total profit, keeps the balance as reserve fund which is known as undistributed profit
(or corporate savings or retained income). The reserve fund is maintained and augmented
to meet unexpected contingencies, to expand the size of production and to provide social
security benefits to the employees.

pg. 18
Mixed Income from self-employed (MISE) – Income of own account workers like farmers,
doctors, barbers etc. and unincorporated enterprises like small shopkeepers, repair shops,
retail traders etc is known as mixed income.
Net Factor Income from Abroad (NFIA)
Precautions of income method
1. Transfer earnings like old-age pensions, unemployment allowance etc. should not be
included in national income.
2. Income from illegal activities like theft and gambling is not included in national
income.
3. Commission paid on the sale and purchase of second hand goods are to be included in
national income.
4. Brokerage on the sale/purchase of shares and bonds is to be included in national
income.
5. Income in terms of windfall gains should not be included in national income.
Expenditure Method
According to this method, national income is measured in terms of expenditure on the
purchase of final goods and services produced in the economy during an accounting year. It is
also called consumption and investment method or income disposal method.
Classification of Final Expenditure
a. Private final consumption expenditure (PFCE)
b. Government final consumption expenditure (GFCE)
c. Gross domestic capital formation (GDCF)
d. Net exports
e. Net factor income from abroad (NFIA)
f. Depreciation (-)
g. Net indirect taxes (-) [Indirect Taxes – Subsidies]
𝐺𝐷𝐶𝐹 = 𝐺𝑟𝑜𝑠𝑠 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝐹𝑖𝑥𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐹𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 + 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑡𝑜𝑐𝑘
Precautions of Expenditure method
Following five items of expenditure should not be included –
1. To avoid double counting, expenditure on all intermediate goods and services is
excluded. For example, purchase of eatable items by a restaurant, expenses on
electricity by a factory are not included as they are intermediate consumption.

pg. 19
2. Government expenditure on all transfer payments such as scholarship, unemployment
allowance, old-age pension etc. is excluded because no productive services are
rendered by the recipients in exchange.
3. Expenditure on second-hand goods is excluded.
4. Expenditure on purchase of old shares/bonds or new shares/bonds etc. are excluded
because it is not payment for goods or services currently produced.
5. Imputed expenditure on own account output should be included.
National Income at Current Prices – It is market value of the final goods and services produced
in the economy during an accounting year. Current year prices are the prices prevailing during
the year of estimation.
National Income at constant Prices – It is the market value of the final goods and services
produced in the economy during an accounting yea, as estimated using the base year prices.
Base year is the year of comparison when macro variables are believed to be normal.
GNP Deflator – It measures the average level of the prices of all goods and services produced in
the economy during an accounting year.
𝑮𝑵𝑷 =
𝑵𝒐𝒎𝒊𝒏𝒂𝒍
𝒓𝒆𝒂𝒍
𝑿 𝟏𝟎𝟎
GDP and Welfare
(i) Distribution of GDP
(ii) Composition of GDP
(iii) Non-monetary exchanges
(iv) Externalities
Methods of Calculating National Income
The circular flow model reveals that it passes through three phases of economic activities –
 Production of goods and services
 Generation of income as factor payments and
 Disposition of income on the goods and services
Value Added Method
It is that method which measures national income in terms of value addition by each producing
sectors in the economy during an accounting year. Value added is the difference between value
of output of an enterprise and the value of its intermediate consumption.

pg. 20
Value Added = Value of output – intermediate
consumption
Value of Output – It refers to market value of the goods or services produced by a firm during
an accounting year. If the entire output of the year is sold during the year, value of output =
sales.
Intermediate consumption – It refers to the value of non-factor inputs (all inputs other than
factor inputs of land, labour, capital and entrepreneurship).
Method of Calculating National Income
Output Method Income Method Expenditure Method
1. Value of Primary
Sector
2. Value of Secondary
Sector
3. Value of Tertiary
Sector
4. I C of Primary sector
5. I C of Secondary
Sector
6. I C of Tertiary Sector
7. NFIA
8. Depreciation (COF)
9. NIT (IT – S)
1. COE – (i) Wages &
Salaries (ii) Employers
contribution towards
SSS (iii) Payment in
Kind or Cash (iv)
Pension
2. OS – (i) Rent (ii)
Royalty (iii) Interest
(iv) Profit – a.
Corporation Tax b.
Dividend c.
Undistributed Profit
3. MISE
4. NFIA
5. Depreciation (D)
6. NIT
1. GFCE
2. PFCE
3. GDCF –
_ GDFCF – a. Business
Fixed Investment b.
Residential Construction
Investment c. Public
Investment
_ Change in Stock
4. Net Export
5. NFIA
6. Depreciation
7. NIT
GDPMP = 1 + 2 + 3 – 4 – 5 – 6 GDPMP = 1 + 2 +3 + 5 + 6 GDPMP = 1 + 2 + 3 + 4
NNPFC = GDPMP – D – NIT +
NFIA
NFIA
NFIA
Assignments for Calculation of National Income
1. Name the methods for measuring national income.
2. What is meant by income method?
3. Salaries to Indian employees working in Indian embassies abroad are a part of net factor
income from abroad. Give reasons.
4. Explain expenditure method of measuring national income.
Ans. Expenditure methods measures final expenditure on GDPMP during a period of
account. Since all domestically produced goods and services are purchased for final use
either by consumers for consumption or producers for investment, therefore we take
sum of final expenditure on consumption and investment. This sum equals GDPMP.

pg. 21
Under expenditure method national income is calculated first adding up all the items of
final consumption expenditure and final investment expenditure within domestic
economy during a year. The resulting total is called GDPMP . Then by subtracting
depreciation and net indirect taxes from GDPMP and adding to it NFIA, we get NNPFC or
national income. Thus in expenditure method, national income is measured at the point
of actual expenditure by various economic units.
5. What are the main steps involved in estimating national income by expenditure
method?
Ans. Expenditure method involves the following steps:-
(i) Identification of Economic units incurring final expenditure, household sector
(consuming), firm and government sector.
(ii) Classification of final aggregate expenditure into following components:
a. Private Final Consumption Expenditure (PFCE)
b. Government Final Consumption Expenditure (GFCE)
c. Gross Fixed Capital Formation
d. Change is Stock
e. Net Exports
(iii) Measurement of final expenditure on the above components. Sum total of final
expenditure on the above items gives us the value of GDPMP, we get NNPFC.
(iv) Estimation of NFIA which is added to NNPFC.
6. What precautions should be taken in estimating national income by expenditure
methods?
Ans. Following five items of expenditure should not be included –
(i) Expenditure on secondhand goods should be excluded because they form part of
the stock of goods produced in the past.
(ii) Expenditure on the purchases of shares, bonds etc. should be excluded because
these are paper titles which only represent the ownership of property and its
transfer. No material things are produced through the purchase/sale odf shares,
bonds etc.
(iii) Government expenditure on old-age pensions, scholarships, unemployment
allowance etc. should be excluded because these are transfer payments.
(iv) Expenditure on intermediate goods or semi-finished goods should be excluded.
(v) Only the expenditure on final goods and services should be included.
Numerical for Calculation of National Income (Application Based Questions) –
1. Calculate Gross Domestic Product at market price by (a) product method and (b) income
method –
Items ₹ crore
i) Value of output in primary sector 1,000
ii) Value of output in secondary sector 900
iii) Value of output in tertiary sector 700

pg. 22
iv) Intermediate consumption of primary sector 500
v) Intermediate consumption of secondary sector 400
vi) Intermediate consumption of tertiary sector 300
vii) Rent 10
viii) Compensation of employee 400
ix) Mixed income 650
x) Operating surplus 300
xi) Net factor income from abroad - 20
xii) Interest 5
xiii) Consumption of fixed capital 40
xiv) Net indirect taxes 10 ( Ans. 1,400)
2. Calculate value added by firm A and B from the following data –
Items ₹ in lakhs
Sale by firm A 100
Sale by firm B 500
Purchases by households from firm B 300
Export by firm B 50
Change in the stock of firm A 20
Change in the stock of firm B 10
Imports by firm A 70
Sales by firm C to firm B 250
Purchases by firm B from firm A 200
3. From the following data, calculate national income, domestic income –
Items ₹ in crores
Mixed income of self-employed 200
Old-age pension 20
Dividends 100
Operating surplus 900
Wages and salaries 500
Profits 400
Employer’s contribution to SSS 50
Net factor income from abroad (-)10
Net indirect taxes 50
4. From the following data, calculate national income, domestic income, personal income
and personal disposable income on the basis of income method –
Items ₹ in crore
Rent 5,000
Wages 30,000
Interest 8,000
Surplus of public sector 15,000

pg. 23
Profit tax 2,000
Personal tax 1,500
Mixed income 4,000
Undistributed profit 3,000
Transfer payment by government 1,000
Dividend 12,000
Net assets income from abroad 7,000
Transfer from abroad 2,500
5. Calculate national income from the following
Items ₹ in crore
Mixed income of self employed 200
Old-age pension 20
Dividends 100
Operating surplus 900
Wages and salaries 500
Profits 400
Employer’s contribution to SSS 50
Net factor income from abroad (-) 10
Net indirect tax 50
6. Calculate national income by income and expenditure methods from the following data
–
Items ₹ crore
i) Government final consumption expenditure 50
ii) Operating surplus 300
iii) Opening stock 20
iv) Private final consumption expenditure 480
v) Gross fixed capital formation 90
vi) Closing stock 35
vii) Net exports -5
viii) Net indirect taxes 60
ix) Compensation of employees 200
x) Consumption of fixed capital 20
xi) Mixed income of self-employed 50
xii) Net factor income from abroad 20
7. From the following data, calculate gross domestic product at market price –
i) Mixed income of self-employed 100
ii) Gross fixed capital formation 50
iii) Change in stock 20
iv) Net capital formation 60
v) Net factor income from abroad -10

pg. 24
vi) Net exports -10
vii) Compensation of employees 150
viii) Operating surplus 300
ix) Net indirect taxes 40
8. Calculate national income by the (a) product method and (b) income method –
i) Value of output of –
a. Primary sector 1000
b. Secondary sector 800
c. Tertiary sector 600
ii) Intermediate consumption of –
a. Primary sector 400
b. Secondary sector 300
c. Tertiary sector 100
iii) Emoluments of employees 500
iv) Rent 40
v) Consumption of fixed capital 80
vi) Indirect taxes 30
vii) Net factor income from abroad 10
viii) Subsidies 10
ix) Interest 50
x) Operating surplus 100
xi) Mixed income 800
9. Calculate national income by expenditure method and income method –
i) Subsidies 5
ii) Private final consumption expenditure 100
iii) Net factor income from abroad -10
iv) Indirect tax 25
v) Rent 5
vi) Government final consumption expenditure 20
vii) Net domestic fixed capital formation 30
viii) Operating surplus 20
ix) Wages and salaries 50
x) Net exports -5
xi) Addition to stocks -5
xii) Social security contributions by employers 10
xiii) Mixed income 40

pg. 25
1. Are the following items included in estimating a country’s national income?
(i) Free medical facilities to employees – Yes
(ii) Interest on debenture – Yes
(iii) Expenditure on purchase of a second hand car – No
(iv) Sale of share – No
(v) Gifts received from abroad – No
(vi) Dividend received on shares – Yes
(vii) Services of a housewife – No
(viii) Expenditure on feeding beggars – No, (being transfer payment)
(ix) Sale of an old house – No
(x) Services of owner-occupied houses – Yes
(xi) Free meals given to employees – Yes
(xii) Purchase of a new house by a consumer household – Yes
(xiii) Brokerage on sale of shares – Yes
(xiv) Pension to retired persons – Yes
(xv) Contribution to provident fund by employers – Yes
(xvi) Production for self-consumption by farmers – Yes
(xvii) Income from smuggling – No
(xviii) Employer’s contribution towards social security schemes – Yes
(xix) Old-age pension – No
(xx) Expenses of a firm on medical treatment of families of employees – Yes
(xxi) Entertainment allowance to an employee for entertaining business – No
(xxii) Rent-free accommodation to employees – Yes
(xxiii) Bonus received by employees – Yes
(xxiv) Free uniforms to employees – Yes
(xxv) Free ration to defence personnel
(xxvi) Travelling expenses paid to salesman by the employer – No
(xxvii) Interest on national debt – No
(xxviii) Construction of a new floor on an old building – Yes
(xxix) Intermediate goods – No
(xxx) Profit earned by foreign banks in India – No
(xxxi) Government transfer – Yes
(xxxii) Change in stocks – Yes
(xxxiii) Purchase of medicines by a patient – Yes (by expenditure method)

pg. 26
Money and Supply Money
Introduction of Money
Need to facilitate exchange of goods led to evolution of money.
Money is the commonly accepted medium of exchange. In an economy, if individuals do not
take part in market transactions, such as a family living on isolated island, money has no
function for them. Money is required only those societies which are involved in transactions of
goods and services.
Money – It is generally defined as a thing that is commonly accepted as a medium of exchange.
Barter System of Exchange – It is a system in which goods are exchanged for goods. Direct
exchange of goods against goods without use of money is called barter system. It is also called C
– C Economy.
Drawbacks of the Barter system
(i) Difficulty of double coincidence of wants – double coincidence of wants means the
situation when A has what B wants to buy and B has what A wants to buy.
Simultaneous fulfillment of mutual wants by buyers and sellers is known as double
coincidence of wants. There is a lack of double coincidence of wants of buyers and
sellers.
(ii) Lack of common unit of value – In barter system, there is no common measure of
value. Even if buyer and seller of each other commodity happen to meet, the
problem arises in what proportion the two goods are to be exchanged. Each articles
must have as many different values as there are other articles for which it is to be
exchanged.
(iii) Lack of a system for future payments – There is problem of future payments. It is
difficult to engage in contracts which involve future payments due to lack of any
satisfactory unit. As a result, future payments are to be stated in term of specific
goods or services. But there could be disagreement about quality of the goods,
specific type of the goods and change in the value of the goods.
(iv) Lack of system of storage and transfer of value – It is difficult for the people to store
wealth or generalize purchasing power for future use in the form of goods like
cattle, wheat, pulses etc. holding of stocks of such goods involve costly storage and
deterioration.
Function of Money
(i) Money as the Medium of Exchange – Money came into use to remove the
inconveniences of barter system. Money as medium of exchange has solved this
problem as money has separated the act of purchase from sale. A money system is
of greater utility of human being. Money is also called generalized purchasing power

pg. 27
because it provides freedom of choice to buy things he wants most from those who
offer best bargain.
(ii) Money as a Unit of Account – The unit of account function means that money unit is
treated as the standard unit for quoting prices and for borrowing and lending
activities. Different goods produced in the country are measured in different units,
e.g., cloth in metres, milk in litres, rice in kilograms.
(iii) Money as the Standard of Deferred Payments – Deferred payments are payments
are payments which are contracted to be made sometime in future. Loans are taken
and repaid in terms of money.
(iv) Money as a Store of Value – It means money can be stored for use in future. It
serves as a store value of goods in liquid form.
Forms of Money
1. Fiat Money – It is any money backed by the order of the government to act as money. It
is also called legal tender money. For example – currency and coins.
2. Fiduciary Money – This money is accepted on the basis of trust that the issuer of money
commands. It is also known as optional money or non-legal tender money. It includes
cheques, drafts, and bills of exchange.
3. Full-bodied Money – It refers to money in terms of coin whose commodity value is equal
to the money value as and when these are issued. It is also known as standard coins.
4. Credit Money – It refers to money whose intrinsic value is less than its face value.
Function of Money
(i) Medium of exchange – Money is used as a medium of exchange. All kinds of
transactions of goods and services are conducted with the help of money.
Transactions of various goods could be conducted independently, i.e. the purchase
of one good does not require the simultaneous sale of another. Money has, thus,
relieved us from all difficulties that were being faced under the barter system of
exchange.
(ii) Measure of value – Money acts as a standard of value or the unit of account. As unit
of account it measures the value of all kinds of goods and services. If we pay ₹100
for one kg of apples, we have a measure of value in terms of the basic unit of
account, which is rupee.
(iii) Standard of deferred payments – Money serves as a standard of debt or deferred
payments. Money is preferred as a standard of deferred payments because its value
remains stable over time. Other goods are perishable and their vale gets depleted
overtime.
(iv) Store of value – Money serves as a store of value. Wealth can be stored in the form
of other assets as well but money is the best form of holding assets. It is so because

pg. 28
money is the most liquid form of all assets. Liquidity means the ability of an asset to
be exchanged for something else of value without loss of value and time.
(v) Transfer of value- Money serves as a transfer of value. Money helps in the transfer
of value from one person to another and from one place to another. It is difficult to
transfer fixed assets, however by converting them into money their value can easily
be transferred from one place to another.
Supply of Money
Supply of money is a stock concept. It refers to total stock of money held by the people of
a country at a point of time.
Who are the producers of money?
Producers of money refers to the suppliers of money. They include :
a. The government of the country
b. The banking systemof a country including both the central bank and the commercial
banks.
Measurement of Money Supply
𝑴𝟏 = 𝑪 + 𝑫𝑫 + 𝑶𝑫
𝑀2 = 𝑀1 + 𝐷𝑒𝑝𝑜𝑠𝑖𝑡𝑠 𝑤𝑖𝑡ℎ 𝑝𝑜𝑠𝑡 𝑜𝑓𝑓𝑖𝑐𝑒 𝑠𝑎𝑣𝑖𝑛𝑔 𝑏𝑎𝑛𝑘 𝑎𝑐𝑐𝑜𝑢𝑛𝑡
𝑀3 = 𝑀1 + 𝑁𝑒𝑡 𝑡𝑖𝑚𝑒 𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠 𝑤𝑖𝑡ℎ 𝑐𝑜𝑚𝑚𝑒𝑟𝑐𝑖𝑎𝑙 𝑏𝑎𝑛𝑘𝑠
𝑀4 = 𝑀3 + 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠 𝑤𝑖𝑡ℎ 𝑝𝑜𝑠𝑡 𝑜𝑓𝑓𝑖𝑐𝑒𝑠 ( 𝑜𝑡ℎ𝑒𝑟 𝑡ℎ𝑎𝑛 𝑁𝑆𝐶𝑠)
Higher Order Thinking Skills
1. How is currency issued in India?
Ans. Currency in India is issued by on the basis of minimum reserve system. RBI has to
maintain a minimum reserve of ₹200 crore in the form of gold and foreign securities. Out of
this reserve, value of gold must be ₹115 crore.
Currency issued by RBI is inconvertible i.e., currency issued by RBI is not convertible into
gold.
All cotes except one rupee notes are issued by RBI.
2. What is the difference between face value and intrinsic value?
Ans. Face value refers to the value which is written on the unit of money, e.g., face value of
a 100 rupee note is equal to 100 rupees, means goods and services worth ₹100 can be
purchased using this note.

pg. 29
Intrinsic value refers to the commodity or metallic value of the unit of money, e.g., the gold
coin contains gold in it; if the coin is sold as gold, the value at which it is sold is known as its
intrinsic value.
3. What role does CRR play in the creation of credit by the commercial banks?
Ans. CRR sets a limit up to which commercial banks can legally create credit. If CRR is 4%, it
implies that the commercial banks can create credit (by way of loan) maximum upto 25
times of their cash reserves with the RBI.
4. What is meant by ideal supply of money?
Ans. It is that amount of money supply which keeps the total purchasing power in a state of
balance with aggregate supply, so that the economy does not slip into inflationary or
deflationary situations.
Assignment for Money
1. What is barter system?
2. Give some examples of modern form of money.
3. What is money?
4. Explain medium of exchange function of money.
5. What is money supply?
6. What is liquidity trap? Explain it with help of a diagram.
Ans. Liquidity trap is a situation of very low rate of interest where people expect the
interest rate to rise in future and consequently bond prices to fall. So, it becomes totally
unattractive to invest money in bond causing capital loss. People withhold, as inactive
balance of any amount of money they have and nothing is invested. In such a situation,
when rate of interest declines to minimum, say 3%, speculative demand for money
becomes infinite (perfectly elactic) nmaking the demand curve a horizontal straight line
curve parallel to x-axis beyond point L as shwown in figure. Economists call it a situation
of liquidity trap because expansion in money supply gets trapped in the sphere of
liquidity trap and therefore, cannot affect the rate of interest.

pg. 30
7. What factors were responsible for the evolution of money?
8. What is paper money?
9. What is liquidity?
10. Define term deposits.
Application Based Questions
1. Name three problems of barter system.
2. What is meant by ideal supply of money?
Ans. Ideal money supply is that amount of money supply which keeps the total
purchasing power in a state of balance with aggregate supply, so that the economy does
not slip into inflationary or deflationary situations.
3. Commodity value of money has never been greater than the face value. Is it true?
4. What role does CRR play in the creation of credit by the commercial banks?
Value Based Questions
1. Explain how introduction of money has led to the expansion of markets?
2. Do you agree with the view that the excess of money supply hinders the process of
economic growth? Give reasons.

pg. 31
Commercial Banks and Central Bank
Commercial Bank – A commercial bank is that financial institution which accepts deposits from
the people and gives loans for the purpose of consumption or investment.
Functions of commercial banks
(i) Accepting deposits – A commercial bank accepts deposits in the form of current,
saving and fixed deposits. It collects the surplus balance of the individuals and firms
and finances the temporary needs of commercial transactions. The first task is,
therefore, the collecting of the savings of the public. This the bank does by accepting
deposits from its customers. Deposits are lifeline of banks.
(ii) Advancing loans – The second major function of a commercial bank is to provide
loans and advances particularly to businessmen and entrepreneurs and thereby earn
interest. This is, in fact, the main source of income of the bank.
(iii) Collection and payments of various items
(iv) Purchase and sale of securities
(v) Locker facilities
(vi) Business information and statistics
Credit Creation by the Commercial Banks
Commercial banks are an important source of money supply in the economy. They contribute
to money supply by creating credit. They create credit in the form of demand deposits. Demand
deposits of the commercial banks are many times more than their cash reserves.
Suppose new deposits of Rs.1000 are made in banks. The minimum reserve requirement is
being put at 10% of the total deposits, i.e., to meet any demands arising out of its deposits,
bank will keep a cash reserve equal to Rs.100 only and lend the remaining of Rs.900. for this
bank has not with its cash reserves, instead borrowers are credit with chequeable deposits. This
is the round creation and equal 90% of the initial deposit. Borrowers will use the deposits to
meet their obligation to their debtors, by paying them, most probably in the form of cheques
will deposit the same in their respective bank accounts. The banks get new deposits. They keep
10% of these deposits i.e., Rs.900 as cash and lend the remaining Rs.810. Thus the second
round increases. It is 10% of the previous round increase. In the same manner, the third round
creation of deposits will be 90% of 810, i.e., Rs.729 and in the fourth round it will be 90% of 729
of Rs.656.1 and so on.
𝐷𝑒𝑚𝑎𝑛𝑑 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =1/ Reserve Deposit Ratio
Round Deposits Loans Cash
Reserves
First round 1000 900 100
Second
round
900 810 90

pg. 32
Third r
ound
810 729 81
Fourth
round
729 656.1 72.9
------ ------ ------- ------
------ ------- ------- -------
10000 9000 1000
Currency Deposit Ratio (CDR) is the of money held by the public in currency to their holding in
bank deposits. It shows people’s preference for liquidity.
𝐶𝐷𝑟 = 𝐶𝑈/𝐷𝐷
Cash Reserve Ratio (CRR) – It refers to the minimum percentage of a bank’s total deposits
required to be kept with central bank. Presently, it is 4% in India.
Statutory Liquidity Ratio(SLR) – Every bank is required to maintain a fixed percentage of its
assets in the form of cash or other liquid assets. Presently, it is 23% in India.
Bank Rate – It is the rate at which the central bank gives credit to the commercial banks.
Open Market Operation – It refers to the sale and purchase of securities in the open market by
the central bank.
Margin Requirement – It refers to the difference between the current value of the security
offered for loans and the value of loans granted.
Rationing of Credit – It refers to fixation of credit quotas for different business activities.
Rationing of credit is introduced when the flow of credit is to be checked particularly for
speculative activities in the economy.
Moral Suasion – It means advising, requesting and persuading the commercial banks to
cooperate with the central bank in implementing its general monetary policy. The central bank
may request the commercial bank not to grant loans for speculative purposes.
Direct Action – It refers to the direction issued by the central bank to the commercial banks
regarding their ending and investment policy. Direct action may take different forms (a) refusal
to rediscount the bills of exchange (b) it may charge a penal rate of interest over and above the
bank rate on the money demanded by the bank beyond its prescribed limit.
The Central Bank
It is the apex bank that controls the entire banking systemof a country. It is the sole agency of
note issuing in a country. In every country of the world, there is an apex institution which
serves as the central bank. The central bank is called by different names in different countries.
In India, it is called by the name Reserve Bank of India, in England, Bank of England etc.

pg. 33
Functions of Central Bank
(i) Issue of Currency – The central bank is the sole authority for the issue of currency in
the country. Notes issued by it are circulated as legal tender money. It has its issue
department which issues notes and coins.
(ii) Banker to the Government – It is a banker, agent and financial advisor to the
government. As a banker to the government, it manages accounts of the
government banks across all in the country. As an agent to the government, it buys
and sells securities, treasury bills on the behalf of the government. As an advisor to
the government, it keeps the government in framing policies to regulate the money
market.
(iii) Lender of the last resort – It acts as a lender of the last resort for commercial banks.
When commercial banks fail to meet obligations of their deposits, the central bank
comes to their rescue.
(iv) Collection of Statistics – It collects statistical information relating to banking,
currency and foreign exchange. This is useful in making policies and plans of growth
and development.
(v) Custodian of foreign exchange – It the custodian of nation’s foreign exchange
reserve. It maintains foreign exchange reserves in order to promote international
trade and stabilize exchange rate.
Difference of Commercial Banks and Central Bank
(i) Central bank is the apex monetary institution which controls the entire money and
banking system of the country while the commercial bank is a constituent unit of the
banking system.
(ii) Central bank does not operate with a profit motive. Its aim is to maximize the public
welfare through monetary measures. The commercial bank have profit motive as
the main objective.
(iii) Central bank is a state owned institution while the commercial bank is either state
owned or private owned institution.
(iv) Central bank does not deal directly with the public. The commercial bank has direct
dealing with the public.
(v) Central bank has the monopoly of note issue whereas the commercial banks do not
enjoy such right.
(vi) Central bank acts as banker to the government whereas the commercial banks acts
as a banker to the general public.
(vii) Central bank controls credit through various instrument whereas the commercial
banks create credit.
Assignment of Banks
1. What is banking?

pg. 34
2. What is a commercial bank?
3. Name the central bank of India.
4. What is credit money?
5. What are the differences of central bank and commercial banks?
6. What are the instruments of monetary policy of RBI?
7. What is repo rate?
8. What is meant for reverse repo rate?
Application Based Questions
1. If the commercial banks buy government securities, their capacity to create credit is
reduced. Do you agree?
2. Why are financial institutions like UTI, LIC are not considered banks?
3. Explain the acceptance of deposits functions of the commercial banks.
4. If CRR is lowered, investment demand must rise. Defend or refute.
5. Commercial banks create credit only the advice of the government. Is it true.

pg. 35
Concept of Aggregate Demand (AD)
In macroeconomics, demand is measured in terms of expenditure. Thus AD means sum total of
expenditure made on the purchase of goods and services during a fiscal year. In other words,
AD is the total demand for goods and services in the economy.
𝑨𝑫 = 𝑪 + 𝑰 + 𝑮 + (𝑿 − 𝑴)
Where AD = aggregate demand
C = private consumption expenditure
I = investment expenditure
G = government expenditure
X = export, M = import
1. Private Consumption Expenditure – It is the most important component of aggregate
demand. It refers to the total amount of expenditure incurred by the households on the
purchase of goods and services to satisfy their wants. Disposable income affects private
consumption expenditure. There is a positive relationship between the consumption
expenditure and the level of disposable income.
2. Investment Expenditure – It refers to the expenditure incurred by the private firms in
the purchase of capital goods such as plant and equipment, construction works etc. Rate
of interest affects the investment demand the most. There is a negative relationship
between the rate of interest and investment demand.
3. Government Expenditure – It refers to the expenditure by the government on the
purchase of goods and services. The level of government expenditure is determined by
the government policy.
4. Net Exports – It is the difference between exports and imports. It shows the effect of
domestic spending on foreign goods and services and foreign spendings on domestic
goods and services on the level of aggregate demand.
Aggregate Demand Schedule – It is a schedule showing combined behavior of consumption and
investment corresponding to the different level of income in the economy.
Two important points for AD –
a. At the very low level of income, AD may be greater than income. Because some
minimum expenditure is always essential in the economy even when income does not
allow.

pg. 36
b. At the higher levels of income, expenditure is often less than income. This is because, at
the higher level of income, people starts saving a part of their income.
Table No. 1
Y
(income)
Consumption
©
Investment
(I)
AD = C+
I
0 200 100 300
200 250 100 350
400 300 100 400
600 350 100 450
800 400 100 500
1000 450 100 550
1200 500 100 600
Concept of Aggregate Supply (AS)
AS refers to the value of total output available in the economy during a period, say a year. In
fact, AS represents the national income of the country. It means flow of goods and services in
the economy during an accounting year.
𝐴𝑆 = 𝐶 + 𝑆
Consumption – It is always positive. It is never zero, even when Y = 0.

pg. 37
Saving – It may be negative when the level of income is low, when C>Y. There is positive
relationship between income and savings.
Consumption Function
The relationship between consumption and income is called consumption function or
propensity to consume.
𝐶 = 𝑓( 𝑌)
𝐶 = 𝑎+ 𝑏𝑌
Where c= consumption
a= consumption when the level of income is zero
b= slope of the consumption curve
Y = income
Observations from the diagram
(i) OC is the minimum level of consumption. It must be incurred even when income is
zero. Because survival needs consumption.
(ii) CC line constantly moves up showing a rise in consumption as income rises.
(iii) C = Y at point Q which therefore is a break-even point.
(iv) Beyond point Q, C lags behind Y. This suggests that after a particular level of income
is reached, people save a part of their income.
(v) Prior to Q, C>Y, a situation of borrowing or negative saving. After Q, C<Y, a situation
of positive saving.

pg. 38
Propensity to Consume
It refers to the schedule which shows the level of consumption at different levels of income in
an economy. It simply is a ratio between C and Y.
Two aspects of propensity to consume –
(i) Average Propensity toConsume (APC) – It is the ratio of consumption expenditure
to any particular level of income. 𝐴𝑃𝐶 = 𝐶/𝑌
(ii) Marginal Propensity toConsume (MPC) – It is the ratio of a change in consumption
to change in income.
𝑀𝑃𝐶 = 𝑑𝐶/𝑑𝑌
Saving Function
Saving is the excess of income over and above consumption during an accounting year.
𝑆 = 𝑌 − 𝐶
Propensity to Save
It may be defined as a schedule showing amounts that will be saved at different levels of
income. Two aspects of propensity to consume –
(i) Average Propensity toSave (APS) – It is the ratio of saving in income.
𝐴𝑃𝑆 =
𝑆
𝑌
(ii) Marginal Propensity toSave (MPS) – It is the ratio between change in saving caused
by change in income. 𝑀𝑃𝐶 =
𝑑𝑆
𝑑𝑌
Algebraic Expression 𝑺 = −𝑺 + 𝒃𝒀

pg. 39
𝑪 = 𝑪 + 𝒃𝒀
Relationship between APC and APS
We know that 𝐴𝑃𝐶 =
𝐶
𝑌
and 𝐴𝑃𝑆 =
𝑆
𝑌
We know that 𝑌 = 𝐶 + 𝑆
APC + APS =
𝐶
𝑌
+
𝑆
𝑌
= Y/Y = 1
Relationship between MPC and MPS
We know that MPC =
𝑑𝐶
𝑑𝑌
and MPS =
𝑑𝑆
𝑑𝑌
MPC + MPS = 𝑑𝐶/dY + dS/dY = dY/dY = 1
Important Formulae
i) National Income = C + I + G + (X-M)
ii) AD = C + I
iii) AS = C + S
iv) APC =
𝐶
𝑌
v) APS =
𝑆
𝑌
vi) MPC =
∆𝐶
∆𝑌
vii) MPS =
∆𝑆
∆𝑌
viii) APC + APS =1
ix) MPC + MPS = 1
Assignment for Aggregate Demand and its components
1. What do you mean by aggregate demand?
2. What do you mean by aggregate supply?
3. What is consumption function?
4. What is propensity to consume?
5. What is saving function?
6. Name the principal components of aggregate demand in an open economy.
7. What is average propensity to consume?
8. Define marginal propensity to save.
9. What is break-even point?
1. Do you agree that MPS cannot be negative, but APS can be?
2. What is aggregate demand? How it is different from market demand?

pg. 40
3. From the following income consumption schedule calculate (i) saving (ii) APC (iii) APS (iv)
MPC and (v) MPS.
Income 0 100 200 300 400
Consumption 60 110 150 180 200
4. State the relationship between MPC and MPS.
5. Explain the relationship between APC and APS.
6. Complete the following table –
Level of Income (₹) 400 500 600 700
Consumption Expenditure 240 320 395 465
MPC
MPS
HOTS
1. Define APS and MPS. Can the value of average propensity to save be negative? Give
reason for your answer.
2. Why autonomous investment is essential?
3. High propensity to consume is a virtue, while high propensity to save is not. Explain.

pg. 41
Short Run Equilibrium Output
Concept of Short Run
In macroeconomics short run is defined as a period of time during which level of output is
determined exclusively by the level of employment in the economy. Higher level of
employment causes proportionately higher level of output and vice versa.
Concept of equilibrium
Equilibrium level of output refers to that level of output where
𝐴𝐷 = 𝐴𝑆
𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝐷𝑒𝑚𝑎𝑛𝑑 = 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑆𝑢𝑝𝑝𝑙𝑦
AS = C +S (Planned Consumption + Planned Saving)
AD = C + I (Planned Consumption + Planned Investment)
AD = AS
C + I = C + S
I = S
Note –ex-ante (before the event)
Ex-ante Saving –Savings whichthe savers desire toundertake at
different levels ofincome and employment.
Ex-ante Investment –Investment which the entreprenuers desire to
undertake at differentlevels ofincome and employment.
`ex-post (after the event)
Ex-post saving –Savings which are actually undertaken
by the savers.
Ex-post Investment –Investment actually undertaken by
the investors.
Determination of Equilibrium of Output/Income (GDP)
Three basic assumptions –
(i) Short Period Analysis – Equilibrium GDP according to Keynesian theory is reference
to short period of time.
(ii) Closed Economy – Keynes discusses the theory of equilibrium GDP in the context of a
closed economy. This is an economy which has no economic relations with the ROW:
there are no exports or imports. So that AD = C + I
(iii) AS is perfectly Elastic – Keynes assumes that AS is perfectly elastic. It means that we
are studying an economy in which there is an excess capacity: production capacity is
lying idle or there is unemployment of resources. So that, whenever there is a rise in
AD, there is a corresponding rise in AS (as excess capacity begins to be utilized).
Thus, AS always equates itself with AD.

pg. 42
Determination of equilibrium output/income by two ways –
(i) AD = AS Approach
(ii) S = I Approach
AD = AS Approach
According to this approach, equilibrium GDP is achieved when
AS = AS
Y C ∆C ∆Y I AD
0
200
400
200
300
400
___
100
100
___
200
200
100
100
100
300
400
500
600 500 100 200 100 600
800
1000
1200
600
700
800
100
100
100
200
200
200
100
100
100
700
800
900
S =I Approach

pg. 43
The determination of the equilibrium level of income can also be shown with the help of
schedule –
Y C I S
0
20
40
60
20
30
40
50
20
20
20
20
-20
-10
0
10
80 60 20 20
100
120
140
70
80
90
20
20
20
30
40
50
In the above diagram, the equilibrium is determined at point E, where investment is equal to
saving. At income levels below the equilibrium level, investment is more than savings, while at
income levels above the equilibrium level, investment is less than saving. It is only at the
equilibrium level the two are equal.
Shift in Equilibrium: Impact of Injections and Withdrawals
Equilibrium of the economy will be established at the level of income and employment where
AD=AS. Aggregate supply depends on technical production conditions. It depends on the
productivity of the men, machines and raw materials available to the community. Now these
conditions generally do not change in the short run, therefore, we can assume the aggregate
supply is given and constant.
The shift in equilibrium condition can occur only due to a change in the aggregate demand
(change in investment).

pg. 44
Investment Multiplier and its Mechanism
The concept of Multiplier (K)
Multiplier is the ratio of increase in national income (∆Y) due to an increase in investment (∆I).
𝐾 =
∆𝑌
∆𝐼
Or ∆Y= 𝐾𝑋∆I
Where K= Investment multiplier
∆Y = change in income
∆I = change in investment
Increase in investment causes increase in income. But increase in income is not to the same
extent as in investment rather it increases by a multiple of increase in investment. The number
of times by which income increases as a result of increase in investment is called investment
multiplier. Suppose if an increase in investment of ₹50 crores cause an increase in national
income of ₹300 crores, thevalue of multiplier would be 6 (300/50).
Relationship between Multiplier and MPC (Marginal Propensity to Consume)
There is a direct relationship between multiplier and MPC. Higher the value of MPC, higher the
multiplier and vice versa.
𝐾 =
∆𝑌
∆𝐼
We know that ∆𝑌 = ∆𝐶 + ∆𝐼

pg. 45
𝐾 = ∆𝑌/∆𝑌/∆𝑌/∆𝑌 − ∆𝐶/∆𝑌
Working of Multiplier
We know that multiplier works through consumption. How? The concept of multiplier is based
on the fact that from economics point of view expenditure of one person is another person’s
income, e.g., expenditure of A is income of B, B’s expenditure is income of C, C’s expenditure is
income of D and so on until expenditure becomes zero. Suppose government invest ₹100
crores more in expansion of a fertilizer factory. The first impact of this additional investment
will be that the income of employees engaged in this factory will go up by ₹100 crores. If their
marginal propensity to consume (MPC) is ¾ or 75%, they will spend ₹75 crores (3/4 of 100) on
new consumption goods. This is not the end of story. The consumption expenditure will give an
extra income of ₹75 crores to the producers of these goods who, in turn, will spend ₹56.25
crores (3/4 of 75) on consumption expenditure. So this process will go on with each round of
expenditure being ¾ of previous round till consumption expenditure becomes nil. In other
words,, the process of increase in income stops when change in income (∆I) becomes equal to
change in saving (∆S), i.e., ∆I = ∆S. this process of working of multiplier is further clarified in the
following table –
Round of income
generation
∆I ∆Y ∆C
Round 1 100 100 75 = (
3
4
X100)
Round 2 ____ 75 56.25 = (
3
4
X75)
Round 3 ____ 56.25 42.19 = (
3
4
X56.25)
Round 4 ____ 42.19 31.64 =(
3
4
X42.19)
Round 5 ____ 31.64 -------
--------- ------ ------ -------
Last Round ------- ------- -------
Total 500 400

pg. 46
The above table clearly shows that initial increase in investment of ₹100 crores has resulted in
an increase of additional income of ₹400 crores, i.e., resultant increase in income is multiple of
initial increase in investment. Thus, multiplier (K) = 400/100 = 4 or K =
∆𝑌
∆𝐼
.
Autonomous Investment –It refers to investment whichis independentofthe rate ofinterest and the levelofGDP intheeconomy.
Assignment for Short Run Equilibrium Output
1. Give the meaning of aggregate demand.
2. Give the meaning of aggregate supply.
3. What is autonomous investment?
4. What are desired stocks with the producers?
5. What are actual stocks with the producers?
6. Give the formula of multiplier.
7. Briefly explain the concept of equilibrium output.
8. Explain the relationship between MPC and MPS.
9. In an economy, the autonomous investment is 500 and consumption function is
250+0.5Y. Is the economy in equilibrium at an income level 2000? Justify your answer.
10. In an economy planned savings exceed planned investment. How will the equality
between the two be achieved? Explain.
11. Explain working of multiplier with the help of a numerical example.
Applications and Value Based Questions
1. In an economy, MPC is 0.75. If investment expenditure increases by ₹500 crores,
calculate total increase in income and consumption expenditure.
2. A ₹200 crores increase in investment leads to a rise in national income by ₹1000 crores.
Calculate MPC.
3. In an economy, investment is increases by ₹2000 cores. Calculate change in total income
if MPS is 0.25.
4. In an economy, 75% of increase in income is spent on consumption. Investment is
increased by ₹1000 crores. Calculate:
(a) Total increase in income and (b) Total increase in consumption expenditure.
5. Find the consumption expenditure from the following –
National income = ₹5000
Autonomous expenditure = ₹1000
Marginal propensity to consume = 0.80
6. The saving function of an economy is S = - 200 + 0.25Y. The economy is in equilibrium
when income is ₹2000. Calculate –
(i) Investment expenditure at the equilibrium level
(ii) Autonomous consumption
(iii) Investment multiplier

pg. 47
Problem of Deficient Demand and Excess Demand
Concept of full employment
Generally full employment means a situation in which persons are willing to work at the
prevailing wage rate are able to get work. However, at the full employment , some kind of
unemployment may exist.
(i) Natural rate of unemployment – It refers to unemployment which is bound to exist
even when labour market is in a state of equilibrium. It occurs largely due to -
a.
time required in shifting from one job to the other, and
b. time required in adjusting to change in technology
(ii) Frictional Unemployment – It is the unemployment associated with the changing of
jobs in dynamic economy.
(iii) Structural Unemployment – It is the unemployment that results from the long-term
decline of certain industries.
(iv) Involuntary Unemployment – It refers to a situation in persons are willing to work at
the prevailing wage rate but are not able to get work. They are unemployed to their
wishes.
(v) Voluntary Unemployment – It refers to a situation when a person is unemployed
because he is not willing to work at the prevailing wage rate.
(vi) Underemployment Equilibrium – It is the situation of equilibrium between
aggregate demand and aggregate supply at which all resources are not fully used
and some resources are lying idle or unutilized.

pg. 48
Deficient Demand – If the aggregate demand falls short of aggregate supply corresponding
to full employment level in the economy, then a situation of deficient demand exists.
Deficient demand leads to fall in the general price level i.e., deflation in the economy.
Deflationary Gap – It is the difference between the actual level of aggregate demand and
the level of aggregate demand to establish full employment equilibrium. The deflationary
gap is the measure of the amount of deficient demand.

pg. 49
In the above diagram, ADf shows aggregate demand at full employment level, ADu indicates
underemployment in the economy.
Deficient Demand = ADf – Adu
Causes of Deficient Demand
(i) Reduction in private consumption expenditure
(ii) Reduction in investment expenditure
(iii) Reduction in government expenditure
(iv) Decline in export
(v) Rise in imports
(vi) Increase in tax rates
Measures of Deficient Demand
Measures to reach full employment equilibrium –
(i) Increase in government expenditure to pump more money in the systemto increase
demand.
(ii) Bank Rate (Repo Rate) should be increased.
(iii) Central bank should buy Government Bonds and securities from commercial banks
to increase cash stock of banks for lending.
Excess Demand – If the aggregate demand is the excess of aggregate supply corresponding
to full employment in the economy, then a situation of excess demand exists. Excess
demand gives rise to inflationary gap. The gap is called inflationary because it causes
inflation (continuous rise in prices) in the economy.

pg. 50
Inflationary Gap – It is the difference between the actual level of aggregate demand and
the level of aggregate demand required to establish full employment equilibrium. The
inflationary gap is a measure of the amount of the excess demand.
Inflationary gap is measure of amount of the excess of aggregate demand over aggregate
supply at full employment. It indicates that the buyers intend to buy more than the
maximum physical output, the producers can produce by employing all the available
resources. In such a situation an increase in demand means only an increase in money
expenditure without any corresponding increase in output and employment because all the
resources are have already been fully employed. For example, by employing all available
resources can produce 10,000 unit of good. If actual demand is, say 11,000 units, this
demand will be called an excess demand, because output at level of full employment level is
10,000 units. As a result, excess of 1,000 units will be called an inflationary gap.
Cause of Excess Demand
(i) Increase private consumption expenditure
(ii) Increase in investment expenditure
(iii) Increase in government expenditure
(iv) Increase in export
(v) Decrease in import
(vi) Decrease in tax rates
Impact of Excess Demand
(i) It causes rise in prices.
(ii) It causes inequalities.

pg. 51
Causes of Excess Demand
Measures to Control Situation of Excess Demand & Deficient Demand
Measures are suggested to rectify the situation of excess demand & deficient demand
A. Fiscal Policy
B. Monetary Policy
Fiscal Policy – It is the expenditure and revenue policy of the government. It is also called
budgetary policy. It focuses on economic stability and economic growth.
Component of Fiscal Policy
a. Government Expenditure – In a situation like that of excess demand, government should
curtail its expenditure on public works such as roads, buildings, irrigation works thereby
reducing the money income of the people and their demand for goods and services. In
addition all wasteful expenditure should be curtailed. In this way, government should
reduce the budget deficit which shows excess of expenditure over revenue.
But in deficient demand, the government should make large investments in public works
like construction of roads, bridges, railway lines and provide free education and medical
facilities although it may enlarge budget deficit. This aim is to give more money in the
hands of people so that they should also spend more.
b. Taxes – During inflation, government should raise rates of all taxes especially on rich
people because taxation withdraws purchasing power from the tax payers and to that
extent reduces effective demand.
But in deflation, taxes on personal incomes and corporate incomes should be reduced to
encourage private consumption expenditure. If possible, tax on lower income groups be
abolished. This will increase their disposable income for spending.
c. Public Borrowing – During inflation, the government steps up public borrowing by
offering attractive rates of interest. This reduces liquidity with the people. While in
deflation, the government reduces its borrowing from public.
d. Borrowing from RBI – Borrowing from the RBI is another element of fiscal policy. It is
increased to fight deflationary gap, and reduced to fight inflationary gap.
Monetary Policy – It is the policy of the central bank of a country to regulate and control money
supply and credit in the economy.
Measure of Monetary Policy
1. Quantitative Measures
a. Bank Rate
b. Open Market Operation
c. Cash Reserve Ratio

pg. 52
2. Qualitative Measures
a. Margin Requirement
b. Moral Suasion
a. Bank Rate – Bank rate or Repo rate is the rate of interest charged by central bank on
loans given to commercial banks. Changing bank rate by the Central Bank to influence
credit availability is called Bank Rate Policy. In a situation of excess demand leading to
inflation, Central Bank raises bank rate. This raises cost of borrowing which discourage
commercial banks in borrowing from central Bank. Raising bank rate forces the
commercial banks to raise their lending rate of interest to consumers and investors.
Thus, makes credit costlier.
In deficient demand, the Central Bank reduces bank rate thereby enabling the
commercial banks to take more loans from it and, in turn, give more loans to producers
at a lower rate of interest.
At present (29, September 2015) Repo Rate – 6.75% and Reverse Repo Rate – 5.57%
b. Open Market Operation – It refers to sale and purchase of government securities and
bonds in the open market by the central bank. During inflation, Central Bank sells
government securities to commercial banks which lose equivalent amount of cash
reserve thereby affecting their capacity to offer loans. This absorbs liquidity from the
system. As a result, there is fall in investment and aggregate demand. Thus, it is an
effective measure to control credit. During deflation,
Central Bank buys government bonds and securities from commercial banks by paying in
cash to increase their cash stock and lending capacity.
c. Cash Reserve Ratio – It is ratio or fraction of bank deposits that a commercial bank must
keep as reserve in cash with the Central Bank. Every commercial bank is required under
law to keep with Central Bank a minimum percentage (4%) of its deposits as reserve in
the form of cash, is called CRR. When there is an inflationary situation, Central Bank
raises the rate of CRR thereby making the banks to keep more cash reserve with RBI
which curtails the lending capacity of commercial banks. While in deflationary gap,
Central Bank reduces the rate of CRR thereby increasing bank’s capacity to give credit.
d. Margin Requirement – It refers to the amount of security that banks demand from
borrower of loan. It is the difference between the amount of loan granted and the
current value of security offered for taking loan.
Inflationary gap – Margin Requirement ↑
Deflationary gap – Margin Requirement ↓
e. Moral Suasion – This refers to written or oral advice given by Central Bank to
commercial banks to restrict or expand credit. During inflation, the Central Bank of a
country employs selective credit control measures like moral suasion. For instance, it
persuades its member banks not to advance credit for speculation or prohibits banks
from entering into certain transactions. This advice is generally followed by member
banks.

pg. 53
Fiscal Policy Monetary Policy
Excess Demand Deficient Demand Excess Demand Deficient Demand
Govt. Expenditure↓ Govt. Expenditure ↑ Bank Rate ↑ Bank Rate ↓
Taxes ↑ Taxes ↓ OMO – Selling OMO – Buying
Public Borrowing ↑ Public Borrowing ↓ CRR ↑ CRR ↓
Deficit Financing ↓ Deficit Financing ↑ SLR ↑ SLR ↓
Assignment for Problem of Deficient Demand and Excess demand
1. What is full employment?
2. Define frictional unemployment.
3. Define deflationary gap.
4. What is inflationary gap?
5. What is fiscal policy?
6. How should repo rate be changed to check inflation?
7. Explain role of the following in correcting deficient demand in the economy – (i) Open
Market Operations and (ii) Bank Rate
8. Explain role of the following in correcting excess demand in the economy – (i) Open
Market Operations and (ii) Bank Rate

pg. 54
Government Budget and the Economy
A government budget is an annual statement of the estimated receipts and expenditure of the
government over the financial year, which runs from 1st April to 31st March.
The Objectives of the Government Budget –
(i) To achieve economic growth – to promote rapid and balanced economic growth so
as to improve living standard of the people. Economic growth implies a sustained
increase in real GDP of the economy i.e., a sustained increase in volume of goods
and services. Public welfare is the main objective.
(ii) Reallocation of Resources – To reallocate resources in line with social and economic
objectives, government provides more resources into socially productive sectors
where private sector is not coming, e.g., sanitation, water supply, rural
development, education, health etc.
(iii) To achieve economic stability – Government can bring economic stability i.e., can
control fluctuations in general price level through taxes, subsidies and expenditure.
For instance, when there is inflation, government can reduce its own expenditure
and when there is depression characterized by falling output and prices, government
can reduce taxes and grant subsidies to encourage spending by people.
(iv) Management of public enterprise – to finance and manage public enterprises which
are of the nature of monopolies like railways, power generation and water lines etc.
(v) Reduction of Inequalities – To reduce inequalities of income and wealth,
government can influence distribution of income through levying taxes on the rich
and spending more on poor along with granting subsidies to poor. This will reduce
income of the rich and raise standard of living of the poor. Government uses
progressive taxation policy to reduce inequalities among the people.
Revenue Receipts – Revenue receipts refer to those receipts of the government which (i) do
not create any liability for the government or (ii) do not cause any reduction in the assets of the
government. Revenue receipts consist of tax revenue and non-tax revenue.
Taxation – A tax is a compulsory payment made by an individual, household or a firm to the
government without reference to anything in return.
Classification of Taxation
1. Progressive and Regressive Taxes
2. Ad Valorem (Value Added Tax) and Specific Taxes
3. Direct and Indirect Taxes
Progressive tax means that rate of tax increases with increase in income. Regressive tax means
that rate of tax decreases with increase in income.

pg. 55
Value Added Tax (TAX) is an indirect tax which is imposed on value added at the various stages
of production. Value added refers to the difference between value of output and value of
intermediate consumption. It is imposed at each stage of production and is a proportional tax.
Specific Tax is a tax which levied on a commodity on the basis of its units, size or weight.
Direct Taxes – Taxes which are not shifted i.e., the incidence of which falls on persons who pay
them to the government are direct taxes. For example – income tax, wealth tax etc.
Indirect Taxes – The burden of tax is shifted to other i.e., tax is levied on a commodity is termed
as indirect tax. For example – sale tax, custom duty etc.
Capital Receipts – Capital receipts refer to those receipts of the government which
(i) tend to create a liability for the government or
(ii) Cause reduction in its assets.
Revenue Expenditure – Revenue expenditure is the expenditure incurred for the normal
running of the government administration departments, provision of various services, interest
payments on debt incurred by the government functioning, subsidies granted by the
government, defense expenditure etc.
Capital Expenditure – Capital expenditure is that expenditure which leads to creation of an
asset or reduction in liabilities, like expenditure on construction, etc.
Comparison between Revenue Expenditure and Capital Expenditure
Revenue Expenditure Capital Expenditure
It is incurred for normal running of
government departments and maintenance.
It is incurred for acquisition of capital assets.
It does not result in creation of assets. It results in creation of assets.
It is short-period expenditure. It is generally a long-period expenditure.
It is recurring in nature and incurred
regularly.
It is non-recurring in nature.
Government Budget Expenditure
Revenue Expenditure Capital Expenditure
Expenditure which neither creates assets
nor reduces liabilities
Expenditure
a. Payment of interest
b. Payment of salaries & pensions
c. Grants and subsidies
d. Education and health services
e. Defence services
a. Construction of roads, bridges, buildings
b. Purchase of land and machinery
c. Investment in shares
d. Loans to states and foreign government
e. Repayment of loans

pg. 56
Budget Deficit – It refers to a situation when budget expenditure of the government are
greater than the budget receipts.
𝐵𝐷 = 𝐵𝐸 − 𝐵𝑅
These are three types –
A. Revenue Deficit (RD) – RD is the excess of revenue expenditure over revenue receipts.
𝑅𝐷 = 𝑅𝐸 − 𝑅𝑅
For instance, revenue deficit in government budget estimates for the 2014-15 is ₹ crore.
Remedial Measure –
A high revenue deficit warns the government either to cut its expenditure or increase its
tax and non-tax receipts. Thus, main remedies are –
(i) Government should raise rate of taxes especially on rich people and levy new
taxes where possible.
(ii) Government should try to reduce its expenditure and avoid unnecessary
expenditure.
Implications of RD –
There are two implications of revenue deficit.
Firstly, a part of RD is financed through borrowed funds from the capital account. This
implies that government’s investment or capital expenditure is reduced to the extent of
deficit on the revenue account. This affects economic growth of the economy.
Secondly, because of high revenue deficit, government has to borrow from the market
which reduces the resources available for private investment. This again lowers the rate
of economic growth.
Thirdly, it increases burden of taxes.
Fourthly, since borrowed funds from capital account are used to meet generally
consumption expenditure of the government, it leads to inflationary situation in the
economy with all its ills.
B. Fiscal Deficit (FD) – FD is the excess of total expenditure over total receipts (revenue +
capital other than borrowing)
Implications of Fiscal Deficit – Greater fiscal deficit implies greater borrowings by the
government (i) causes inflation (ii) increases foreign dependence (iii) accumulates
financial burden for future generation and (iv) multiple borrowings
C. Primary Deficit (PD) – PD is the difference between FD and interest payment.
𝑃𝐷 = 𝐹𝐷 − 𝐼𝑛𝑡𝑒𝑟𝑠𝑒𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡
Implications – While fiscal deficit shows borrowing requirement of the government to
meet with her expenditures inclusive of interest payment, primary deficit shows
borrowing requirement of the government to cope with her expenditures exclusive of
interest payments.
Measures to contain Budgetary Deficit

pg. 57
(i) Lowering Government Expenditure
(ii) Raising Government Receipts (taxation and disinvestment)
Questions for 1 mark –
1. What do you mean by the fiscal year in India?
2. State any one objective of government budget.
3. Give two example of capital receipts.
4. Give two example of capital expenditure.
5. What is primary deficit?
6. What is meant by public goods?
Questions for 3 or 4 marks –
1. Distinguish direct taxes and indirect taxes.
2. Classify public expenditure.
Ans. Public expenditure may be classified in three ways, namely –
(a) Revenue vs. capital expenditure
(b) Plan vs non-plan expenditure
(c) Developmental vs non-developmental expenditure
3. What are the objectives of a budget?
4. How may a deficit be financed?
Ans. A deficit may be financed –
(i) By printing new currency , i.e., monetary expansion
(ii) By borrowing from internal sources i.e., public and external sources
5. Distinguish between tax revenue and non-tax revenue.
6. What is meant by the term disinvestment?
7. Explain allocation of resource function of a government budget.
Questions for 6 marks –
1. What is meant by deficit financing? Illustrate with an example.
2. What is meant by domestic borrowing? Mention its three sources.

pg. 58
Foreign Exchange Rate
Foreign exchange is the name given to any foreign currency. Thus US dollar, British pounds are
foreign exchange for India. Foreign exchange rate refers to the rate at which one unit of
currency of a country can be exchanged for the number of units of currency of another country.
£1 = 𝑅𝑠. 100
System of Exchange Rate
1. Fixed Exchange Rate System – It is the rate which is officially fixed in terms of gold or
any other currency by the government. Such rate does not vary with changes in demand
and supply of foreign currency. Only the government has the power to change it. 𝑅 =
𝑓(𝐷, 𝑆)
2. Flexible Exchange Rate – It is that rate which is determined by the forces of demand
and supply of foreign exchange. There is an official intervention. It is free to fluctuate
according to changes in demand and supply of foreign currency.
Merit of Fixed Exchange Rate
(i) It ensures stability in exchange rate the exporters and importers do not have
operate under uncertainty about the exchange rate. Thus it promote foreign trade.
(ii) It promotes capital movements. Fixed exchange rate system attracts foreign capital
because a stable currency does not involve any uncertainty about the exchange rate
that may cause capital loss.
(iii) Stable exchange rate prevents capital outflow.
(iv) It prevents speculation in foreign exchange market.
(v) It forces the government to keep inflation in check. In case of fixed exchange rate,
inflation causes balance of payments deficit resulting in deflation of foreign
exchange reserves.
Demerits of Fixed Exchange Rate
(i) It contradicts the objective having free market.
(ii) Under this system, countries deficit in balance of payments run down this stock of
gold and foreign currency. This can creates serious problem for them. They may be
forced to devalue their currency. On the other hand, countries with surplus in
balance of payments will face the problem of inflation.
(iii) It discourages venture capital in the international money market. Foreign exchange
fails to develop as a commodity of trade.
(iv) Since exchange rate is fixed by the government, supply and demand forces are not
allowed to operate.
Merits of Flexible Exchange Rate

pg. 59
(i) It eliminates the problem of overvaluation or undervaluation of currencies, deficit or
surplus in balance of payments is automatically corrected under this system.
(ii) It frees the government from problem of balance of payments.
(iii) There is no need for the government to hold any foreign exchange reserves.
(iv) It enhances the efficiency in the economy by achieving optimum resources
allocation.
Demerits of Flexible Exchange Rate
(i) It creates situation of instability and uncertainty. Wide fluctuations in exchange rate
are possible. This hampers foreign trade and capital movements between countries.
(ii) It encourages speculation which may lead to larger uncertainties and fluctuations.
(iii) The uncertainty caused by currency fluctuations can discourage international trade
and investment.
Nominal Exchange Rate – It is defined as price of foreign currency in terms of domestic
currency.
Real Exchange Rate – It is defined as price of goods abroad relative at home.
Real Exchange Rate = Nominal exchange rate ×Foerign price level
Domestic price level
Main Sources of Demand for Foreign Exchange
(i) To purchase goods and services from other countries by the domestic residents.
(ii) To send gifts and grants to foreign countries.
(iii) To invest and purchase financial assets in some other country.
(iv) To speculate on the value of foreign currencies.
(v) To make payments of international loans.
Main Sources of Supply of Foreign Exchange
(i) Foreigner’s purchasing domestic country’s goods and services through exports.
(ii) Direct foreign investment in the domestic country.
(iii) Direct purchase of goods and services by the non-residents in the domestic market.
(iv) Speculative purchases by the non-residents in the domestic market.
(v) Remittances by the non-residents living in foreign countries.
Equilibrium Rate of Exchange

pg. 60
In the above diagram, SS is the supply of foreign currency and DD is the demand for foreign
currency. DD is negatively sloped. It indicates that quantity demanded of a currency (USD)
increases when exchange rate falls (USD becomes cheaper in relation to ₹). SS is positively
sloped. It indicates that quantity supplied (USD) increases when exchange rate rises (USD
becomes expensive in relation to ₹).
Foreign Exchange Market
It refers to the market for national currencies of different countries in the world. It is the centre
of trade for different currencies. Buyers and sellers in foreign exchange market wish to buy
foreign exchange or sell foreign exchange.
Spot Market (Current Market) – It is that market which handles only spot transaction or
current transactions. In other words, if the operation is of daily nature, it is called spot market
or current market. The exchange rate that prevails in the spot market for foreign exchange is
called spot rate. For example, if €1 can be exchanged for ₹60 at the point of time in the foreign
market, it will be called spot rate of foreign exchange.
Forward Market – It that market which handles such transaction of foreign exchange as are
meant for future delivery. Such transactions are signed today but are to materialize on some
future date. A forward contract is entered into r=two reasons (i) to minimize risk of loss due to
adverse change in exchange rate and (ii) to make a profit.
Questions for Foreign Exchange Rate 1 mark –
1. What is foreign exchange rate?
2. Define foreign exchange market.
3. Describe the equilibrium in foreign exchange market.

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