MACROECOMICS

8.INCOME DETERMINATION AND MULTIPLIER
Introduction
• The present chapter deals with determination of
equilibrium level of income and output.
• We will compare the actual situation with
desired situation of equilibrium.
• It is desired that economy should be at full
employment level of output, but actually it can
be at under employment and over full
employment also.

DETERMINATION OF EQUILIBRIUM LEVEL OF INCOME/OUTPUT/
EMPLOYMENT
• According to Keynesian theory, equilibrium is determined in terms of aggregate demand
aggregate supply. Income/output/employment are in equilibrium at that level at which
AD = AS.
AD= AS ...(1)
AD=C+l ...(2)
AS=C+S ...(3)
Therefore, S=l (Because AD = AS at equilibrium) Here,
AD = Aggregate demand C = Consumption
I = Investment
AS = Aggregate supply S = Savings

Equilibrium level of income/output/employment implies that there is no surplus or
deficiency in the economy. What is produced (AS) is demanded (AD) by the
economy. Under AD and AS approach it is assumed that
• AD is planned level of demand by various sectors of the economy.
• AS is planned level of aggregate supply. AS is amount of goods and services which producers
are planning to sell.
• Equilibrium is achieved when planned expenditure (AD) is equal to planned level of supply of
goods and services (AS) or AD = AS or C+ I = C+ S or S = I.
Hence, there are two approaches to determine equilibrium level of income / output/
employment.

Determination of Equilibrium by AD and AS
Approach
According to Keynesian theory,
• The equilibrium level of income is determined where
planned level of aggregate demand (AD) is equal to
level of aggregate supply (AS).
Since AD is aggregate expenditure on consumption (by
households) and investment (by firms) therefore AD is
represented by C+I curve (also known as C+I approach).

Y C S I AD =C+I AS=C +S
0 50 -50 100 150 0
100 100 0 100 200 100
200 150 50 100 250 200
300 200 100 100 300 300
400 250 150 100 350 400
500 300 200 100 400 500
Assumptions : The following table is based on two assumptions :
Planned level of investment = Rs100 crore (autonomous investment)
C = 50+0.5Y ; here Cbar = 50 crore and MPC(b)=0.5
Equilibrium level of Income = S = I, or AD = AS
The above table shows that economy is at equilibrium at Rs300 crore of income, as at this level.

Aggregate demand = Aggregate supply = Rs300 crore (Planned)
• Before this income level (Rs300 crore) AD>AS (planned) so, an economy will
produce further till it reaches equilibrium.
• After this income level (Rs300 crore) AS>AD, hence an economy should reduce
production till it reaches equilibrium.

Observations:
1. AD is C+1 curve as demand is for
and investment in a two sector economy.
2. AS is total amount of goods and services or
national income. Since income is consumed
and saved that is why it is shown by 45° line.
3. The above table and diagram show that
equilibrium level of income and output is
crore because at this level AD(300) = AS(300)
4. Equilibrium is determined at point E, which
corresponds to full employment equilibrium.
Accordingly, OM is equilibrium level of
income/output/employment of resources.

Adjustment Mechanism
1.If AD > AS i.e., when economy is planning to produce at OM2. It refers to excess of AD in relation
to supply. It means that buyers (consumers and firms) are planning to buy more goods and
services than what producers are planning to produce {i.e., supply). In this situation, inventory level
(stock of goods) starts falling and comes below the desired level.
2..If AD< AS, i.e., when economy is planning to produce at OM2. It means that buyers (consumers
and firms) are consuming and spending less or they are planning to buy less than what sellers are
planning to sell. This will lead to accumulation of inventories (stock of goods) with producers.

Determination of Equilibrium Through S an d I Approach
• According to this approach, the equilibrium level of
income/output/employment is determined at a point where planned or ex-
ante savings (S) are equal to planned or ex-ante investment (I).
Since AD=C+I
and AS = C+S
Therefore, if AD = AS
C+I = C+S or S = I

Assumptions : The following table is based on two assumptions :
• Planned level of investment (autonomous) = Rs100 crore
• C = 50+0.5Y ; here Cbar = Rs50 crore and MPC(b)=0.5
Table shows that
• The equilibrium level of income is Rs300 crore as at this level S = I = Rs100
crore.
• Before this income level, S < I (planned) so an economy should produce further
till it reaches equilibrium.
• After this income level, S > I, hence economy should reduce production till it
reaches equilibrium.
Y C S I AD =C+I AS=C +S
0 50 -50 100 150 0
100 100 0 100 200 100
200 150 50 100 250 200
300 200 100 100 300 300
400 250 150 100 350 400
500 300 200 100 400 500

Observations
• Part (B) of the diagram has been
derived from Part (A) or savings and
investment curves have been derived
from AD and AS curves
AD = AS (at equilibrium) or C+I = C+S or
S = I
• The saving curve slopes upwards
implying positive relation between
saving and income.
• Investment curve is parallel to X-axis because investment is autonomous (which remains same at all
levels of income).
• Equilibrium level of income/output/employment (Rs300 crore) is determined at point E2, where,
Planned savings = Planned investment (Rs100 crore)
• This corresponds to OM level of income/output/employment at full employment level.

Adjustment Mechanism
• If I > S, i.e., when economy is planning to produce at OM1. It refers to excess
of AD in relation to aggregate supply. It means that buyers plan to consume
more and save less than what producers are planning to produce (i.e., supply).
In this situation inventory level (stock of goods) starts falling and comes below
the desired level. To bring back the inventories at the desired level producers
expand production. This raises the employment level and in turn income level.
The two levels keep rising till AD = AS or S = I (equilibrium).
• If S > I, i.e., when economy is planning to produce at OM2. It means that
buyers are consuming less and saving more or they are planning to buy less
(AD) than what sellers are planning to sell (AS). This well lead to accumulation
of inventories (stock of goods), producers will reduce production. This reduces
the level of employment and in turn income level. The two levels keep falling
till AD = AS or S = I (equilibrium).

MEANING OF INVESTMENT MULTIPLIER
• Investment multiplier is the ratio of change in income to the initial change in
investment expenditure.
• Multiplier gives relation between an initial increase in investment and the
corresponding increase in income.
• In other words, change in income is a multiplier of change in investment. It
explains the number of times income increases due to an increase in
investment.
• For example, if investment increases by 4 crore and due to which income
increases by 20 crore, multiplier would symbolically be:
K = Change in Y= 20 = 5 Change in I 4

Working of Multiplier
(A).Forward Working of Multiplier
• If with increase in investment, income increases multiple times, it is
known as forward working of multiplier.
• "It refers to the actual process whereby a multiple increase in income is
brought about by increased expenditure on consumption due to new
investment".
• Multiplier works on a simple theory that more the consumption
expenditure, more will be the income generation.
• The multiplier process works on the basis :
1. Investment generates income.
2. Additional income causes a change in consumption.
3. Change in consumption depends on MPC i.e., on marginal propensity to
consume.
4. Additional consumption expenditure generates additional income for producers
of goods and services.
5. This process keeps repeating till the total increase in income equals the product
of multiplier and change in investment

Illustration. Assuming that additional investment is Rs20 crore and MPC is 0.5.
The working is as follows :
• The multiplier process keeps repeating till the additional income generated is
Rs40 crore. In the given situation,
K = 1 = 1 = 2
1 – MPC 1 – 0.5
Change in Y = Change in I x 2 = 20 x 2 = 40

Diagrammatic presentation of multiplier
The concept of investment multiplier can be explained as under :
1. Economy is at equilibrium at point E.
2. It corresponds to OM level of income at equilibrium.
3. With additional investment, A 7, equilibrium shifts to £, on ADX.
4. E1 corresponds to OM, level of income at equilibrium.
5. Equilibrium income increases from OM-OM1
6. The additional income MM1 is greater than additional investment II1 or MM1> II1 It is due
to the multiplier effect.

(B).Backward Working of Multiplier
• If with fall in investment, there is multiple times decrease in income, it is called
backward working of multiplier.
• For example, if investment decreases by Rs100 crores and multiplier is 2 then income
will finally decrease by 100x2 =7200 crores
• In the diagram AD curve and AS curve intersect at point E, hence equilibrium level of
income is OM.
• If on account of decrease in investment by Rs100 crore, AD curve shifts downward to
ADlthen equilibrium level of income decreases to OM1 i.e.,

Characteristics of Multiplier
1.Multiplier works in both the forward and backward directions.
• Forward working of multiplier shows multiple increase in income in response to
given increase in investment.
• Backward working of multiplier shows multiple decrease in income in response to
given decrease in investment.
2.There is positive relation between MPC and multiplier.
• Higher the value of MPC, higher is the value of multiplier.
• Lower the value of MPC, lower is the value of multiplier.
3.There is inverse relationship between MPS and value of the multiplier.
• Higher the value of MPS, lower is the value of multiplier.
• Lower the value of MPS, higher is the value of multiplier.

4.Aggregate demand causes the multiplier effect i.e., increase in
components of AD brings multiplier effect (Forward effect).
Components of AD
i. Increase in consumption exp.
ii. Increase in government exp.
iii. Increase in investment exp.
iv. Increase in exports.
CHAPTER OVER

9.EXCESS DEMAND AND DEFICIENT DEMAND
EQUILIBRIUM LEVEL OF EMPLOYMENT
• According to the Keynesian theory, equilibrium level of
income/output/employment can be determined at the
full employment level, under-employment level or at
over full employment level.
Possibility of Employment
• Full Employment level
• Under-Employment level
• Over Full Employment level

Full Employment Equilibrium
• Full employment equilibrium refers to a situation when the aggregate demand is equal to the
aggregate supply at full employment level, i.e., all those who are willing and able to work at
the prevailing wage rate get employment
1. AD and AS curves intersect at point £, which is full employment equilibrium because
aggregate demand EM corresponds to full employment level of output OM.
2. At OM level of output, economy is at full employment equilibrium because all those who are
willing to work at the prevailing wage rate have got employment.
3. Here, actual level of aggregate demand (EM) is equal to required level of aggregate demand
(EM) to maintain full employment
EM = EM Hence Full Employment

Over Full Employment Equilibrium
• Over employment equilibrium refers to a situation when the aggregate demand is
equal to the aggregate supply beyond the full employment level
Observations
1. Planned level of equilibrium is at point E,
where planned AD is equal to planned AS.
2. Accordingly, OM is full employment level of
output.
3. Actual level of AD (AD1) is higher than the
required level of AD (AD0).
4. Actual equilibrium is determined at point E1
which corresponds to over full employment of
resources (OM1).
5. Actual AD = FM required AD = EM Hence, there is excess demand = FM- EM = EF
6. Accordingly, OM1 is more than OM which implies over employment of resources by MM1

Under Employment Equilibrium
• Under Employment Equilibrium refers to a situation when the aggregate demand is
equal to the aggregate supply corresponding to under-employment of resources. It
occurs prior to the full employment level.
Observations
1. Planned level of equilibrium is at point E, where planned
AD is equal to planned AS.
2. Accordingly, OM is full employment level of output.
3. Actual level of AD (AD1) is lesser than the required level
of AD (AD0).
4. Actual equilibrium is determined at point E-, which
corresponds tounder employment of resources (OM2).
5. Actual AD= FM required AD= EM Hence there is
deficient demand = EM-FM= EF.
6. Accordingly, OM2 is less than OM which implies under-
employment of resources by MM2.

SCHOOLS OF THOUGHT : CLASSICAL AND KEYNESIAN
Classical Theory
The classical economists believed that full employment is a normal feature of a
capitalist economy.
The economy is always at full employment equilibrium because of two assumptions :
1. Supply creates its own demand
2. Wage rate and price of the commodity are flexible.
Keynesian Theory
Keynesian theory believes that full employment is an ideal situation, but economy can
be in equilibrium even at less than full employment level.
The economy may not always be at full employment equilibrium because of two
assumptions:
1. Demand creates its own supply
2. wage rate and price of the commodity are fixed.

MEANING OF EXCESS DEMAND/INFLATIONARY GAP
• Excess demand refers to the situation when aggregate demand is in excess of
aggregate supply corresponding to full employment in the economy i.e., AD > AS.
(Or)
• When actual level of aggregate demand is more than required/planned level of
aggregate demand to maintain full employment.
• Inflationary gap refers to the situation of excess demand. It is equal to the difference
between AD beyond full employment and AD at full employment equilibrium.

Observations:
1. In the diagram at point E, AD = AS and there is full
employment in the economy.
2. If aggregate demand rises to ADV then there is excess
demand in the economy as AD AS.
3. In AD0 is the aggregate demand at full employment
level (required).
4. AD1 is the aggregate demand at beyond full
employment level (actual), when equilibrium is at 'E1'
and MM, is over full employment of resources.
5. Point E is a point of equilibrium corresponding to full
employment of resources. Point E1 is also a point of
equilibrium but, corresponding to over full
employment of resources.
6. The difference between AD1 and AD0 is the
inflationary gap i.e., Inflationary gap = Excess
demand.(measured at full employment output)=
Actual AD - Required AD = EM- EM = EE

Causes of Excess Demand
Cause of excess demand is, increase in money supply in the economy which is
due to
• Increase in consumption expenditure.
• Increase in exports.
• Increase in investment expenditure.
• Increase in Govt, expenditure.
Impact of Excess Demand
Impact of excess demand is as follows :
1. Impact on employment. As there is full utilisation of the resources available in
the economy, thus there is full employment. Hence, excess demand does not
lead to any increase in the level of employment.
2. Impact on output. Since the resources have already been utilised to the full,
thus excess demand does not lead to any increase in the output.
3. Impact on prices. As output and employment can-not change, so ultimate
pressure is on price. Prices tend to rise as competition among buyers will push
the price up.

MEANING OF DEFICIENT DEMAND/DEFLATIONARY GAP
• Deficient demand refers to the situation when aggregate demand is short of
aggregate supply corresponding to full employment in the economy i.e., AD < AS.
(Or)
• When actual AD is less than required / planned AD to maintain full employment.
• Deflationary gap refers to the situation of deficient demand. It is the shortfall in
aggregate demand from the level required to maintain full employment equilibrium
in the economy.

Observations
1. In the diagram, the desired level of demand at full
employment level is indicated by AD0.
2. AD2 indicates deficient demand level in the economy
when equilibrium is at point E2 and MM2 is under
3. In the diagram, AD0 is the desired aggregate
demand corresponding to full employment.
4. AD2 is the actual aggregate demand corresponding
to under employment.
5.
6. Point E is a point of equilibrium corresponding to full
employment of resources. Point E2, is also a point of
equilibrium but, corresponding to under
7. The difference between AD0 and- AD2 is the
deflationary gap i.e.,
Deflationary gap = Deficient demand (measured at full employment output)
= Required AD - Actual AD = EM-FM = EF

Causes of Deficient Demand
Cause of deficient demand is, decrease in money supply in the economy which
is due to
• Decrease in consumption expenditure.
• Decrease in exports.
• Decrease in investment expenditure.
• Decrease in government expenditure.
Impact of Deficient Demand
1. Impact on employment. As the level of investment falls in an economy, the level
of employment also decreases thereby causing unemployment in the economy.
2. Impact on output. Due to fall in investment and employment in the economy,
the output also tends to fall.
3. Impact on prices. As there is excess supply in the economy, thus the prices tend
to decrease leading to deflation which causes deflationary gap.

MEANING AND PHASES OF TRADE CYCLES
• Aggregate demand should be equal to aggregate supply.
• However, in reality, aggregate demand keeps changing, causing trade cycles. Trade
cycles or business cycles refer to the fluctuations in business activity.
• Thus, trade cycles refer to the ups and downs of business activity.
• In the curve moves in a cyclical manner showing the trade cycle which has jour phases
:
1. Boom
2. Recession
3. Depression
4. Recovery

1. Boom. It is a situation when aggregate demand is maximum because of increasing
economic activity i.e., investment, employment, income and output. It causes
inflation.
2. Recession. Because of inflation, aggregate demand starts falling which reduces
investment, employment, income and output.
3. Depression. It is a stage where economic activities like income, production,
employment, output and prices fall. Profitability is low and aggregate demand is at
its lowest.
4. Recovery. In depression, the government and monetary authorities start investing
more and help economy recover from depression by raising income, employment
and thus aggregate demand.

POLICY MEASURES TO CONTROL EXCESS DEMAND AND DEFICIENT DEMAND
There are two policy measures to solve the problem of excess demand and
deficient demand.
1. Fiscal Policy measures.
2. Monetary Policy measurers.
Fiscal Policy (Fiscal Measures)
Fiscal policy refers to revenue and expenditure policy of the government. It is
also called Budgetary Policy of the government. It focuses on stability of the
economy by correcting the situations of excess demand (inflationary gap) and
deficient demand (deflationary gap).

1.Government Expenditure
• It is the principal component (or principal instrument) of fiscal policy. The government
of a country incurs various types of expenditure, mainly:
1. Expenditure on public works programmes such as the construction of roads, dams,
bridges, etc.
2. Expenditure on education and public welfare programmes.
3. Expenditure on the defence of the country and the maintenance of law & order.
4. Expenditure on various types of subsidies to the producers with a view to encourage
production.
2.Taxes
• Taxes are a compulsory payment made to government by the Household. By
increasing the tax burden on the households, the government 'educes their
disposable income. Accordingly, AD is reduced or excess demand is managed.
• On the other hand, by lowering the tax burden, die government
• increases disposable income of the households. Accordingly, AD is raised and deficient
demand is managed.

3) Public Borrowing/Public Debt
• By borrowing from the public, the government creates
public debt. In a situation of deficient demand (or
when AD needs to be increased), ne government
reduces its borrowing from the public. So that ceople
are left with greater liquidity (or cash balances) and
aggregate expenditure remains high.
4.Borrowing from RBI (the Cental Bank)
• Borrowing by the government from the RBI is another
element of fiscal policy. It is increased to fight
deflationary gap, and reduced to fight inflationary
gap. Higher borrowing releases greater liquidity in the
economy, as required to correct deflationary gap
(deficient demand).

Monetary Policy: Meaning and Its Instruments to Impact Availability of Credit
Monetary policy refers to the policy of the central bank of a country to control money
supply and credit in the economy.
Instruments of Monetary Policy
The measures of monetary policy are
1. Quantitative measures
2. Qualitative measures

1.Quantitative Measures
These measures influence the total amount of money supply in circulation. These
are :
I.Bank rate. It is the minimum rate at which the Central Bank of a country gives credit to
the commercial banks against approved securities. To control:
1. Inflation/Excess demand. Bank rate is increased,
which further increases the rate of interest (i.e., the
lending rates of commercial banks). It makes the
credit costlier, demand for credit reduces, less money
goes to the economy, purchasing power is curtailed,
AD falls and excess dd is corrected.
2. Deflation/Deficient demand. Bank rate is reduced, it
decreases the rate of interest, makes the credit
cheaper, dd for credit increases, more money flows to
the system, purchasing power increases, AD rises and
def. dd is corrected.

2.Repo rate ;-
The rate at which RBI offers short term loans to the commercial banks by buying
the government securities in the open market is called repo rate .
• Inflation/Excess demand. Repo rate is increased, which further increases the cost of capital .
It makes the credit costlier, demand for credit reduces, less money goes to the economy,
purchasing power is curtailed, AD falls and excess demand is corrected.
• Deflation/Deficient demand.Repo rate is reduced,
which further decrease the cost of capital, makes
the credit cheaper, dd for credit increases, more
money flows to the system, purchasing power
increases, AD rises and def. dd is corrected.

• Inflation/Excess demand :- Reverse Repo rate is
increased ,More funds are parked with RBI
,decreased money supply from an economy AD
falls and excess demand is corrected.
• Deflation/Deficient demand:- Reverse Repo rate is
decreased ,less funds are parked with RBI
,Increased money supply from an economy AD
rises and defient demand is corrected
3.Reverse Repo rate :-
The rate at which the RBI accept deposit from the commercial banks is
called Reverse Repo Rate . It is also called Reverse repurchase rate.

4.Open market operations.
It refers to purchase and sale of government securities in the open market (public and
commercial banks) by the Central Bank.
To control:
1. Excess demand. Government securities are sold by the
Central Bank in the open market. The Central Bank
withdraws additional purchasing power. There will be
contraction of credit, less money will flow in the system.
Purchasing power in the economy reduces. Aggregate
demand falls and excess demand stands corrected.
2. Deficient demand. By purchasing the government
securities, the Central Bank injects additional
purchasing power in the system which expands credit.
More money supply will flow in the system, purchasing
power in the economy increases. Aggregate demand
rises and deficient demand is corrected.

1.CRR (cash reserve ratio or minimum reserve ratio).
It is the minimum percentage of deposits of commercial banks (net demand and
time liabilities) which is kept with RBI.
• Excess demand. CRR is increased to control excess demand. The Central Bank withdraws
additional purchasing power. There will be contraction of credit, less money will flow in the
system, purchasing power in the economy reduces. Aggregate demand falls and excess
demand stands corrected.
• Deficient demand. CRR is decreased to control deficient demand. The Central Bank injects
additional purchasing power in the system which expands credit. More money supply will
flow in the system, purchasing power in the economy increases.

1.Excess demand.
• SLR is increased to control excess demand. The
Central Bank withdraws additional purchasing power.
• There will be contraction of credit, less money will
flow in the system, purchasing power in the
economy reduces.
• Aggregate demand falls and excess demand stands
corrected.
2.Deficient demand.
• SLR is decreased to control deficient demand.
• The Central Bank injects additional purchasing power
in the system which expands credit.
• More money supply will flow in the system,
purchasing power in the economy increases.
2.SLR (Statutory Liquidity Ratio).
It is the percentage of deposits of commercial banks which every
bank is required to maintain with itself in the form of designated liquid
assets. Liquid assets may be :
1. Excess cash reserves.
2. Unencumbered government and other approved securities.
3. Current account balances with other banks.

II.Qualitative Measures
• These measures affect allocation of credit between alternative uses.
1. Imposing margin requirement. A margin is the difference between market
value of the security offered by the borrower against the loan and the amount of
the loan granted e.g., if margin requirement is 20% then the bank is allowed to
give loan only upto 80% of the value of securities.
To control :
a) Excess demand. Margin requirement is increased to correct excess demand. The Central
Bank withdraws additional purchasing power. There will be contraction of credit, less
money will flow in the system, purchasing power in the economy reduces. Aggregate
demand falls and excess demand stands corrected.
a) Deficient demand. Margin requirement is reduced to correct deficient demand. The
Central Bank injects additional purchasing power in the system which expands credit.
More money supply will flow in the system, purchasing power in the economy
increases. Aggregate demand rises and deficient demand is corrected.

2. Moral suasion and direct action.
It is a combination of persuasion and pressure that the Central Bank applies to other banks in
order to get them fall in line with its policy. It is done through letters, speeches and hints to
the banks. Central Bank may take direct action against member banks which do not comply
with its policies of credit expansion or contraction.
3. Selective credit control. This can be applied in both a positive as well as a negative
manner.
• In a positive manner, the credit will be channelized to particular priority sectors.
• In a negative manner, the flow of credit will be restricted to particular sectors.
CHAPTER OVER

10.GOVERNMENT BUDGET AND THE ECONOMY

BUDGET: MEANING
"Budget is a statement of the estimates of the government receipts and
government expenditure during the period of the financial (fiscal) year which
runs from April 1 to March 31"
Features
 It is an estimate and not an actual
statement.
 It is prepared annually.
 It is a constitutional requirement to
present budget before parliament.
 Revenue and expenditure are planned
according to government budget.
 Budget impacts the economy
through aggregate fiscal discipline
and resource allocation.

OBJECTIVES OF A BUDGET
1. Reducing inequalities in Income and Wealth. The government uses fiscal instruments of
taxation and subsidies to improve the distribution of income and wealth in the economy.
2. Allocation of Resources. Private enterprises will always desire to allocate resources to those
area of production where profits are maximum .
3. Economic Stability. Using its revenue and expenditure policy, the government ensures
economic stability in the economy. Free interaction of market forces i.e., the forces of supply
and demand are bound to generate trade cycles, also called business cycles
4. Direct Participation and Economic Growth by Managing Public Sector Enterprises. The
government seeks to accelerate the pace of growth by establishing public sector enterprises.
5. Employment opportunities:-Bugetary policy focuses on the generation of employment
opportunities through investment in public enterprises. Budgetary provisions are made for
schemes like MGNGEGA offering employment to poorer section of the society.

There are two components of budget:
• Budget receipts. It has two parts :
1. Revenue receipts.
2. Capital receipts.
• Budget expenditure :
i. Revenue expenditure and capital expenditure.
Or
ii. Development expenditure and non-development expenditure.
Or
iii. Plan expenditure and non-plan expenditure.

MEANING OF BUDGET RECEIPTS
Budget receipts refer to estimated money receipts of the government from all
sources during the fiscal year.
It consists of:
• Revenue receipts.
• Capital receipts.
Revenue Receipts
Revenue receipts are those estimated receipts of the government during the fiscal
year which do not affect asset or liability status of the government.
These receipts :
• Do not create a corresponding liability for the government e.g., tax receipts.
• Do not lead to reduction in assets of the government e.g., fees, fines, grants etc. It
consists of :

• Tax revenue receipts. Receipts from all types of direct and indirect taxes, e.g.,
income tax, corporation tax, sales tax, excise duty etc.
• Non-tax revenue receipts. These are received from sources other than taxes, e.g.,
fees, fines, grants etc.

A Tax Receipts
• A tax is a compulsory payment made by an individual, household or a firm to the
government without anything corresponding in return.
Its main features are:
• It is a compulsory payment i.e., if tax is imposed by government on a person, he
has to pay it. It is compulsory payment.
• The revenue received through taxes is spent for public welfare.
• There is no proportionate relation between the tax and the social benefits offered
correspondingly.
• Payment of taxes is the personal responsibility of the person.
• Taxes are imposed legally i.e., according to the law of land.

• Progressive Tax: Progressive tax implies that the rate of tax increases with an
increase in income i.e., a tax which causes greater real burden on the rich
compared to the poor, e.g., income tax in India is progressive in nature.
• Regressive Tax: Regressive tax implies that the rate of tax decreases with the
increase in income i.e., tax which causes greater real burden on the poor compared
to the rich. It implies that incidence (effect) of tax decreases with increase in income,
e.g., if rate of tax is 10% for all, then a person who earns Rs 5000 per month will
have more burden than who earns Rs50,000 per month
• Value added Tax: It is an indirect tax which is imposed on "value added" at the
various stages of production. It is a tax cn value of output minus intermediate
consumption. It is imposed on each stage of production.

• Specific Tax: When a tax is levied on a commodity on the basis of its units, size or
weight, it is called the specific tax.
• Direct Taxes: Direct taxes are those taxes whose final burden falls on that person
who makes the payment to the government. Here, the incidence and impact of the
tax lie on the same person, e.g., income tax, wealth tax etc.
• Indirect Taxes: Indirect taxes are those taxes which are paid to the government by
one person but their burden is borne by another person. Here, the incidence and
impact of tax lie on different persons, e.g., sales tax, excise tax etc.

Basis Direct Tax Indirect Tax
Meaning
Direct taxes are those taxes whose final
burden falls on that person who makes the
payment to the
government.
Indirect taxes are those taxes which are
paid to the government by one person
but their burden is borne by
another person.
Incidence and
Impact of tax
When the incidence and impact of the tax
lie on the same person, it is called direct tax.
When the incidence and impact of tax lie
on different persons then it is called
indirect tax.
Shift of
taxation
The impact of direct taxation cannot be
shifted.
The impact of indirect taxation can be
shifted to others.
Nature
Direct taxes are generally progressive in
nature.
Indirect taxes are generally regressive in
nature.
Effect on market
price
These taxes do not affect the market price
of the product.
Indirect taxes have a direct and positive
effect on the market price of a product.
Examples
Income tax, wealth tax, corporation tax
etc.
Sales tax, excise duty, VAT etc.

Capital Receipts
• Capital receipts are those estimated receipts of the government during the fiscal
year which affect asset or liability status of the government.
These receipts:
• Create a corresponding liability for the government e.g., borrowings,lead to
reduction in assets of government e.g., disinvestment, recovery of loans.
Thus, it consists of:
• Borrowings from within the country and abroad.
• Other receipts like proceeds from disinvestment i.e., when the government sells off
its shares of public sector enterprises to private sector.
• Recovery of loans from state government and other debtors

Classification of Capital Receipts
1. Borrowing and other Liability
2. Recovery of loans
3. Other receipts (Disinvestment)
1.Borrowings and Other Liabilities. Borrowing creates liability for the
government. Accordingly, borrowings are to be treated as capital receipts. It is
a debt creating capital receipt. The government borrows money from :
• The general public (market borrowings).
• The Reserve Bank of India.
• The rest of the world.

2.Recovery of Loans.
• The debtors are assets for the government. Recovery of loans causes a reduction
in assets (debtors) of the government.
• Hence, recovery of loans is a capital receipt. It is a non-debt creating capital receipt.
3.Other Receipts.
• It includes proceeds from 'disinvestment'. It is the opposite of investment.
Disinvestment occurs when the government sells off its shares of public sector
enterprises to private sector. It is called privatisation.
• It is treated as capital receipt because it causes reduction in assets of the
government. It is a non-debt creating capital receipt

Basis Revenue Receipt Capital Receipt
Creation of liability
These receipts do not create any
corresponding liability for the
government, e.g., Tax receipt, licence
fees.
These receipts create corresponding
liability for the government, e.g.,
Borrowings.
Reduction in
assets
These do not cause any reduction in
assets of the government, e.g., Licence
fees, gifts and grants, fines and
penalties etc.
These cause reduction in assets of the
government, e.g., Recovery of loans,
disinvestment.
Effect on assets
and liabilities of
government
Assets and liabilities of the government
are not affected.
Assets and liabilities of the
government are affected.

Categorise: Government Receipts into Revenue Receipts and Capital Receipts
• Borrowings from ROW. It is a capital receipt as it creates liability for the government.
• Receipts from sale of shares of public sector undertakings. It is a capital receipt as
it leads to reduction in assets of the government.
• Profits of public sector undertakings. It is a revenue receipt as it neither creates a liability
nor reduces any assets of the government.
• Recovery of loans. It is a capital receipt as it leads to reduction in assets of the
government.
• Corporate tax. It is a revenue receipt as it neither creates a liability nor reduces assets of
the government.
• Sale of public undertakings. It is a capital receipt as it leads to reduction in assets of the
government.
• Dividends on investment made by the government. It is a revenue receipt as it
neither creates a liability nor reduces any assets of the government.

MEANING OF BUDGETARY EXPENDITURE
• It refers to the estimated expenditure of the government, on its 'development and
non- development programmes' or on its plan and non-plan programmes during
the fiscal year. It may be classified in three ways :
• Revenue expenditure and capital expenditure.
• Development expenditure and non-development expenditure.
• Plan expenditure and non-plan expenditure.

Revenue Expenditure and Capital Expenditure Revenue Expenditure
1.Revenue expenditure
• It refers to the estimated expenditure of the government in a fiscal year which does
not affect assets and liabilities status of the government.
• This expenditure :
• Does not create assets of the government.
• Does not cause a reduction in liabilities of the government.
• For example, old age pensions, salaries and scholarship, expenditure on
administration, defence etc.

2.Capital Expenditure
• Capital expenditure refers to the estimated expenditure of the government
in a fiscal year which affects assets and liabilities status of the government.
This expenditure :
• Creates assets of the government,
• Causes a reduction in liabilities of the government.
• For example, purchase of shares of MNCs', construction of dams and steel
plants, repayment of loans etc.

Basis Revenue Expenditure Capital Expenditure
Creation of assets
These expenditures do not create
assets for the government, e.g.,
expenditure on old age
pension,unemployment
allowance.
These create assets for the
government, e.g., expenditure on
construction of building, on
purchase
of shares etc.
Reduction in liabilities
These do not cause any reduction in
liability of the government, e.g.,
expenditure on salaries,
scholarship, subsidy etc.
These cause reduction in liability of
the government, e.g., repayment of
loans.
Effect on assets and
liabilities of
government
government are not affected.
government are affected.

Categorise: Government Expenditure into Revenue Expenditure and Capital
Expenditure
• Repayment of loans. It is a capital expenditure as it leads to reduction in liability of the
government.
• Grants given to the state government. It is revenue expenditure because it neither
creates an asset nor causes a reduction in liabilities of the government.
• Subsidies. It is a revenue expenditure as it neither creates an asset nor reduces the
liability of the government.
• Construction of hospitals. It is a capital expenditure as it leads to creation of assets of
the government.
• Payment of interest. It is a recurring expenditure, thus it is treated as revenue
expenditure as it neither creates assets nor causes a reduction in liabilities of the
government.

Development Expenditure and Non-Development Expenditure
Development Expenditure
• Development expenditure is incurred on economic and social development of the
country.
• It relates to growth and development projects of the country.
• For example, expenditure on development of agriculture, industries, transport
and communication, health, education etc.
• Non-Development Expenditure
• Non-development expenditure is the expenditure on general services of the
government which do not usually promote economic development.
• It relates to non-developmental activities of the government.
• For example, expenditure on administration, defence, justice, grants to state
government etc.

Development Expenditure Non-development Expenditu
Development expenditure directly contributes to flow
of goods and services.
Non-development expenditure
contributes to flow of goods and services.
Development expenditure is productive in nature as
it adds to the flow of goods and services.
Non-development expenditure is not pr
nature as it does not add to flow of
services directly.
Examples : Expenditure on development of
agricultural sector, industries, transport etc.
Examples : Expenditure on administration,
justice etc.

Plan Expenditure and Non-plan Expenditure
Plan Expenditure
• Plan expenditure is the expenditure to be incurred during the year in
accordance with the central plan of the country.
• It is incurred on financing the objectives of central plans of different sectors of
the economy.
• For example, planned expenditure on health, education, law and order etc.
Non-Plan Expenditure
• Non-plan expenditure refers to all such government expenditures which are
non- planned.
• It is incurred on financing those projects which are not planned in the central
plan.
• For example, expenditure as a relief to the earthquake victims, expenditures on
construction of houses demolished due to floods etc.

Plan Expenditure Non-plan Expenditure
It is within the scope of government plans. It is out of scope of government plans.
It shows expenditure to be incurred on projects
covered under the central plans.
It shows expenditure to be incurred on projects
not covered under the central plans.
Examples : Expenditure on electricity
generation, rural development, roads, bridges
etc.
Examples : Expenditure on relief to the
earthquake victims, construction of houses
demolished due to floods etc.

BUDGET DEFICIT AND ITS TYPES
• Budgetary deficit is defined as the excess of total estimated expenditure
over total estimated revenue. When the government expenditure exceeds its
revenue it incurs a budgetary deficit.Budgetary deficit can be of three types :
• Revenue deficit = Total revenue expenditure - Total revenue receipts
• Fiscal deficit = Total expenditure - Total receipts (excluding borrowings)
• Primary deficit = Fiscal deficit - Interest payments

1.Revenue Deficit
• Revenue deficit is the excess of revenue expenditure over revenue receipts.
• Revenue Deficit = Revenue expenditure - Revenue receipts RD = RE - RR, when RE >
RR
Implications
1. Because of revenue deficit, the government may have to cut its expenditure on
several welfare programmes in the country. This leads to loss of social welfare.
2. The government may have to raise funds through borrowing. This raises liabilities of
the government and lowers its credit-worthiness.
3. The government may be compelled for disinvestment—selling its ownership of
public enterprises. The ownership of public enterprises may be lost to foreign
companies. Consequently, economic control of the foreigners may increase in the
domestic economy.

2.Fiscal Deficit
Fiscal deficit is the excess of total expenditure over total receipts (other than
borrowings).Fiscal Deficit = Total expenditure (Revenue expenditure + Capital
expenditure) - Total receipts other than borrowings (Revenue receipts + Capital
receipts other than borrowings)
• FD = BE - BR other than borrowings, when BE > BR other than borrowings
Here, FD = Fiscal deficit; BE = Budget expenditure; BR= Budget receipts.) In fact,
fiscal deficit is the estimation of total borrowings by the government. It is often called
'Gross Fiscal Deficit'.
• Gross Fiscal Deficit = (i) Borrowing from RBI + (ii) Borrowing from abroad + (iii) Net
borrowing at home

Implications
• Fiscal deficit is an estimate of borrowings by the government. Greater fiscal deficit
implies greater borrowings by the government. It has following implications:
1. Inflationary Spiral: Borrowing from RBI is often linked to inflationary spiral in the
economy. This is how it happens: Borrowing from RBI increases money supply
in the economy.Increase in money supply leads to increase in the general price
level. A persistent increase in the general price level (over a period of time)
leads to inflationary spiral
2. National Debt: Fiscal deficit leads to national debt. It hinders growth. Because, a
significant percentage of national * :cme is used up to pay the past debts.
3. Vicious Circle of High Fiscal Deficit and Low GDP Growth:Constantly high
fiscal deficit leads to a situation where: (a) GDP growth remains low because of
high fiscal deficit, and (b) fiscal deficit remains high because of low GDP
growth.[High fiscal deficit —> Low GDP growth -* High fiscal deficit.]

4. Crowding-out: High fiscal deficit leads to 'Crowding-out Effect'. This is a situation
when high borrowings by the government (owing to high fiscal deficit) reduces
the availability of funds (in the money market) for the private investors.
Accordingly, overall investment in the economy is reduced.
5. Erosion of Government Credibility: High fiscal deficit (and consequently,
the mounting national debt) erodes credibility of the government in the
domestic as well as international money market. 'Credit rating' of the
government (and the economy) is lowered. Owing to lower credit rating,
global investors start withdrawing their investment from the domestic
economy.

Primary Deficit
• Primary deficit is the difference between fiscal deficit and interest payment.
• Primary Deficit = Fiscal deficit - Interest payment PD= FD - IP
• (Here, PD = Primary deficit; FD = Fiscal deficit; IP = Interest payment.) While fiscal
deficit shows borrowing requirement of the government inclusive of interest
payment on the past loans, primary deficit shows borrowing requirement of the
government exclusive of interest payment, in other words, primary deficit indicates
government borrowings on account of current year expenditures and current year
receipts of the government.
Implications
• Implications of primary deficit are similar to those of fiscal deficit. The only
difference is that primary deficit does not carry the load of interest payments, on
account of the past loans. Primary deficit just indicates borrowings when: Current
year expenditure > Current year revenue.

Fiscal Deficit Primary Deficit
It shows the total borrowing requirements of the
government, including interest payments.
It shows the total borrowing requirements of the
government, excluding interest payments.
It is the difference between total expenditure and total
receipts excluding borrowings.
It is the difference between fiscal deficit and interest
payments.
Fiscal deficit = Total estimated expenditure (-) Total
estimated receipts excluding borrowings.
Primary deficit = Fiscal deficit (-) Interest
payments.

TYPES OF BUDGET
Balanced Budget
• A balanced budget is that budget in which government receipts are equal to
government expenditure.
• Balanced budget Estimated government receipts = Estimated government
expenditure
Merits of Balanced Budget
• The government does not indulge in wasteful expenditure.
• A balanced budget implies financial stability of the economy. Demerits of Balanced
Budget
• It is not useful to solve the problem of unemployment during depression.
• Process of economic growth is very slow as less efforts are done to grow the
economy.

Unbalanced Budget
• An unbalanced budget is that budget in which receipts and expenditure of the government
are not equal. It may be
1. Surplus budget
2. Deficit budget
Surplus Budget
• It is that budget in which government receipts are greater than government expenditure.
• Surplus budget = Estimated government receipts >Estimated government expenditure
Merits of Surplus Budget
• It solves the problem of inflation or excess demand by lowering the level of AD in the
economy due to
• Huge revenue collection by the government which reduces purchasing power of the people.
• Reduced government expenditure which reduces supply of money to correct inflation.

Demerits of Surplus Budget
• During depression, a surplus budget may lower the level of AD to such an extent that
causes low level of output, low level of employment and low level of income in the
economy as government spends less and generates more revenue.

Deficit Budget
• It is that budget in which government receipts are less than government
expenditure. Deficit Budget = Estimated government receipts < Estimated
government expenditure
Merits of Deficit Budget
• It solves the problem of deflation or deficient demand. During depression, a
deficit budget raises the level of AD by : .
• Low level of revenue collection which leaves public with more purchasing power.
Demerits of Deficit Budget
• During excess demand, a deficit budget would further increase the difference
between AD and AS which would lead to inflationary gap as here government
spends more and generates less revenue.

MACROECOMICS

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