NOTES BY SUMAN (MA ECONOMICS, B.

ED PGDVES, AN AUTHOR, CONTENT WRITER

AND EX-PRINCIPAL SPS

NATIONAL INCOME & RELATED

AGGREGATES

MEANING OF CIRCULAR FLOW OF INCOME

Circular Flow of income refers to the flow of money income or the flow of goods and services across
different sectors of the economy in a circular form.
Actually, income is generated within firms and flows back to firms only in the form of revenue but in
the process all sectors get the share of the cake according to their contribution in this production and
government rules. Thus, income flows in a circular manner in an economy.
Production generates income, income gives rise to demand for goods and services and demand in turn
gives rise to expenditure. Expenditure leads to further production. The flow of production, income and
expenditure represents three related phases i.e. production, distribution and disposition. They are
interlinked in a circular flow. It is shown in the diagram below:

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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

DISTRIBUITON/
INCOME
(RENT, WAGES,
INTEREST, PROFIT)

DISPOSITION /
EXPENDITURE
PRODUCTION
(CONSUMPTION
(GOODS AND
EXPENDITURE +
SERVICES)
INVESTMENT
EXPENDITURE)

Flow vs Stock Variables

A flow variable is one that is measured over a period of time. The time period can be weekly, monthly,
yearly etc. But without time period flow variables do not make sense. For example, if a person says that
my income is Rs. 200, it does not communicate anything about his financial status. If his income is Rs.
200 Per Annum, he is below poverty line. On the other hand if it is Rs. 200 Per Hour, he is quite a rich
man. Examples of flow variables are Demand, Supply, Aggregate Demand, Savings, National Income,
Investment etc.
A stock variable is one that is measured over a point of time. For example my bank balance as on 1 July
is Rs. 20,000. Examples of stock variables are capital stock of an economy, resources available etc.
Stock and flow variables are not mutually exclusive. The change in the value of stock are brought about
by change in the flow variables. For example, increase in income (Flow Variable) will increase one’s
bank balance (Stock Variable).

Difference between stock & flow:

Basis Stock Flow
Meaning Stock refers to that variable, which Flow refers to that variable which is
is measured at a particular point of measured over a period of time.
time.
Time dimension It does not have a time dimension. It has a time dimension since its
change can be measured over a
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AND EX-PRINCIPAL SPS

period of time.
Nature It is a static concept. It is a dynamic concept.
Examples (a) Population of India as on (a) Number of births/deaths
31.3.2013 during the year 2012
(b) Water in a tank (b) Water in a stream
(c) National wealth (c) National income

Types of circular flow

1. Real Flow means the flow of factor services (from households to producers) and flow of goods
and services (from producers to households). It is also called product flow or output flow. These
are real because they consist of actual goods and services. Factor services (land, labour, capital,
enterprise) flow from households to firms which require them for producing goods & services.
Similarly, goods & services produced b firms flow from producing enterprises to households
who buy them for satisfaction of their wants. Such flows are continuous and there is no
beginning or end point in these flows.
2. Money Flow refers to the flow of factor income, viz., rent, interest, profit and wages from
producing sector to household sector and flow of consumption expenditure from household
sector to producing sector. It is also known as income flow. Factor incomes flow from firms to
households for rewards of their factor services. Similarly, households spend their incomes on
purchase of goods & services and as a result money flows back to firms.
The following diagram shows the flows. The inner two arrows indicate real flows and the outer two
arrows reflect money flow. Income flows and product flows are always equal. The circular flow in the
diagram clearly prove that income flows in the form of factor income and consumption expenditure and
product flows in the form of factor services and final goods and services are equal.

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AND EX-PRINCIPAL SPS

MODEL OF CIRCULAR FLOW OF INCOME IN A TWO

SECTOR ECONOMY
Under this model, to present the flows of income and expenditure the economy is divided into two
sectors i.e. Households sector and firm sector. It is assumed there are no savings in the economy i.e.
neither the households save from their incomes nor the firms save from their profits. It is a model of
private closed economy.
Features of household sector are:
(a) They are owners of all factors of production.
(b) The total income received is the sum of wages, rent, interest and profit.
(c) They are the consumers of goods and services.
Features of firm sector are:
(a) They hire factors of production from the household sector.
(b) They produce and sell goods & services to the households and receive income from them.
(c) They make factor payments to the household sector.
The figure shows the circular flow of income in a two sector economy. The firm sector hires factor
services from household who are the owners of factors of production for production of goods & services
and pays them remuneration in the form of incomes which is generated in the production process. Thus,
money income flows from firm sector to the households. With this money, the households purchase
from the firms, goods & services to satisfy their wants. With the result, the same money flows back form
households to the firm sector. Thus, the entire income of the economy comes back to firms in the form
of sale revenues.

Injections and Leakages

Injection is an addition to the circular flow of income. It increases the size of circular flow. These are:
Investment, Exports, Consumption expenditure by the households or government.
Leakages are withdrawals from a circular flow of income. It reduces the size of circular flow. These are:
Savings, Imports, taxes by government.
For stability in the circular flow of income,
Leakages = Injections

ECONOMIC ACTIVITIES
An activity done with a view to earning money or related with spending of money is called economic
activity. All economic activities are broadly classified into Production, consumption and capital
formation.
(a) Production: Production is the process of converting inputs into output. In other words, production
means addition in utility of something.
(b) Consumption: Consumption is defined as the process of utilizing goods and services to satisfy
human wants.
(c) Capital Formation / Investment: Capital formation is defined as the increase in an economy’s
stock of capital goods in a given period of time. Capital goods are the goods which help in the
production of other goods.

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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

SECTORS OF AN ECONOMY
A modern economy can be categorized into four sectors
(a) Households: Households is the sector that owns factors of production. It supplies these factors of
production to the firms who pay for them in return. Consumption is the primary activity undertaken
by households.
(b) Firms: Firms is the sector that hires factors of production to produce goods and services in an
economy. Thus, production is the primary activity of the firms.
(c) Government: The government is the sector that receives taxes from both households and firms. It
also gives subsidies and provides administrative services.
(d) Rest of the world: When the domestic sector of an economy buys goods and services from other
countries, it is called imports. When the domestic sector sells goods and services to the external
economy, it is termed as exports.

CONCEPT OF ECONOMIC TERRITORY / DOMESTIC

TERRITORY
According to United Nations, ‘Economic Territory is the geographical area administered by a
government within which persons, goods and capital circulate freely.’
Since government does not enjoy such freedom in the embassies even if these are located within
political boundaries of a country, these are not included in economic territory of a country.
Based on freedom criterion, Economic territory includes:
1. Political frontiers including territorial waters and air space.
2. Embassies, consulates, military bases, etc. located abroad, but excluding those located within its
own political frontiers. For example: Indian Embassy in USA is a part of domestic territory of
India but Japanese Embassy in India is a part of domestic territory of Japan and not of India.
3. Ships, aircrafts, etc. owned and operated by the normal residents between two or more countries.
For example: planes operated by Air India between Russia and Japan are part of domestic
territory of India.
4. Fishing vessels, oil and natural gas rigs, etc. operated by the residents in the international waters
or engaged in extraction in those areas, where the country enjoys the exclusive rights of
operation.

Relation between National Income and Domestic Income

National product = Domestic product + residents’ contribution to output outside the economic territory –
Non residents’ contribution to output inside the domestic territory. Or
National product = Domestic Product + Factor income received from abroad – Factor income paid
abroad. or
National product = Domestic Product + Nat factor income from Abroad

CONCEPT OF RESIDENT
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AND EX-PRINCIPAL SPS

A resident, whether a person or an institution is one who ordinarily resides in a country for a period of
more than one year and whose centre of economic interest also lies in that country. The `Centre of
economic interest’ implies two things:
1) the resident lives within the economic territory;
2) the resident carries out the basic function of earnings, spending and saving/investment from that
location.
Following are not included under the category of normal residents:
(a) Foreign tourists & visitors who visit a country for recreation, holidays, study, sports etc.
(b) Foreign staff of embassies, officials, diplomats and members of armed forces of a foreign
country located in the given country.
(c) International organizations like UNO, WHO etc. are not the normal residents of the country in
which they operate. They belong to international area.
(d) Employees of international organizations are considered as residents of the countries to which
they belong.
(e) Crew members of foreign vessels, commercial travelers and seasonal workers provided their stay
is less than one year.
(f) Border workers who live near the international border and cross the border on a regular basis to
work in the other country.
IMPLICATION: National product includes production activities of residents irrespective of whether
they are performed within the domestic territory or outside it.

FACTOR PAYMENT vs. TRANSFER PAYMENT

Factor payment Transfer payment
It is the payment for rendering factor services. It is a payment without getting any goods or
services in return.
Examples: Rent, Interest, Wages etc. Example: Old age pension, pocket money,
donations, unemployment allowance etc.
Factor income of normal residents of a country is It is not included in national income as it does
included in national income. not reflect any production of goods and
services.
It is an earning concept. It is a receipt concept.
It is received by factors of production./ It is received by households & government.
IMPLICATION: Only factor payments are to be included in national income.
Note: Transfer payments are of two types:
(a) Current transfer: It is made out of current income of the payer and added to the current income
of the recipient. These are regular in nature. These are meant for consumption purposes. For
example: tax, donations, scholarships, old age pensions etc.
(b) Capital transfer: It is made out of wealth or capital of the payer and added to the wealth or
capital of the recipient. These are irregular in nature. These are meant for capital formation. For
example: international grants, war damages, payment of taxes on capital & wealth etc.

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AND EX-PRINCIPAL SPS

INTERMEDIATE GOODS vs. FINAL GOODS

Intermediate goods: These refer to those goods which are used either for resale or for further
production in the same year. For example: milk used in dairy shop, coal used in factory. These are
generally purchased by one production unit from other production unit. Generally, intermediate goods
lose their identity when they undergo production process.
Final goods: These refer to those goods which are used either for consumption or for investment. All
the goods purchased by consumer households are final goods as they are meant for final consumption.
Goods purchased by firms are final goods if they are purchased for capital formation / investment. These
are neither resold nor used for any further transformation in the process of production.

Intermediate goods Final goods

These are the goods & services which are These are the goods & services which are
purchased by one production unit from purchased for consumption (by consumers
another production unit for further for satisfaction of wants) and investment
production or resale. (by producers for their own use).
Value of intermediate goods in not Value of Final goods in included in
included in national income. national income.
Example: Sugar being used in a bakery Example: Sugar being used in a family
They are not ready for use i.e. some value They are ready for use by final users i.e. no
is needed to be added before use. value is added.

IMPLICATION: Only final goods are included in national income otherwise it will lead to the problem
of Double Counting.

CONSUMER GOODS/CONSUMPTION GOODS vs.

CAPITAL GOODS
Consumption goods: They refer to those goods which satisfy the wants of consumers directly. For
example: bread, butter, pens, clothes etc. they can be further divided into:
1. Durable goods: These can be used again and again for consumption for a long period of time like
television, refrigerators etc.
2. Semi-durable goods: These can be used for a limited period of time around one year. For
example: clothes, shoes, crockery etc.
3. Non-durable goods: These are used in a single act of consumption. For example: milk, fruits,
food grains etc.

Capital goods: These are those goods which help in production of other goods and services like
machinery, equipments etc.

Consumer goods Capital Goods

These are the goods which are bought by These are the goods which are used up in
consumers for the satisfaction of their the production process or form the capital

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AND EX-PRINCIPAL SPS

wants. stock of the country at the end of the year.

These are meant for the satisfaction of These are meant for the satisfaction of
present wants. future wants.
They do not promote production capacity. They help in raising production capacity.
They have a limited expected life except They generally have an expected life of
durable goods. more than one year.
Examples: Examples:
Cars, television, crockery, utensils, fruits, Machinery, plant, equipments etc.
oil, milk, services of doctor, teacher etc.

DEPRECIATION
It is the fall in price/value of an asset due to wear and tear. Obsolesce is fall in value due to change in
technology; depreciation is fall in value due to usage. It is also known as ‘consumption of fixed
capital’. If the value of an asset falls due to unforeseen obsolescence or natural calamities like floods,
earthquakes etc., it is called ‘capital losses and not depreciation.

NET INDIRECT TAXES (NIT)

It is the difference between Indirect taxes and Subsidies.
Net Indirect Tax = Indirect taxes – Subsidies
Indirect taxes are the taxes which are levied on the production and sale of goods and services and the
burden of which can be transferred. For example: sales tax, excise duty, custom duty etc. they increase
the price of a product in the market.
Subsidies are the financial assistance given by the government to producers with an objective of keeping
the price of a commodity below its factor cost. For example: subsidy given on LPG cylinder. They
reduce the market price of the commodity.
Implication: The concept of NIT is used to differentiate between factor cost and market price.
Factor Cost VS Market Price
Factor cost: It refers to the amount paid to factors of production for their contribution in the production
process.
Market price: It refers to the price at which product is actually sold in the market.
Market price = Factor cost + Indirect taxes – Subsidies or
Market price = Factor cost + NIT

NET FACTOR INCOME FROM ABROAD

NFIFA is the difference between the income received from abroad by the residents of a country for
rendering factor services and factor income paid to the residents of other countries. NFIA belongs to the
private sector. Public sector does not earn any income in the form of NFIA. Any income earned by
government employees from abroad is paid by the government itself. For example, Indian employee
working in Indian embassy in US will get salary from the Indian government.

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AND EX-PRINCIPAL SPS

NFIA = Factor income received from abroad by normal residents – Factor income paid abroad to
non-residents
IMPLICATION: Production activity within the economic /domestic territory is called domestic
income. Income that the residents of a country are getting from outside the economic territory is called
factor income from abroad; similarly income which residents of other country get from our economic
territory is called factor income paid abroad. The difference between the two is called, Net Factor
Income from Abroad. When NFIA is added to domestic income, we get national income.
The three main components of NFIFA are:
1. Net compensation of employees: It is the difference between compensation of employees
received by resident workers that are living temporarily abroad or are employed abroad and
similar payments made to non-resident workers that are temporarily staying or employed within
the domestic territory of a country.
2. Net Income from Property and Entrepreneurship: It refers to the difference between income
from property & entrepreneurship in the form of rent, interest and profit received by residents of
the country and similar payments make to the rest of the world.
3. Net Retained Earnings of resident companies abroad: It refers to the difference between
retained earnings of the resident companies located abroad and retained earnings of non-resident
companies located within the domestic territory of the country.

NATIONAL INCOME AGGREGATES

National income is defined as the money value of all final goods and services produced within the
domestic territory of a country in an accounting year plus net factor income from abroad. Or
National income is the factor income earned by the normal residents of a country in an accounting year
or
National income is the total expenditure incurred on purchase of final goods and services in an
accounting year.
National income has various dimensions. Each dimension expresses national income differently
depending upon whether national income is being calculated at market price/factor price; whether it
includes depreciation or not; whether it is domestic/ national.
Each of these is explained below:
1. Gross Domestic Product at Market Price (GDPmp): It is the gross market value of final
goods and services, inclusive of depreciation and net indirect taxes produced in an accounting
year within the domestic territory of a country.
2. Net Domestic Product at Market Price (NDPmp): It is the market value of final goods and
services, exclusive of depreciation produced in an accounting year within the domestic territory
of a country.
NDPmp = GDPmp – Depreciation Or
GDPmp = NDPmp + Depreciation
3. Gross Domestic Product at Factor Cost (GDPfc): It is the gross market value of final goods
and services, inclusive of depreciation produced in an accounting year within the domestic
territory of a country.
GDPfc = GDPmp – Net indirect taxes (indirect taxes – subsidies) or
GDPfc = NDPmp + Depreciation – NIT (indirect taxes – subsidies)
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AND EX-PRINCIPAL SPS

4. Net Domestic Product at Factor Cost (NDPfc): It is the sum of net value added by all the
producers exclusive of depreciation in an accounting year within the domestic territory of a
country. It is the domestic income.
NDPfc = NDPmp – Net indirect taxes (indirect taxes – subsidies) or
NDPfc = GDPmp - Depreciation – NIT (indirect taxes – subsidies)
5. Gross National Product at Market Price (GNPmp): It is the market value of final goods and
services, inclusive of depreciation produced in an accounting year within the domestic territory
of a country plus Net Factor Income from Abroad.
GNPmp = GDPmp + NFIA or
GNPmp = GDPfc + NFIA + NIT
6. Net National Product at Market Price (NNPmp): It is the market value of final goods and
services, exclusive of depreciation produced in an accounting year within the domestic territory
of a country plus Net Factor Income from Abroad.
NNPmp = NDPmp + NFIFA or
NNPmp = GDPfc + NFIFA + NIT -Depreciation
7. Net National Product at Factor Cost (NNPfc) or National Income: It is the sum of net value
added by all the producers exclusive of depreciation in an accounting year within the domestic
territory of a country plus NFIA. It is the national income.
NNPfc = NDPmp – Net indirect taxes (indirect taxes – subsidies) + NFIA or
NNPfc = GDPmp - Depreciation – NIT (indirect taxes – subsidies) + NFIA
8. Gross National Product at Factor Cost (GNPfc): It is the sum of net value added by all the
producers inclusive of depreciation in an accounting year within the domestic territory of a
country plus NFIA.
GNPfc = GNPmp – Net indirect taxes (indirect taxes – subsidies) or
GNPfc = GDPmp + NFIFA – NIT (indirect taxes – subsidies)
NOTE: Basis of difference between gross and net is DEPRECIATION.
Basis of difference between Domestic and national is NET FACTOR INCOME FROM ABROAD
Basis of difference between Market price and Factor cost is NET INDIRECT TAXES (IT-
SUBSIDIES)

METHODS OF MEASURING NATIONAL INCOME

There are three methods of measuring national income:
1. Income Method
2. Value Added or Production Method
3. Expenditure Method
The three methods give three different angles of looking at the income flow based on different types of
data. Income method measures relative contribution of factor owners. Value added method measures
contribution of production units to total output of a economy. Expenditure method measures the relative
flow of consumption and investment expenditures. National is identical by all the three methods.
National Product≡ National Income≡ National Expenditure

INCOME METHOD

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AND EX-PRINCIPAL SPS

According to this method, NI is measured in terms of payments made to primary factors of production.
All the incomes that accrue to the factors of production by way of wages, profits, rent, interest etc. are
added to obtain the national income. Income method is also called factor payment method or distribution
method. According to Income method, national income is calculated by adding:
1. Compensation of Employees
2. Operating Surplus
3. Mixed income of self employed
4. Net Factor Income from Abroad
NNPfc = 1 + 2 + 3 + 4

Compensation of employees:
It includes:
1. Wages in cash (Basic Salary, Dearness Allowance, House Rent Allowance, Bonus, Conveyance
Allowance, Commission, Overtime Allowance, Medical Allowance etc.)
2. Wages in Kind (Free food, Free uniform, Free accommodation, Free Education, Interest free
loans, Free conveyance etc.)
3. Employers’ contribution to Social security benefits such as Provident Fund (PF), Pension, Life
insurance etc.
It does not include:
Traveling Allowance, Employees’ contribution to Social Security benefits.

Operating Surplus:
It is income from property (Rent, Royalty, and Interest) and entrepreneurship (Profit = Dividend +
Corporation tax + Undistributed profits/Retained Earnings).
 Rent: Amount payable in cash or in kind for the use of land for production. It includes both actual as
well as imputed rent of self-occupied properties.
 Royalty: Amount payable for granting the leasing rights of subsoil assets only. For example: owners
of mineral deposits like coal, iron ore, natural gas etc. can earn income by giving rights of mining to
contractors.
 Interest: Amount payable by a production unit for the use of money borrowed. Interest income
includes interest on loans taken for productive services only. It includes both actual as well as
imputed interest.
Interest income does not include
 Interest paid by govt. on public debt and interest paid by consumers as such interest is paid
on loans taken for consumption purposes.
 Interest paid by one firm to another firm as it is already included in their profits.
 Profit: Amount payable to the owner of production unit for his entrepreneurial abilities. It is used
for three purposes:
 Corporate tax
 Dividend
 Undistributed profit

Mixed Income of self employed:

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AND EX-PRINCIPAL SPS

It is mixed in the sense that it is not possible to classify it into rent, wages, profit or interest. It is
generated by own-account workers and unincorporated enterprises. It arises in the case of enterprises
like sole proprietorship, small partnership, farmers, barbers etc.

NDPfc

Compensation of Mixed income of self

Operating Surplus
employees employed

Rent & Royalty Interest Profit

Precautions Involved In Estimating National Income by Income

Method:
1. Transfer payments are not to be included in national income.
2. Income through illegal activities is not to be included.
3. Income from the sale of Second Hand Goods is not to be included.
4. Corporation tax is a part of profit hence if profit is given; it is not to be included separately.
5. Sale of shares or securities is not to be included as there is no corresponding production of goods
and services. But commission paid to the broker is to be included.
6. Windfall gains are unearned income, hence not included in national income.
7. Goods produced for self consumption are included but services produced for self consumption
are not included.
8. Rent of owner occupied building is to be calculated on market price and is to be included.
9. Death duties, Wealth Tax, Gift tax etc. are paid out of past savings, hence not to be included in
national income.

VALUE ADDED METHOD OR PRODUCTION OR

OUTPUT METHOD

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AND EX-PRINCIPAL SPS

It is a method which measures national income by estimating the contribution of each enterprise to the
production in the domestic territory of the country plus NFIA. This method is used to measure national
income in different phases of production in circular flow. It shows the contribution i.e. value added of
each producing unit in the production process. In the computation of NI, value added by different
enterprises is included and value of output is not included.
(a) Value of output: it refers to market value of all goods & services produced during a year. It
includes NIT as it is calculated at the market price. Value of output can be measured in the
following ways:
Value of output = Sales, if the entire output of the year is sold
Value of output = sales + change in stock
Where, Change in stock = Closing stock – Opening stock
(b) Value added: It refers to the addition of value to the raw material or intermediate goods by a
firm through its productive activities.
Value Added = Value of Output – Intermediate consumption

GDPmp or GVAmp = Value of Output – intermediate consumption

National Income or NNPfc = GDPmp – depreciation – NIT + NFIA

Precautions Involved In Estimating National Income by Product

Method:
1. The value of intermediate goods is not to be included as it will lead to double counting.
2. Leisure time/voluntary activities are not to be included as these are non economic activities.
3. Sales include exports also unless expressed otherwise.
4. Purchases include imports also unless expressed otherwise.
5. Sale & purchase of second hand goods is not included but commission or brokerage paid for that
is included.
6. Value of goods retained for self consumption is included in NI.

EXPENDITURE METHOD
It is a method which measures the final expenditure on purchase of new goods and services at market
price in an accounting year. This total final expenditure is equal to gross domestic product at market
price. It measures national income as the sum of final expenditures incurred by households, business
firms, foreigners and government.
According to expenditure method, GDPmp is the aggregate of all the final expenditure in an economy in
a year, i.e.
Y = C + I + G + (X- M)
Where,
 Y is national income
 C = Private Final Consumption Expenditure: It includes final consumption expenditure of
households, and private non-profit institutions serving households on goods & services.
 I = Final investment expenditure or Gross Domestic Capital formation: It includes two
components:
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AND EX-PRINCIPAL SPS

1. Gross domestic fixed capital formation: it refers to purchase of fixed assets. It involves:
(a) Business Fixed Investment i.e. expenditure on purchase of new plants, machinery etc.
(b) Residential Investment by households like purchase of new house, major repairs or
alterations of old buildings.
(c) Government Fixed Investment i.e. expenditure on construction of flyovers, roads, bridge
etc.
2. Inventory Investment i.e. change in stock

 G = Government Final Consumption Expenditure: Total expenditure incurred by the government

for producing various services to satisfy collective wants like compensation paid to employees,
goods & services purchased from domestic markets etc. It includes:
(a) compensation of employees paid by the government
(b) goods & services purchased by the government from domestic market for intermediate
consumption.
(c) Purchases from abroad
 X – M is net exports i.e. exports minus imports

Precautions Involved In Estimating National Income by Expenditure

Method:
1. Financial investment i.e. expenditure on purchase of shares and debentures is not included
because it is not a production activity as financial assets are neither good nor services.
2. Expenditure on purchase of second hand goods is not included.
3. Expenditure on transfer payments is not included.
4. Only final expenditure is included & intermediate expenditure is not included.

GDPmp

Private final Government final Gross Domestic

consumption consumption Net Exports
capital formation
expenditure expenditure

Gross Fixed
capital Formation Change in stock

NNPfc = GDPmp – depreciation – NIT + NFIA

14
By: SUMAN MA (ECO) , B.ED PG DIPLOMA IN VALUE EDUCATION AND SPIRITUALITY
NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

REAL AND NOMINAL GDP/NATIONAL INCOME

Real NI is defined as the value of current output at some base year prices. It is obtained by multiplying
the goods and services produced in the current year with the prices prevailing in the base or constant
year. The base year in India is 2004-05. This estimate is a reliable index of economic growth of a
country. NI at constant prices will increase only when there is rise in output of goods and services in
country during the year.
Nominal NI is defined as the value of current output at current year prices. It is a poor index to measure
the economic growth of a country. It is obtained by multiplying the goods & services produced in the
current year with the prices prevailing in the current year. It gives only the money value of national
income. If the output of final goods & services produced in the current year remains the same and
current prices rise, then NI at current prices will increase. But it is important to note that rise in national
income only in monetary sense does not imply economic growth of an economy.
Real NI or GDP = Nominal GDP/NI at current prices x Base year Price Index i.e. 100
Price index of current year

GDP AND WELFARE

When an economy experiences an increase in national income in real terms, it is said that economic
growth has taken place. When an economy experiences rise in welfare it implies social growth. The term
welfare can be categorized into economic welfare and social welfare. If welfare is affected only by
economic factors then it is economic welfare but when welfare is affected by economic as well as non-
economic factors then it is called as social welfare. It means that social welfare means the total welfare
of the society as a whole. Environmental pollution, land degradation, law & order situation etc. comes
under non-economic factors. GDP at best can indicate economic welfare. For example, industrial growth
increases GDP and consequently the economic welfare. But industrial growth may also lead to increase
in pollution and consequently decrease the welfare.
Hence it can be concluded that per capital real GDP is not an adequate indicator of economic welfare
due to the following reasons:
1. Composition of GDP: Composition of GDP may not be welfare oriented even when the level of
GDP tends to rise. If the product mix has more of explosives, guns, bombs then destruction will
increase and welfare will reduce. Similarly it is also possible that there is increase in national
income because of an increase in the production of goods which are socially undesirable like
drugs. This will, surely not enhance economic welfare of the people. Therefore economic welfare
depends not only on the volume of goods but also on the type of goods and services.
2. Non-Monetary exchange: In national income only those transactions are recorded which are
monetary in nature. There are many goods and services which are not included in the estimation
of NI because of their non-monetary nature. Non-monetary transactions are quite evident in rural
areas where payments for farm labour are often made in kind rather than cash. There are other
examples also like services of housewives, family members etc. which are not included. To this
extent, GDP remains underestimated and therefore not a proper index of welfare.
3. Externalities: It refers to good & bad impact of an activity without paying the price or penalty
for that. For example: Positive externalities occur when a beautiful garden maintained by Mr. X

15
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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

raises the welfare of Mr. Y even when Mr. Y is not paying for it. So there is no valuation of it in
our estimation of GDP. Negative Externalities occur when smoke omitted by factories cause air
pollution. But nobody is penalized for it and there is no valuation of it in GDP. There is either
underestimation or overestimation of welfare.
4. Distribution of GDP: High NI of a country may be due to large contributions made by a few
industrialists. Due to this these exceptional few enjoy a high standard of living. In other words, it
can be said that there is unequal distribution of income. The gulf between haves and have-nots
may increase in which situation the bulk of population may have even lesser goods than before
even when the overall level of GDP has tended to raise. India is facing almost a similar situation
at present.

Some of the major items whether included or excluded in national income are as follows:

1. Construction of a new house.

Yes, it will be included in the national income as it is a part of capital formation and leads to production
of goods and services in the economy.
2. Winning of a lottery prize.
No, it will not be included in the national income as it does not add to the flow of goods and services
3. Increase in the prices of stocks lying with a trader.
No, it will not be included in the national income as it does not amount to any flow of goods.
4. National debt interest.
or
Interest on public debt.
No, it is not included in the national income as it is the interest paid on loans taken by government to
meet its consumption purposes.
5. Rent-free house given to an employee by an employer.
Yes, it is included in the national income by Income Method since it is a part of ‘wages in kind’ paid to
employees.
6. Profit earned by foreign banks in India.
No, it is not included in the national income as it is a part of the factor income paid abroad. It is
subtracted from domestic income to get national income.
7. Purchases by foreign tourists.
Food purchased by a foreign tourist at a hotel in New Delhi.
Yes, purchases by foreign tourists are ‘exports’ and, therefore, they are included in the national income
through the Expenditure Method.
8. Rent received by Indian residents on their buildings rented out to foreigners in India.
Yes, it will be included in the national income as it is a part of the factor income from abroad.
9. Payment of fees to a lawyer engaged by a firm.
It is an intermediate expenditure for the firm because it involves purchase of services by one production
unit (firm) from another production unit (lawyer). So, it is deducted from the value of output of the firm
to arrive at the value added. So, it is not included in national income.
10. Free medical facilities by the employer.
Free boarding and lodging provided to a domestic servant.
Yes. It will be included in national income as these free services are part of compensation to employees.
11. Gifts received from abroad.
Gift received from employer.
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By: SUMAN MA (ECO) , B.ED PG DIPLOMA IN VALUE EDUCATION AND SPIRITUALITY
NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

National income as gifts received are transfer incomes.

12. Profits of Reliance Industries from its chemicals business in Australia.
Yes, it will be included in the national income as it is a part of the factor income from abroad.
13. Salaries received by Indian residents working in Russian Embassy in India.
Yes, it will be included in the national income as it is a pan of factor income from abroad.
14. Subsidized lunch served to workers in a factory.
Firm incurred expenditure on medical treatment of employee’s family.
Yes, it is a part of the compensation of employees and, therefore, it will be included in the national
income
15. Old age pension
No, it will not be included in the national income as it is a transfer payment made by the government
and a transfer income for the receiver.
Old age pension must not be confused with retirement pension. Old age pension is not included in
national income as it is a transfer payment. On the other hand, retirement pension is included in national
income as it is a part of COE.
16. Durable goods purchased by a household.
Purchase of car by a household.
Yes, it will be included in the national income as it is a part of the private final consumption
expenditure.
17. Profits earned by an Indian bank from its branches abroad.
Yes, they will be included in the national income as they are a part of the factor income from abroad.
18. Earnings of shareholders from the sale of shares.
No, it will not be included in the national income as it is a financial claim and does not contribute to any
productive activity.
19. Expenditure on advertisement by a firm.
No, it will not be included in the national income as it is a part of intermediate consumption expenditure.
20. Commodities used in scientific research.
No, it will not be included in the national income as it is a part of intermediate consumption expenditure.
21. Petrol used in police vehicles.
No, it will not be included in national income as petrol is an intermediate good in this case. It is used for
the provision of the final product

Items Domestic income National Income

Salaries of Indians working in US Not included Included

embassy

Salaries of Americans working in Included Not included

Indian Embassy

Profits of SBI in Singapore Not included Included

17
By: SUMAN MA (ECO) , B.ED PG DIPLOMA IN VALUE EDUCATION AND SPIRITUALITY
NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

Profits of Citi Bank in India Included Not included

Priyanka Chopra got income Not included Included

from acting in a Hollywood
Movie

Profits of a Japanese MNC from Included Not included

its office in India

Conclusion Includes FITA excludes FIFA Excludes FITA includes FIFA

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By: SUMAN MA (ECO) , B.ED PG DIPLOMA IN VALUE EDUCATION AND SPIRITUALITY
NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

MONEY AND BANKING

BARTER SYSTEM
When wants were not so multiple, goods were exchanged for goods. Exchange is a sign of
interdependence. Barter system of exchange is a system in which goods are exchanged for goods.
For example: In a village community, a cobbler would make shoes in return for wheat from the farmer; a
farm worker would get grains as a reward for his labour and so on. But with the multiplicity of wants
and greater need for exchange, barter system proved to be inefficient system of exchange. Following are
the drawbacks of barter system:
1. Lack of double coincidence of wants: Double coincidence of wants implies that goods in
possession of two different individuals must be useful and needed by each other. But it is a rare
occurrence. It is difficult to find a person who wants your horse and at the same time possess a
cow that you want to buy. Accordingly, under the barter system, exchange remained extremely
limited.
2. Lack of a common unit of value: Under barter system, the price of each commodity would have
to be defined in terms of other commodities. For example: if somebody asks, “What is the value
of your car”? I can answer Rs.5 lakhs or so, but the same answer is not possible under barter
system. Under such a system, my car would be valued in terms of wheat, horses, vegetables,
furniture etc. simply because there is no money. It limits the amount of trade.
3. Lack of standard of future/deferred payments: With commodity exchange it is not possible to
have a satisfactory unit of future payments like salaries, interest, loan etc. It causes the problem
of choice of goods, or the composition of goods to be delivered in the future.
4. Lack of a store of value: Due to lack of money in a barter economy, wealth is stored in terms of
goods. But it is subject to some problems such as cost of storage, loss of value, difficulty in
quick disposition without loss. It is difficult to store potatoes, tomatoes, grains etc. So in case of
commodities it is difficult for people to store their purchasing power.

MONEY
Money finds its origin in the need to facilitate exchange. Therefore money is generally defined as a thing
that is commonly accepted as a medium of exchange.
Definition of money: According to Fisher,` Money is what money does.’ In the words of Crowther,
Money can be defined as anything which is generally acceptable as a means of exchange and also acts as
a measure and store of value. Money is a function of four; medium, standard, unit and store. Money
is anything which performs following four functions:
1. Medium Of Exchange
2. General Acceptability I.E. Standard Of Deferred Payments
3. Store Of Value

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By: SUMAN MA (ECO) , B.ED PG DIPLOMA IN VALUE EDUCATION AND SPIRITUALITY
NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

4. Unit Of Value

Functions of money:
1. Medium of Exchange: Money acts as a medium of exchange. It means that money acts as an
intermediary for the goods & services in an exchange transaction. In the absence of money,
Barter system used to prevail (exchange of goods for goods). Its major drawback was lack of
double co-incidence of wants. Without money our complicated economic system based on
specialization would have been impossible.
2. A Store of Value: Individuals try to save a part of their income for their future needs. This is
called store of value. It was not possible under barter system as many goods and all services
can’t be stored for future use. Money allows us to store purchasing power, through which we can
exercise our claim on goods and services in the future.
3. A Unit of Account: Unit of account means that the value of each good or service is measured in
the monetary unit. Money works as a common denominator into which the value of all goods and
services is expressed. Money can be used purely for accounting purpose without any physical
existence. Each and every thing needs a unit to be measured. Money acts as a measure of value.
Value of all goods and services can be determined in terms of money.
4. A standard of deferred payments: It means a payment to be made in future can be
denominated in terms of money in just the same way as can a payment to be made today. Here,
money is acting as a unit of account with added dimension of time. Credit has become the life
and blood of a modern economy. The debtors make a promise that they will make payment on
some future date. In those situations money acts as a standard of deferred payments.

MONEY SUPPLY
Supply of money is a stock concept. It refers to the stock of money held by the public at a point of time
in an economy. The money supply of an economy at any point of time is the total amount of money in
circulation.
Supply of money does not include:
(a) stock of money held by the government; and
(b) Stock of money held by the banking system (i.e. both commercial and central bank) of a country.

Components of money supply

1. Currency with the public: It includes coins and paper notes held by the public. Currency is also
known as fiat money. Fiat Money or Currency is defined as the money which under law must be
accepted for all debts. Here also only currency held by the public is included.
2. Demand deposits: These are the money deposits made by the depositor or owner of the deposit
to the bank. Now bank is agreed to honour such demands or pay money on demand at any time
and to whomsoever the owner of the deposit may wish. For this purpose people use cheques.

Money Stock in India: In 1977 the RBI classified money stock in India into the following four
categories.
M1 = C + DD + OD
C = Currency i.e. coins and paper notes;
DD = Demand deposits with the banks;
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By: SUMAN MA (ECO) , B.ED PG DIPLOMA IN VALUE EDUCATION AND SPIRITUALITY
NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

OD = Other deposits of financial institutions, foreign central banks, foreign government with RBI
It is known as NARROW MONEY.

M2 = M1+ Post office savings deposits

M3 = M1 + Net Time deposits of the public with banks
It is called BROAD MONEY.
M4 = M3 + total post office deposits (other than NSC)

The basic distinction between narrow and broad money is that narrow money does not include time
deposits with the banks however broad money includes it.
In the present context, money stock in India refers to M3 only.
The RBI has redefined its parameters for measuring money supply:
M1 = Currency + Demand deposits + other deposits with the RBI
M2 = M1 + Time liabilities portion of saving deposits with banks + certificates of deposits issued by
banks + term deposits maturing within a year excluding FCNR(B) Deposits.
M3 = M2 + term deposits with banks maturing over one year + Call/term borrowings of the banking
system.
M4 has been excluded from the scheme of monetary aggregates.

MEANING OF COMMERCIAL BANKS

Commercial bank can be defined as a financial institution that accepts the deposits from the general
public for the purpose of lending and investing, repayable on demand or otherwise and withdrawable by
cheque, draft, and order or otherwise. Though accepting deposits for the purpose of lending constitute
the main function of banks but it performs many other functions. There are other financial institutions
also like LIC, UTI, IDBI etc. but these are not banks because they lend but do not accept chequable
deposits. Another important point about bank is that they have the capacity to add to the total money
supply of an economy by means of credit creation. Bank’s demand deposits are a part of money supply.
Therefore two characteristics are important to call a financial institution a bank:
1. Bank deposits are chequable
2. Bank create money

Functions of commercial banks:

1) Acceptance of deposits: Banks may accept deposits in the form of demand deposits or time
deposits. Deposits which are withdrawable on demand are called demand deposits. It includes
current deposits and saving deposits. The deposits which can be withdrawn only after expiry of a
fixed time period are called time deposits. Lower interest is paid on saving deposits, higher interest
is paid on time deposits and no interest is paid on current deposits.
2) Lending of loans: Through this function banks acts as a mediator between those who want to save
and those who wish to invest and thereby promotes the rate of capital formation. Banks extend loans
in the form of
a) Cash credit
b) Overdrafts
c) Loans and advances
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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

d) Discounting of bills of exchange

Interest charged by the bank on various loans depends upon the amount, period, social priority,
nature of security offered, and solvency of the borrower.
3) Agency Services: An Agent is one who acts on behalf of someone else. Banks acts as the agent of
its customers in following ways:
i) Collection of Bills, Promissory Notes And Cheque
ii) Collection of Dividends, Interests, Premium Etc.
iii) Purchase and Sale of Securities and Shares.
iv) Acting As A Trustee Or Nominee When So Nominated
v) Making Regular Payments Such As Regular Premiums Etc.
4) General Services: A modern bank performs following general services for its clients:
i) Issue of Letter Of Credit, Traveler Cheque, Bank Drafts Etc.
ii) Locker Facility
iii) Underwriting Of Shares
iv) Conducting Economic Survey
v) Supplying Trade Information And Vital Statistics

Role of a commercial bank:

1. It promotes savings.
2. It mobilizes savings.
3. It promotes the rate of capital formation
4. It helps in optimum utilization of savings.
5. It helps in providing equal opportunity to all section of society.

CREDIT OR MONEY CREATION BY THE COMMERCIAL

BANKS
Commercial Banks are an important source of money supply in the form of demand deposits. The basis
measure of money supply has two components i.e. currency with public and demand deposits in
commercial banks. The currency is created by the Central Bank i.e. the Reserve Bank of India (RBI) and
is called High Powered Money. Demand deposits are created by the commercial banks and are called
Bank Money.
Commercial banks receive deposits from the public. The depositors are free to withdraw their deposit
amounts through cheques. The bank uses these deposits to give loans. But the banks cannot use the
whole of deposit for this purpose. It is legally compulsory for the banks to keep a certain minimum
fraction of these deposits as cash. This fraction is called the Legal Reserve Ratio (LRR). This
function of the bank is the basis of deposit or credit or money creation. How much are the deposits
created depends upon the initial deposits by the public and the Legal Reserve Ratio. this ratio is fixed by
RBI. It has following two components:
1. A part of LRR is to be kept with RBI and this part ratio is known as Cash Reserve Ratio (CRR);
2. The other part is kept by the banks themselves and is called the Statutory Liquidity Ratio (SLR).
Process of credit/money creation

Assumptions:
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By: SUMAN MA (ECO) , B.ED PG DIPLOMA IN VALUE EDUCATION AND SPIRITUALITY
NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

 Initial deposit in the bank = Rs.100

 LRR = 25% i.e. banks keep only Rs.25 as cash reserve.
 Maximum amount that a bank can lend = Rs.75.
 All the transactions are routed through bank

Bank gives loan to a person Rs.75

Now the borrower spends the entire amount on goods & services.

Sellers of these goods receive Rs.75 and his bank account balance is
increased by this amount. Now total deposits are Rs.175 (100 + 75).

When bank receives new deposits i.e. Rs.75 the bank again lends 75% i.e.
Rs.56.25.

The money comes back into the accounts of those who have received the
payments. Now total deposits are Rs.231.25 (100 + 75 + 56.25).

Now again bank lends 75% of the amount it received as deposits i.e.
Rs.42.1875.

The deposit creation continues in the above manner. The deposits go on

increasing round after round but each time only 75% of the last round
deposits. The increase becomes smaller & smaller and ultimately it becomes
virtually zero.

The total deposit creation comes to Rs.400 i.e. 4 times the initial deposit.

How many times the total deposits would be of initial deposits is determined
by LRR. The multiple is called the money or deposit multiplier. It is
calculated as:
Money Multiplier = 1 ÷ LRR
Money Creation = Initial deposit x 1 / LRR
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By: SUMAN MA (ECO) , B.ED PG DIPLOMA IN VALUE EDUCATION AND SPIRITUALITY
NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

CENTRAL BANK (RESERVE BANK OF INDIA)

Meaning and Functions: Reserve bank of India is the central bank of India. RBI performs all central
banking functions for Indian Economy. A central bank is one which constitutes the apex of the
monetary and banking structure of a country and which performs in the national interest following
functions:
1. Issue of Currency: The central bank is the sole authority for the issue of currency in the
country. It is so because it brings about uniformity in note circulation and gives central bank
direct control over money supply. All the currency issued by the central back must be backed by
assets of equal value. These assets generally include gold coins, gold bullion, foreign securities,
and the domestic government’s local currency securities. For this function RBI is also called
`Bank of Issue’.
2. Banker to the Government: Central bank acts as a banker to both central as well as State
governments. As a banker to the government RBI performs following functions:
a) It transacts all the banking business for government departments. It accepts money, makes
payment and also transfers the funds.
b) It manages Public debt.
c) It advises government on the quantum, timing and terms of new loans, capital markets and
economic policy matters.
3. Custodian of Foreign Exchange Reserves: All foreign exchange reserves of a country remain
in the custody of RBI. This function helps the central bank to overcome the problems of foreign
exchange fluctuations and BOP difficulties. In order to minimize the foreign exchange
fluctuations, central Bank buys or sells foreign currencies in the market when their value falls or
rise.
4. Banker’s Bank and Supervisor: The RBI has extensive powers to control and supervise
commercial banking system under RBI Act, 1934 and Banking Regulations Act 1949. Banks
need to keep a minimum proportion of their net total liabilities with the central bank, it is called
cash reserve ratio. CRR is used as an instrument of credit control in the economy.
The central bank supervises, regulates and controls the commercial banks. The regulation of
banks may be related to their licensing, branch expansion, liquidity of assets, management,
amalgamation, The control is exercised by periodic inspection of banks and the returns filled by
them.
5. Controller of credit: It is the principal function of a central bank. The central bank controls the
money supply and credit in the best interest of the economy. By making use of various tools of
monetary policy, it ensures that monetary system in the economy functions according to the
national priorities.
Various instruments that help in controlling credit are called instruments of monetary policy.
Such instruments can be:
1) Quantitative credit control instruments
2) Qualitative credit control instruments

24
By: SUMAN MA (ECO) , B.ED PG DIPLOMA IN VALUE EDUCATION AND SPIRITUALITY
NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

Quantitative Qualitative
Instruments Instruments

Bank Rate
Margin Requirements
The bank rate is the rate at
Margin is the difference
which central bank lends funds
between the amount of loan
as lender of last resort to the
and the market value of
commercial banks against
security offered by the
approved securities or eligible
borrower against the loan. To
bills of exchange. To control
control inflation, RBI increases
inflation, RBI increases this rate
the margin requirements.
and vice versa.

Cash Reserve Ratio Moral Suasion

It is the % of net deposits of the This is the combination of the
banks, which they are required to persuasion and pressure that the
keep with the central bank. To central bank applies on
control inflation, RBI increases commercial banks to get them to
this ratio. fall in line with its policy. it is
exercised through discussion,
letters, speeches etc.
Statutory Liquidity Ratio
It is the specified % of net
deposits of banks, which the
banks have to maintain in the
form of designated liquid assets.
To control inflation, RBI increases
SLR.

Open Market Operations

Under this, central bank buys
or sells government securities
from or to the general public or
banks. To control inflation, RBI
sells the securities.

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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

6. Lender of Last Resort: Central bank is under an obligation to provide funds to commercial
banks in the times of crisis. The aim is that no sound and genuine transaction should be restricted
or abandoned due to shortage of funds. Commercial banks approach the central bank as a last
resort in distress. The central bank advances loan to the commercial banks, subject to certain
terms and conditions.
7. Acts as a Clearing House: Central bank acts as a clearing house in Inter-Bank transactions.
Central bank also gives facility of transfer of funds at zero cost. All banks have interbank
transactions which are easily settled down by involvement of central bank, which otherwise will
be a very complicated process.
8. Promotional Functions: RBI also performs a variety of developmental and promotional
functions like:
a) Promoting banking habits among people;
b) Mobilizing Savings;
c) Development of Banking System;
d) Provision of Finance to agriculture through NABARD and SSI through SIDBI.
9. Collection and Publication of Data: It provides information related to financial sector.
10. Price Stabilization: RBI controls inflation and deflation in the economy by using various
monetary tools.

DIFFERENCE BETWEEN CENTRAL BANK AND COMMERCIAL BANK:

BASIS COMMERCIAL BANK CENTRAL BANK
Meaning It is a financial institution that accepts It is an apex authority in the monetary
deposits from the general public for the structure of the country. It is entrusted
purpose of lending and investing; with the monopoly power of note issue.
repayable on demand or otherwise and
withdrawable by cheque, draft, and order
or otherwise.
Status Small units of central bank Supreme authority
Number Many One
Objective Profit Social and Economic Development
Principal Credit creation Credit control
function
Dealing Direct Indirect
with public
Relation It has no advisory responsibility towards It acts as an agent and a banker to the
with the the state. government.
government

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 NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

DETERMINATION OF INCOME &

EMPLOYMENT

BASIC CONCEPTS
I. Aggregate Demand: Aggregate demand means the total demand for final goods and
services in the economy. Since aggregate demand is measured by total expenditure of
community on goods & services, therefore, it also means the total amount of money which all
sections are willing / planning to spend on purchase of goods and services produced in an
economy during a given period. Aggregate demand is synonymous with aggregate expenditure.
Components of AD:
AD= C + I + G + (X-M)
Private consumption expenditure (C): It is defined as the value of all goods and services that
households are willing or planning to buy. Alternatively, it refers to ex-ante (planned) consumption
expenditure to be incurred by all households on purchase of goods and services.
Private Investment Expenditure (I): It refers to planned (ex-ante) expenditure on creation of new
capital assets like machines, buildings, raw material by private entrepreneurs. It comprises of
expenditure on (a) fixed assets of business like machinery, building etc.; (b) inventory and (c) residential
construction.
Government Demand for goods and services (G): It refers to government planned (ex-ante) expenditure
on purchase of consumer and capital goods to fulfill common needs of the society. It includes schools,
transports, hospitals, roads, power, health etc.
Net Exports: (X – M): Net export demand is defined as aggregate of all demand for our goods and
services by foreign countries over our country’s demand for foreign countries’ goods and services.
Net exports = Exports (X) - Imports (M)
Note: For the purpose of our study, it is assumed that there is neither foreign trade nor
government; therefore AD has only two components i.e. private consumption and private
investment.
AD = C + I
In the figure, AD curve has been shown as the sum of consumption
& investment.
(a) AD curve has a positive slope which means when income
rises AD also rises.
(b) AD curve does not originate at point O which shows that
even at zero level of income, some minimum level of
consumption is essential.
(c) Investment curve is a straight line parallel of x-axis because
according to Keynes, level of investment in an economy
remains constant at all levels of income during short period.

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 NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

II. Aggregate Supply: Aggregate Supply is the money value of final goods and services
planned to be produced by an economy during a given period. In other words, AS is the
aggregate value of total output which is planned to be produced in an economy. It is the
aggregate cost of total output. It is Net National Product at Factor Cost i.e. National Income.
Components of AS:
Main components of aggregate supply are consumption (C) and saving (S). A major portion of income is
spent on consumption of goods and services and the balance is saved. Thus
AS = C + S
Or Y = C + S
AS = National Income
Aggregate Supply or National Income has been shown on
x-axis and total spending i.e. consumption + saving on y-
axis. AS curve is artificially represented by a 45° line from
the origin. Because every point on this line is equidistant
from x-axis and y-axis. In other words, each point on this
line indicates Expenditure (AD) = Income (AS).

III. Consumption Function (Propensity to Consume): The functional relationship

between consumption and income is called consumption function or propensity to consume. It
refers to the schedule which shows the level of consumption at different levels of income. In
other words, it means the proportion of income spent on consumption. Since consumption
directly depends upon income. Thus consumption (C) is a function (f) of income (Y).
symbolically: C = f (Y)
There are two main features of consumption function:
1. At zero level or very low level of income, consumption expenditure is higher than income as
minimum consumption is necessary for survival. This is called autonomous consumption.
2. As income increases, consumption expenditure also increase but in less proportion. It means
additional consumption (C) is less than additional income (Y) or C / Y (Marginal
propensity to consume i.e. MPC) is less than 1.

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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

Consumption function equation: Consumption function is

represented by the _ following equation:
C = C + bY _
Where C represents total consumption, C represents autonomous
consumption, b shows MPC, Y represents income. Thus, total
consumption comprises of two components i.e. autonomous
consumption and induced consumption (bY).
The figure shows the consumption function curve. It slopes
upward which shows direct relation between consumption and
disposable income. Since slope is constant the curve is a straight
line curve.

Relation between Income and Consumption Expenditure:

According to Keynes, as income rises, consumption expenditure also increases but by less than an
increase in income. This is called Keynes’ Psychological Law of Consumption.
This means there is a tendency amongst people not to spend on consumption all of the additional income
i.e. they save a part of it. In other words, MPC is less than 1.

Propensity to consume is of two types:

(a) Average Propensity to Consume: APC is defined as the ratio of aggregate consumption
expenditure to aggregate income.
APC = Total consumption Expenditure = C
Total Income Y
If Y = Rs. 100 crores and C = Rs. 40 crores then APC = 40/100 = 0.4 or 40%
Features of APC:
(i) At zero level of income, APC = ∞
(ii) APC declines continuously as income rises.
(iii) Value of APC can be greater than one when consumption exceed total income. It
happens when income is very low and consumption can’t fall below a minimum level.
(iv) APC can be less than 1 when consumption is less than income.
(v) APC can never be zero.

(b) Marginal Propensity to Consume: MPC is defined as the rate of change in aggregate
consumption expenditure as aggregate income changes. Symbolically,
MPC = Change in consumption Expenditure = C
Change in Income Y
If income rises from Rs.100 crores to Rs.120 crores and consumption rises from Rs.40 crores to
Rs.50 crores then MPC = 10/20 = 0.5 or 50%.
Features of MPC:
(i) Graphically, MPC is the slope of consumption curve.
(ii) Value of MPC lies between 0 &1.
(iii) MPC is always less than APC.
(iv) For the purpose of study, MPC is assumed to be constant throughout.

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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

IV. Saving Function / Propensity to Save: It shows the relationship between income and
saving. It is the proportion of income saved. Saving is a function of income. Symbolically: S =
f(Y)
There are two main features of saving function:
1. Saving can be negative at zero or low level of income.
2. As income increases, saving also increases but not more than the increase in income.
S=Y–C
Saving Function Equation: It shows the relationship between
income and saving. Saving is that part of income which is not spent.
S=Y–C
Saving function can be derived from consumption function.
S=Y–C
_ _
S = Y – (c + bY) (C = c + bY)
_
S = Y – c – bY
_
S = -c + (1- b) Y
_
Where -c = Autonomous consumption and 1-b = 1- MPC = MPS
Accordingly, saving function = Autonomous consumption + MPS x
Income

The saving function curve has been shown in the figure. It is a straight line because slope of saving is
constant. The curve slopes upwards which depicts direct relationship between income and saving. The
point where savings are zero is called Break-even point. At this point consumption is equal to income.
Savings are negative to the left of BEP and positive towards its right.
Saving function is of two types:
(a) Average Propensity to Save: APS is defined as the ratio of aggregate saving expenditure to
aggregate income. Value of APS can be negative.
APS = Total Savings = S
Total Income Y
If Y = Rs. 100 crores and S = Rs. 60 crores then APS = 60/100 = 0.6 or 60%
(b) Marginal Propensity to Save: MPS is defined as the rate of change in aggregate saving
expenditure as aggregate income changes. Value of MPS varies from zero to one. Symbolically,
MPS = Change in Savings = S
Change in Income Y
Relationship between APC & APS and MPC & MPS:
APC + APS = 1
MPC + MPS = 1
It is so because out of the total income, a person can either spend or save or partly do both. If 60% of
total income is spent then it means that 40% of it is saved. The same applies in the case of increase in
income also.
Derivation of Saving curve from Consumption curve

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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

Savings at different levels of income can be obtained

by taking the vertical difference between the
consumption curve and income curve. It has been
shown in the figure above also. When consumption
curve lies above the income curve then there are dis-
savings or negative savings and when consumption
curve lies below the income curve then there are
positive savings. When these curves intersect then
there are zero savings.

V. Investment Function: Investment function is the behaviour of investment corresponding

to different levels of income. Investment means expenditure made on purchase of new capital
assets like machines, tools, equipments etc. It means an addition to existing stock of assets to
increase productive capacity of an economy.
According to Keynes, volume of investment depends upon (i) marginal efficiency of capital
(MEC is the rate of return from marginal unit of capital) or rate of return and (ii) rate of interest.
Firms undertake investment as long as return form investment is greater than cost. There are
following two types of investment:
(a) Induced Investment: This investment is made with the motive of earning profit as done by
private sector. It is a positive function of national income i.e. it changes directly with change
in national income. It is income elastic. However, it is an inverse function of rate of interest.
It changes inversely with the change in rate of interest. Induced investment curve is like
supply curve. It has a positive slope.
(b) Autonomous Investment: It is investment which is to be done irrespective of level of
income and rate of interest. It is income inelastic. It is a straight line parallel to income axis.
In our study we have assumed investment to be autonomous investment. It is generally done
by the government.

VI. Full Employment: It refers to a situation in which every able bodied person who is willing
to work at the existing wage rate is, in fact, employed. Full employment implies absence of
involuntary unemployment. In other words, under full employment situation the entire labour
force in the economy is employed. Labour force is that part of population of the country which is
physically & mentally able and willing to work.

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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

VII. Voluntary Unemployment: It refers to those people who are not willing to work
although; sustainable work is available for them. In other words, they are voluntarily
unemployed. They are not included in labour force of the country.
VIII. Involuntary Unemployment: It occurs when those who are willing and able to work at
the existing wage rate, do not get suitable work. According to Keynes, involuntary
unemployment arises due to insufficiency of effective demand which can be solved by increasing
the aggregate demand through government intervention.
IX. Full Employment income level: It is the potential income level that can be achieved
when resources of an economy are fully employed. It is the maximum that an economy can
achieve with the available resources in the long run.
X. Ex-ante & Ex-post: Ex-ante means planned or desired or intended during a particular period.
For example: ex-ante investment means the planned investment during a particular period.
Ex-post means actual or realized during a particular period. For example: ex-post investment
means actual or realized investment.

DETERMINATION OF EQUIBRIUM LEVEL OF

INCOME, OUTPUT AND EMPLOYMENT / THE
THEORY OF INCOME DETERMINATION
AD- AS approach / Consumption – Investment Approach:
According to Keynes, equilibrium level of national income is determined at a point where Aggregate
Demand equals Aggregate Supply. Symbolically, Equilibrium condition is given as:
AD = AS
C+I=C+S
Consumption/Saving/Investment

AS
In the figure, AD is Aggregate Demand Curve.
AS is Aggregate Supply curve. AD
E is the point of equilibrium
OY is the equilibrium level of national income
Effective Demand is EY at equilibrium level of
national income. It is a point where AD = AS. It E
A AD = AS
determines the level of national income.

Y Income / Output

Adjustment mechanism when AD is not equal to AS.

a) AD<AS: In this situation the economy will face recession. It means planned demand is less than
planned production. There will be unsold stock of goods. The producer will reduce the factors of
production to cut down the level of output. This will reduce the income level till AD and AS once
again becomes equal. Then equilibrium is achieved again. It can be concluded that when AD<AS
then National income tends to fall.

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 NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

b) AD>AS: In this situation, there will be excess demand and producers will earn abnormal profits. It
means planned demand is more than the planned production. In this case there will be a fall in the
stock of goods with the producers. Hence, they will expand their output which will raise the
income level. The income level will rise till AD once again becomes equal to AS and equilibrium
is achieved. Hence, when AD>AS then national income tends to rise.

Saving Investment Approach:

According to Keynes, equilibrium level of national income can be alternatively determined by the point
where planned investment equals planned savings. Both AD = As and S = I give same level of
national income equilibrium because:
AD = AS
C+I = C+S
S=I
Or planned savings = Planned investment
Or Ex- ante savings = Ex-ante investment
Equilibrium level of national income is shown in the figure given below with the help of Saving -
Investment approach.
Investment is assumed to be autonomous investment
which is same irrespective of level of national income.
Saving curve starts from a negative intercept equal to
autonomous consumption which is the level of
consumption at zero level of national income.
Economy is in equilibrium when S = I at point Q.
Adjustment mechanism when Savings are not
equal to Investment.
a) If S< I: When investments are more than savings, it
means households are saving less than what firms are
willing to invest. In other words, buyers are planning
to spend more what the producers are planning to
invest. Output would fall short of demand. To cope
up, firm will plan to expand its investment and
production. It will hire more factors. This will raise
the income levels to the equilibrium level of income
where planned saving is equal to planned investment.

If S>I: When savings are more than the investment, then the households is saving more than what the
firms are wanting to invest. In other words, buyers are not spending to match with investment plans of
the producers. As a result, some goods would remain unsold. To cope with the situation, lesser output
would be planned for the following year, implying lesser investment, lesser production, lesser income
and lesser saving. This will reduce national income level to equilibrium level of income where planned
saving is equal to planned investment.

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 NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

Simultaneous Equality between AD & AS

approach and S & I approach
The figure shows equality between AS & AD as
well as S & I. Equilibrium is attained at point E
where AD = AS & S = I.

Numerical example on equilibrium level of income:

C = 100 + 0.7Y
I = 50
Therefore, saving function can be derived as S = Y – C
S = Y – (100 + 0.7Y)
S = Y – 100 – 0.7Y
S = 0.3Y - 100
Output Planned Planned Planned AS (C+S) AD (C+I) Tendency
and Consumption Saving investment of output
income (C) (S) (I) to change
50 135 -85 50 50 185 +
100 170 -70 50 100 220 +
500 450 50 50 500 500 Equilibrium
1000 800 200 50 1000 850 -
2000 1500 500 50 2000 1550 -
3000 2200 800 50 3000 2250 -
4000 2900 1100 50 4000 2950 -

In the table, planned consumption (C) has been calculated by substituting the values of income in the
consumption function equation given and planned savings (S) has been calculated by substituting the
values of income in saving function equation.

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 NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

When AD>AS then firms will sell from their existing stock, hence inventory investment which is
unplanned investment will be negative therefore, output will expand for the future.
On the contrary, when AS>AD, it means firms are temporarily producing more than what they can sell,
they will contract their operations and output will fall.

CLASSICAL THEORY VS KEYNESIAN THEORY

Classical Theory:
Classical theory was propounded by Karl Marx, Malthus, Adam Smith, Ricardo, Marshall. They believe
that:
An economy always functions at full employment level: The classical economists asserted that full
employment is a normal feature of a capitalist economy. Full employment level of output of goods and
services is the largest output that the economy is capable of producing when all its resources are fully
employed. This situation is defined as an absence of involuntary unemployment. There is an in-built
system in the economy that makes economy work at the full employment level. Unemployment is a
temporary phenomenon.
Assumptions of the theory:
3. Say’s Law of Market: This law was formulated by J.B. Say. He stated that “Supply creates its
own Demand”, i.e. there is never a deficiency of aggregate demand. It states that an increase in
output creates an equal increase in income and spending. There is neither over production nor
under production.
4. Flexibility in wage rates and price exists: Wage and price flexibility means that real wages (i.e.
purchasing power of workers) and prices can change freely and quickly. This assumption of
wage flexibility implies that supply of labour equals demand for labour i.e. there is no
unemployment. For instance, if there is unemployment in an economy then wage rates will fall.
This will raise the demand for labour till all labour is absorbed and full employment is achieved.
Flexibility in prices implies that AD = AS and there is no excess demand or excess supply.

Full-Employment Equilibrium: The classical theory shows equilibrium level of output at the full
employment level. It is shown in diagram given below:

AS is the aggregate supply curve. It is perfectly

inelastic with respect to price level. Because there
is full employment in the economy and production
can’t be increased beyond that. AD is the
aggregate demand curve. It is downward sloping
due to inverse relationship between price and
output demanded. E is the equilibrium point. It is
full employment equilibrium.

Criticism of the theory:

1. In reality, J B Say’s law of market does not operate due to its unrealistic assumptions.
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AND EX-PRINCIPAL SPS

2. Keynes’ proved that the economy may be in equilibrium at less than full employment level.
3. Saving and investment do not depend on interest rates only. Savings depend on disposable
income and investment depends on expected return on investment.
4. Wage rates and prices are not so flexible in reality due to presence of monopolies and trade
unions.
5. It ignored the role of state in influencing markets through its fiscal and monetary policy.
The great depression of 1929-33 fully shattered the classical myth of full employment. It was at
such a crucial time that Keynes developed his alternative theory of income and employment.

Keynesian Theory:
An economy can be in equilibrium even at less than full employment level: Economic system does
not ensure automatic equality between AD & AS at full employment as believed by classical. He proved
that economy could be in equilibrium at less than full employment level. This is the basic difference
between Classical theory and Keynesian theory.
Assumptions of the theory:
1. Demand creates its own supply: Aggregate demand for goods & services directly determines the
level of output, income & employment. If AD increases, level of output will go up by increasing
employment of resources to meet the increased demand and as a result income will also go up. Thus,
demand creates its own supply.
2. Rigid wages and Prices: Government intervenes through minimum wage laws to fix wages when
supply of labour is more. It results in involuntary unemployment. Government also intervenes to fix
the prices of essential commodities through various policies.
3. Constant MP of labour: If MP of each labour is constant and Wage rates are also same then it
means that each additional unit cost the same to the producer.

The concept of Aggregate supply: Keynes’ AS curve is perfectly elastic till full employment level and
perfectly inelastic after attainment of full employment as shown in figure. It means firms are willing to
produce any amount of output at the prevailing price level till full employment is achieved. . It is
because when there is unemployment in the economy, there is excess capacity in the economy. When
excess or unutilized capacity is utilized to increase output, cost of production remains constant, and
hence price remains constant.
Under-Employment Equilibrium:

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 NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

It is a situation of equality between AD and AS before resources are fully employed. So that, there is
equilibrium but some resources remain unemployed.
Full Employment Equilibrium:
In such a situation, equality between AD & AS coincides with fuller utilization of resources in the
economy.
Equilibrium beyond full employment
Here, equilibrium occurs between AD & AS after full employment.

INVESTMENT MULTIPLIER
Meaning: It is the measure of change in national income as a result of change in investment. In other
words, multiplier is that number which when multiplied by the amount of change in investment gives us
the value of consequent change in income. When there is an increase in investment, national income
increases not by the amount of investment but by a multiple of it. Measure of it is called multiplier.
Symbolically,
ΔY = K x ΔI or
K = ΔY/ΔI
Where K = Multiplier
ΔY = Change in National Income
ΔI = Change in Investment
The operation of multiplier ensures that a change in investment causes a change in output by an
amplified amount, which is a multiple of the change in investment.
Example: Suppose Government of India makes an investment of Rs.100 crore in the villages in order to
generate employment opportunities. As a result of this investment, national income rises by Rs.200 crore.
Thus, K = 200 / 100 = 2
Relationship between Multiplier, MPC and MPS
There is a direct relationship between MPC and Multiplier i.e. more will be MPC, more will be the value
of multiplier and vice-versa. It is so because from the point of view of the entire economy, expenditure of
one individual is the income of another. When investment is increased, income of the people is also
increased. They spend a part of this increased income on consumption and they save the rest. How much
of their income people would spend on consumption depends on MPC. If MPC is more they will spend
more.
There is an indirect relationship between MPS and Multiplier i.e. more will be MPS, less will be the
value of multiplier and vice-versa.
This relation can be expressed in terms of an equation as under:
K = ΔY ………………. (i)
ΔI
We know that Y = C + I
Or ΔY = Δ C + Δ I
Or Δ I = Δ Y – Δ C
Putting the value of Δ I in equation (i), we get
K = ΔY___
ΔY – Δ C
Dividing RHS by ΔY
K= ΔY / ΔY_____
ΔY/ ΔY – Δ C / ΔY
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 NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

K= 1_____
1 – MPC (since, MPC = Δ C / ΔY)
Or
K = 1 / MPS
Thus, MPC & multiplier are directly related while MPS & multiplier are inversely related.

Working of Multiplier
Let us take an example. Suppose, investment has been increased by Rs.100 crore; MPC is ½ or 0.5, K = 2

Period Increase in Change in Induced change in Savings

investment Income (ΔY) consumption (MPC = 0.5) (Rs. crore)
(Rs. crore) (Rs. crore) (Rs. crore)
0 100 100 50 50
1 - 50 25 25
2 - 25 12.5 12.5
3 - 12.5 6.25 6.25
4 - 6.25 3.12 3.12
5 - 3.12 1.56 1.56
6 - 1.56 0.78 0.78
7 - 0.78 0.39 0.39
8 - 0.39 0.20 0.20
9 - 0.20 0.10 0.10
Total 100 200 100 100
The table shows that as a result of initial increase in investment by Rs.100 crores, there is change in
income by Rs.100 crore. It is assumed that MPC is 0.5. Hence, due to increase in income by 100 crore,
consumption will increase by 50 crore and the remaining 50 crore will be saved. One man’s expenditure is
another man’s income. Therefore, due to expenditure of 50 crore in the second time period income will be
increased by 50 crore. Hence, there will be increase in consumption by 25 crore and in saving also by 25
crore.
Thus, in different time periods as shown in the table income will go on increasing due to increase in
consumption expenditure. Ultimately income will increase to Rs.200 crore.

PROBELEMS OF EXCESS AND DEFICIENT DEMAND

AND POLICY MEASURES TO CORRECT THEM
Excess Demand
When in an economy, aggregate demand is in excess of aggregate supply at full employment, the
demand is called excess demand. The gap between AD and AS is then called inflationary gap since it
causes inflation in the economy.
Inflationary Gap: When there is excess demand at full employment level, it cannot be fulfilled by
increasing AS by corresponding amount. It leads to inflation in such a case. In such a case an increase in
demand means only increases in money expenditure without any corresponding increase in output and
employment because all the resources are fully employed.
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 NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

The situation of inflationary gap has been shown in the

future. Point E is the equilibrium point which is an ideal
situation. Here, AD is represented by EM which is equal to
full employment level of output i.e. OM. Suppose, the
actual aggregate demand is for a level of output BM which
is greater than full employment level of output. The
difference between the two is BE which is a measure of
inflationary gap.
In short, inflationary gap is the amount by which the actual
AD exceeds the AD required to establish full employment
equilibrium.

Causes for excess demand:

1. Increase in household consumption expenditure due to rise in propensity to consume.
2. Rise in private investment demand because of easy availability of credit facilities.
3. Rise in government expenditure.
4. Growth of black money.
5. Increase in export demand
6. Increase in deficit financing i.e. financing the deficit by printing of new notes.
7. Decrease in imports due to higher international prices as compared to domestic prices.

Effects/Impacts of excess demand:

1. It causes a continuous and persistent rise in prices.
2. The producers gets abnormal profit margin.
3. The consumers’ purchasing power goes down.
4. It does not affect the level of output because economy is already at full employment equilibrium.

Deficient Demand
It refers to the situation when AD is less than AS corresponding to full employment level of output in
the economy. This situation arises when planned aggregate expenditure falls short of aggregate supply at
the full employment level.
Deflationary gap
In an economy when AD is than AS at full employment, then the deficiency or gap is called deflationary
gap. It is a measure of amount of deficiency in AD.
The situation of deflationary gap has been shown in the
figure. Point E is the point of equilibrium. Here, AD is
represented by EM and AS by OM. Suppose the actual
demand is for a level of output OM1 which is less than full
employment level of AS i.e. OM. The difference between
the two is EB which is a measure of deflationary gap or
deficient demand.

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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

Causes of deficient demand:

1. Fall in household consumption expenditure due to decrease in propensity to consume.
2. Fall in private investment demand because of increase in rate of interest.
3. Decrease in government expenditure.
4. Fall in black money.
5. Decrease in export demand due to comparatively higher prices of domestic goods.
6. Decrease in deficit financing.
7. Increase in imports due to lower international prices as compared to domestic prices.

Effects / Impacts of deficient demand:

1. There is a fall in general price level or deflation.
2. The producers incur losses or their profits are nil. There is unsold stock of goods.
3. Consumers’ purchasing power increases.
4. Fall in the level of national income and employment which may lead to strikes & lockouts.
5. It will lead to recession and depression in the economy.

Measures to control the situation of excess and deficient demand

There are two policy measures to deal with the problems of deficient and excess demand.
1. Fiscal Policy Measures: Fiscal policy is the expenditure and revenue policy of the government.
These measures are also called change in government spending. The main tools of fiscal policy are:
a. Revenue Policy: The main source of revenue to t he government is through taxes.
 In the case of excess demand or inflation government raises the rates of all taxes,
especially on the rich people. This reduces the purchasing power of people and reduces
both consumption & investment expenditure. Thus AD gets reduced.
 In the situation of deficient demand, the government reduces the rates of taxes. It will
increase the purchasing power of people and thy will spend more on consumption &
investment. Thus AD will rise and producers will increase the production.
b. Expenditure Policy: Government spends huge amount on public works like construction of
roads, flyovers, buildings etc. changes in such expenditure directly affects the level of AD.
 In the situation of excess demand, government reduces its expenditure. It will result in a
fall in demand for goods & services.
 In the situation of deficient demand, government increases its expenditure. It will result
in the rise in demand for goods & services.
c. Deficit Financing: It means printing of new currency notes to finance the deficits in budget.
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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

 In the situation of excess demand, government should reduce deficit financing to bring
the excess demand down.
 In the situation of deficient demand, government should encourage deficit financing so
that demand can be increased.

2. Monetary Policy Measures: It is the policy concerning money supply and availability of credit in
an economy. These measures are also called change in availability of credit. Central bank is
officially authorized to design the monetary policy in the country. Therefore, it is also called Central
Bank’s Credit Control Policy. Various instruments that help in controlling credit are called
instruments of monetary policy. Such instruments can be:

Monetary Policy
Measures

Quantitative Qualitative
Measures Measures

OPen Cash Statutory Margin Moral

Bank Rate Market Reserve Liquidity Requirement Suasion
Oerations Ratio Ratio

Quantitative credit control instruments: As the name suggests these are the instruments which affect
the total volume i.e. total quantity of the credit.

QUANTITATIVE MEASURES
Bank Rate / Repo Meaning It is the rate of interest charged by central bank on loans
rate given to commercial banks.
In the case of Central bank raises the bank rate which discourages
excess demand commercial banks in borrowing. Increase in bank rate
forces commercial banks t increase their own lending
rate which in turn discourages people to borrow money
from banks. Thus AD gets reduced due to decrease in
purchasing power of people.
In the case of RBI reduces the bank rate. It encourages people to
deficient demand borrow money from banks. It will raise investment
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AND EX-PRINCIPAL SPS

expenditure.
Open Market Meaning It refers to buying and selling of government securities
Operations and bonds in the open market by the central bank.
In the case of RBI sells these securities to commercial banks so that
excess demand their cash is blocked in these securities and their capacity
to offer loans will be reduced which in turn reduces
purchasing power of public.
In the case of RBI buys securities from the open market and release
deficient demand funds for the banks and the individuals and increases the
investment activities in the economy.
Cash Reserve Meaning It is defined as that portion of total deposits which a
Ratio commercial bank requires to keep with RBI in the form
of cash reserves.
In the case of RBI increases CRR. This will reduce the cash deposits
excess demand left with commercial banks to be loaned out.
In the case of RBI reduces CRR. As a result of this there will be
deficient demand surplus cash reserves with the banks and hence banks
credit creation power increases.
Statutory Meaning It is that portion of total deposits which a commercial
Liquidity Ratio bank has to keep with itself in the form of liquid assets.
In the case of RBI raises the SLR. It results in the reduction of surplus
excess demand cash reserves of the commercial banks.
In the case of RBI reduces SLR. It expands the cash reserves of banks
deficient demand which will increase people’s purchasing power.
QUALITATIVE MEASURES
Margin Meaning Margin is the difference between the amount of loan and
Requirements the market value of security offered by the borrower
against the loan.
In the case of RBI raises the margin requirements. It implies that
excess demand borrowers will get less credit against their securities and
thus keep down the volume of credit.
In the case of RBI reduces the margin requirements. It implies that
deficient demand borrowers will get more credit against their securities. It
will encourage borrowings.
Moral Suasion Meaning This is the combination of the persuasion and pressure
that the central bank applies on commercial banks to get
them to fall in line with its policy. It is exercised through
discussion, letters, speeches etc.
In the case of RBI issues letters to the banks encouraging them to
excess demand exercise their control over credit and grant loans for
essential purpose only and not for speculative purposes.
In the case of RBI issues instructions to banks to increase the
deficient demand availability of credit to borrowers for non-essential
purposes also.

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GOVERNMENT BUDGET & THE

ECONOMY
MEANING OF BUDGET

Government budget is an annual statement, showing item wise estimates of receipts and expenditures
during a fiscal year.
In other words, a government budget is a statement showing estimated receipts and estimated
expenditure for a financial year i.e. 1 April to 31 March. In the beginning of every year, government
presents before the Lok Sabha an estimate of its receipts and expenditure for the coming financial year.
The government plans expenditure according to its objectives and then tries to raise resources to meet
the proposed expenditure.
OBJECTIVES OF THE BUDGET

1. Redistribution of Income and Wealth / Reduction of inequalities: Government through fiscal

tools of taxation, subsidies and transfer payments makes an effort to make income distribution
equitable in the economy. Equitable distribution of income and wealth is a way to bring social
justice. Government levies high rate of tax on rich people reducing their disposable income and
lowers the rate on lower income group. Government also provides subsidies and amenities to people
whose income level is low.
2. Reallocation of resources: the government through budgetary policy reallocates resources so as to
achieve social and economic objectives. Government produces those goods which may not be
economically beneficial but are extremely useful in terms of social benefits like public sanitation,
rural electrification, education, health etc. It also levies high taxes on commodities that are
undesirable socially or ethically. It provides essential goods to the poor at subsidized rates.
Government draws away resources from some other areas to promote balanced economic growth of
regions by allocating more funds to production of socially useful goods.
3. Economic Stability / Price Stability: The government tries to prevent business fluctuations and to
maintain price and employment stability through taxes, subsidies and expenditure. Economic
stability increases the inducement to invest and increase the rate of growth and development.
4. Managing Public Enterprise: The budgetary policy of the government shows interest of the
government to increase the rate of growth through public enterprises. Often, government undertakes
such activities which are of utmost importance or which have monopoly advantage. Budget is
prepared with the objective of making various provisions for managing such enterprises and
providing them financial help.
5. Economic growth: Economic growth implies a sustained increase in real GDP of the economy, i.e.,
a sustained increase in volume of goods & services. For this purpose, budgetary policy aims to
mobilize sufficient resources for investment in the public sector.

COMPONENTS OF GOVERNMENT BUDGET

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AND EX-PRINCIPAL SPS

Two components of government budget are:

Revenue Budget: It consists of revenue receipts and revenue expenditure of the government.
Capital Budget: It consists of capital receipts and capital expenditure

Government
Budget

Revenue Capital
Budget Budget

Revenue Revenue Capital Capital

Receipts Expenditure Receipts Expenditure

Non-tax
Tax Revenue
Revenue

Indirect
Direct Taxes
Taxes

REVENUE BUDGET

1. Revenue Receipts: Revenue receipts are those receipts which does not create a liability or lead to
reduction in asset. Revenue receipts are of recurring nature. Revenue receipts can be further
classified into tax revenue and non tax revenue.
a. Tax Revenue: Tax revenue refers to sum total of receipts from taxes and other duties imposed
by the government. A tax is a legally compulsory payment imposed by the government.
Government imposes tax on income, manufacturing, services, wealth etc. Tax revenue is the
main source of regular receipts of the government. Taxes are of two types:
I. Direct Tax: These refer to taxes that are imposed by the government on property &
income of individuals & companies and are paid directly to the government. The liability
to pay a tax and the burden of that tax cannot be shifted and the burden of the tax is borne

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by the same person on whom the tax is levied. Examples are Income tax, Wealth tax, Gift
tax, corporation tax, Death duty etc.
II. Indirect tax: When the burden of a tax can be shifted on other persons, it is called an
indirect tax. They are imposed on goods & services. Examples are Sales Tax, Service Tax,
Entertainment tax, Excise duty etc.
Basis of classification:
 A tax is a direct tax, if its burden can’t be shifted. Its liability to pay and burden falls on the same
person. For example: income tax, corporate tax, wealth tax, gift tax, estate duty etc.
 A tax is an indirect tax, if its burden can be shifted. Its liability to pay and burden falls on
different persons. For example: sales tax (paid by the shopkeeper but recovered from the
customer), excise duty (paid by the producer but recovered from wholesalers & retailers), custom
duty (paid by the importer but recovered from retailers & customers), entertainment tax (paid by
cinema owners but recovered from customers) etc.
b. Non Tax Revenue: Non Tax revenue refers to receipts of the government from sources other
than tax. Its main sources are:
I. Fees: It refers to the charges imposed by the government to cover the cost of recurring
services provided by it. It gives a special advantage to the fee payer. Example college
fee, license fee, registration fee.
II. Fines and penalties: A payment for the violation of law. It is levied to maintain law
and order. For example: fine for jumping red light etc.
III. Forfeitures: A penalty imposed by the court for non compliance with orders or non-
fulfillment of contracts.
IV. Escheat: A claim of the government on the property of a person who dies without
having a legal heir or without leaving a will.
V. Interest: Government receives interest on the funds advanced to states, union
territories, railways, post & telegraph etc.
VI. Profits & dividends: The government earns profits through public sector
undertakings like Indian Railways, LIC, and BHEL etc. It also gets dividend from its
investment in other companies.
VII. License Fee: It is a payment charged by the government to grant permission for
something. For example: license fee paid for permission of keeping gun or to obtain
permission for driving.
VIII. Gifts & Grants: Government received gifts and grants from foreign governments and
international organizations like World Bank. These are generally received during
national crisis such as war, flood etc.
2. Revenue Expenditure: Revenue expenditure is an expenditure which does not result in creation of
an asset or reduction in a liability. Such expenses are incurred on running of government
departments and maintenance of public services. These are financed out of revenue receipts. It is
recurring in nature which is incurred every year. For example, salaries, pensions, interest payments,
subsidies, grants, education & health services etc.

CAPITAL BUDGET

1. Capital Receipts: Those receipts which either create a liability or reduce an asset are called
capital receipts. Capital receipts are receipts under capital account. When government raises funds
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AND EX-PRINCIPAL SPS

either by incurring a liability or by disposing off its assets, it is called a capital receipt. These include
market borrowings, external loans and advances made by the government and provident fund. The
main sources of capital receipts are:
a. Recoveries of loans: Loans offered by government to others are government assets because it
owns money that it lends. Recovery of such loan is capital receipt as it reduces the assets of the
government.
b. Borrowings and other liabilities: These are the funds raised by government to meet excess
expenditure. These are treated as capital receipts because they create a liability of returning
loans. These funds are borrowed from (i) open market, (ii) RBI, (iii) foreign governments and
(iv) international organizations like World Bank, IMF etc.
c. Disinvestment: It is withdrawal of government investment. It refers to selling whole or a part of
the shares of selected PSUs held by the government to private sector. As a result of this,
government assets are reduced. Disinvestment is also termed as privatization because it involves
transfer of ownership from public sector to private sector.
d. Small Savings: It refers to the funds raised from the public in the form of post office deposits,
NSC, Kisan Vikas Patras etc.

2. Capital expenditure: An expenditure which leads to either creation of assets or reduction in

liability is a part of capital expenditure. These expenditures are met out of capital receipts. Its main
sources are:
a. Expenditure on purchase of assets like land, buildings, machinery etc.
b. Investment in shares
c. Repayment of loan

Difference between Capital receipts and revenue receipts:

Basis Revenue Receipts Capital Receipts

Meaning It does not create a liability or lead to It either creates a liability or reduces an
reduction in asset. asset.
Nature It is regular and recurring in nature. It is irregular & non-recurring.
Future There is no future obligation to return the In case of borrowings, there is an
obligation amount. obligation of returning the amount.
Example Tax Revenues like income tax, sales tax Recoveries of loans, Borrowings and other
etc. and non-tax revenue like interest, liabilities etc.
fees, penalties etc.

Difference between Capital expenditure and revenue expenditure:

Basis Revenue Expenditure Capital Expenditure
Meaning It does not result in creation of an asset or It leads to either creation of assets or
reduction in a liability reduction in liability.
Purpose It is incurred for normal running & It is incurred for acquisition of assets or
maintenance of government departments. granting of loans.
Nature It is recurring in nature. It is of non-recurring nature.
Example Salaries, pensions, interest payments, Loans granted to states or other countries,
subsidies, grants etc. repayment of loan, expenditure on
purchasing capital assets
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AND EX-PRINCIPAL SPS

TYPES OF BUDGET

Balanced Budget Surplus Budget Deficit Budget

• A budget is said to be a • A budget is said to be a • A budget is said to be a

balanced budget if surplus budget if deficit budget if estimated
estimated government estimated government government receipts are
receipts are equal to the receipts are more than less than estimated
estimated government estimated government government expenditure.
expenditure. expenditure. • It is a good policy to
• It ensures financial • It is a good strategy to control recession /
stability in the country. control inflation/excess deficient demand.
demand.

Estimated Receipts = Estimated Receipts > Estimated Receipts <

Estimated Expenditure Estimated Expenditure Estimated Expenditure

BUDGETARY DEFICIT

Budgetary Deficit is a situation, wherein the estimated expenditure of the government exceeds its
estimated revenue. When the government spends more than it collects, then it incurs a budgetary deficit.
This excess expenditure is financed by either borrowing from the market or from RBI. Budgetary
deficit can be of three types:
1. Revenue deficit
2. Fiscal deficit
3. Primary deficit
Revenue Deficit Meaning It is the excess of revenue expenditure over revenue receipts. It
signifies that governments’ own earning is insufficient to meet
normal functioning of government departments and provisions
of services.
Revenue deficit = Revenue Expenditure – Revenue Receipts
Implications  It indicates the inability of government to meet its regular &
recurring expenditure.
 It indicates dissavings because the government has to make
up the uncovered gap by drawing upon capital receipts either
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through borrowings or sale of its assets.

 Use of capital receipts for meeting the extra consumption
expenditure leads to inflationary situation.
 Higher borrowings increase the future burden of loan and
interest payments.
 It is a warning signal to the government to either curtail its
expenditure or increase its revenue.
Remedial  Government should take steps to reduce its expenditure &
measures avoid unproductive & unnecessary expenditure.
 Government should increase its receipts from its various
sources.
Fiscal Deficit Meaning It is defined as the excess of total budget expenditure over total
budget receipts excluding borrowings during a fiscal year. In
other words, it is equal to the amount of borrowings during a
year. It is a measure of how much the government needs to
borrow from the market to meet its expenditure when its
resources are inadequate. Greater fiscal deficit implies greater
borrowings.
Fiscal deficit = Total Expenditure – Total receipts excluding
borrowings
Implications  Debt trap: Fiscal deficit is financed by borrowings and
borrowings not only involve repayment of principal amount
but also the payment of interest. Interest payments increase
the revenue expenditure, which leads to revenue deficit. It
creates a vicious circle of fiscal deficit and revenue deficit
wherein government takes more loans to repay earlier loans.
As a result, the country is caught in a debt trap.
 Inflation: Government generally borrows from RBI. This
means there is printing of more currency notes to meet
deficit requirements. It raises the circulation of money and
causes inflation.
 Foreign dependence: Government also borrows from
foreign countries which raises its dependence on them.
 Reduces future growth: Borrowings increases the financial
burden of future generations. It adversely affects the future
growth and development prospects of the country.
Remedial  Reduction in expenditure on major subsidies.
measures  To curtail non-planned expenditure.
 Tax base should be broadened & reductions in taxes should
be curtailed.
 Tax evasion should be effectively checked.
 More emphasis on direct taxes to increase revenue.
Primary deficit Meaning It is defined as the difference between fiscal deficit of the current
year and interest payments on previous borrowings. Primary
deficit reflects the extent to which interest commitments on
earlier loans have compelled the government to borrow in the

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current period.
Fiscal deficit reflects borrowing requirements of the government
for financing the expenditure inclusive of interest payment
whereas primary deficit shows the borrowing requirements
exclusive of interest payments.
Primary deficit = Fiscal deficit – Interest payments
Implications  It shows how much government borrowing is going to meet
expenses other than interest payments.
 Zero primary deficits means that government has to borrow
only to make interest payments.
 The difference between fiscal deficit & primary deficit
reflects the amount of interest payments.
Remedial Interest payments should be reduced through early repayment of
measures loans.

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AND EX-PRINCIPAL SPS

BALANCE OF PAYMENTS

MEANING OF FOREIGN EXCHANGE RATE

The rate at which currency of one country can be exchanged for currency of another country is called the
rate of foreign exchange. In other words, it is the price paid in domestic currency in order to get one unit
of foreign currency. In case of an international payment, currency of one country has to be converted
into the currency of another country because every country wants the payment in its own currency.
Suppose, if an American firm exports goods to India, it wants to receive the payment in dollars. As a
result of this, Indian importer will have to covert Indian Rupees into American dollars.
Example: If 1 American dollar can be obtained / exchanged for 50 Indian Rupees, then
Foreign exchange rate is $1 = Rs.50. this is called foreign exchange rate between USA & India.
Nominal vs Real Exchange rate
Nominal exchange rate is price of foreign currency in terms of domestic currency. Real exchange rate is
the relative price of foreign goods in terms of domestic goods.
Real Exchange rate = Nominal exchange rate x Foreign price level
Domestic price level

TYPES OF FOREIGN EXCHANGE RATES:

1. Fixed Exchange Rate System: It refers to a system in which exchange rate for a currency is
fixed by the government. The basic purpose of adopting this system is to ensure stability in
foreign trade and capital movements. Only a very small deviation from this fixed value is
possible. To achieve stability, government undertakes to buy foreign currency when the
exchange rate becomes weaker and sell foreign currency when the rate of exchange gets
stronger. Historically, it has two variants:
(a) Gold Standard system: According to this system, gold was taken as the common unit of
parity between currencies of different countries in circulation. Each country was to define
value of its currency in terms of gold. Accordingly, value of one currency in terms of the
other currency was fixed considering gold value of each currency. This system was also
known as Mint par value of exchange or Mint parity. It was prevalent in most countries
prior to 1920s.
For example: if €1 = 5 gm of gold and $1 = 2 gm of gold, then exchange rate will be €1 =
$2.5.
(b) Bretton Woods System: According to this system, gold was replaced by US dollar as the
‘core’ of the system. Under this system, all currencies were pegged or related to US dollar at
a fixed exchange rate. US dollar was assigned gold value at a fixed price.

2. Flexible / Floating Exchange Rate System: Flexible rate of exchange is that rate which is
determined by the demand for & supply of the currencies concerned in the foreign exchange
market. In other words, it is determined by the market forces, like the price of any other

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commodity. Here, value of currency is allowed to fluctuate or adjust freely according to change
in demand and supply of foreign exchange. There is no official intervention in foreign exchange
market. The rate at which demand for foreign currency is equal to its supply is called ‘par rate
of exchange’.

3. Managed Floating Rate System: It refers to a system in which foreign exchange rate is
determined by market forces and central bank is a key participant to stabilize the currency in case
of extreme depreciation or appreciation. It is also known as ‘dirty floating’. In this system,
central bank intervenes to restrict fluctuations in the exchange rate within certain limits. The aim
is to keep exchange rate close to desired target values.

FOREIGN EXCHANGE MARKET

Foreign Exchange Market refers to the market for national currencies of different countries in the world.
It is the market in which foreign currencies are bought and sold. The buyers and sellers include
individuals, firms, foreign exchange brokers, commercial banks & central bank.
Functions of foreign exchange market:
1. Transfer function: It refers to transferring purchasing power between countries. It is performed
through credit instruments like bills of foreign exchange, bank drafts, telephonic transfers etc.
2. Credit function: It provides credit for foreign trade. Bills of exchange with maturity period of
three months are generally used for international payments. Credit is required for this period in
order to enable the importer to take possession of goods, sell them and obtain money to pay off
the bill.
3. Hedging function: It implies protection against the risk related to variations in foreign exchange
rate. It is done by forward foreign exchange transactions, through the banks. The exporters and
importers enter into an agreement to sell and buy goods on some future date at the current prices
and exchange rate.

TYPES OF FOREIGN EXCHANGE MARKET

1. Spot market: This market handles only spot transactions or current transactions. In other words,
market in which receipts & payments are made immediately is known as spot market. The rate of
exchange which is determined in the spot market is known as spot rate of exchange. Spot
market is of daily nature and does not deal in future deliveries.
2. Forward market: This market handles such transactions of foreign exchange as are meant for
future delivery. In other words, in this type of market, sale and purchase of foreign currency is
settled on a specified future date at a rate agreed upon today. The rate is settled now but actual
transaction of foreign exchange takes place in future. The exchange rate quoted in forward
transactions is known as forward exchange rate. Forward contract is made for two reasons i.e.
to minimize the risk o floss due to adverse changes in the exchange rate through hedging and to
make profit through speculation.

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REASONS / SOURCES OF DEMAND FOR FOREIGN

EXCHANGE
Demand or outflow of foreign exchange arises due to the following reasons:
1. To make payments for purchase of goods & services by domestic residents from foreign
countries i.e. imports.
2. To send gifts & grants to foreign countries.
3. To undertake foreign tours.
4. To make payments for purchase of assets like land, shares, bonds etc. in the foreign countries.
5. To make gains from speculation on the value of foreign currencies.
6. To make payments of international loans.
There is an inverse relationship between foreign exchange rate & its demand. Higher the foreign
exchange rate, the lower the demand for foreign exchange and vice-versa.

SITUATIONS IN WHICH DEMAND FOR FOREIGN

CURRENCY RISES / FALLS:
1. When price of a foreign currency falls, imports from that country become cheaper. So, imports
increase and hence demand for foreign currency rises. Its reverse happens when price of a
foreign currency rises, i.e. imports become costlier leading to a fall in demand for foreign
currency.
2. When a foreign currency becomes cheaper in terms of the domestic currency, it promotes
tourism to that country. It raises the demand for foreign currency. Its reverse happens when price
of a foreign currency rises, i.e. tourism is discouraged and demand for foreign currency falls.

REASONS / SOURCES OF SUPPLY FOR FOREIGN

EXCHANGE
Supply or inflow of foreign exchange arises due to the following reasons:
1. When foreigner’s purchase domestic country’s goods & services i.e. exports.
2. When foreigner’s invest in bonds or shares of domestic country or they purchase assets from
domestic country.
3. Remittances by the non-residents living abroad in the form of gifts etc.
4. Supply of foreign exchange comes from those who want to speculate on the value of foreign
exchange.
5. When foreign tourists come to India.
There is a direct relationship between foreign exchange rate & its supply. Higher the exchange rate,
higher the supply of foreign exchange and vice-versa.

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SITUATIONS IN WHICH SUPPLY OF FOREIGN

CURRENCY RISES / FALLS:
1. When price of a foreign currency rises, domestic goods become relatively cheaper. It induces
foreign countries to increase their imports from domestic country. So, exports increase and hence
supply of foreign currency rises. Its reverse happens when price of a foreign currency falls, i.e.
exports become costlier leading to a fall in of foreign currency.
2. When a foreign currency becomes costlier in terms of the domestic currency, it promotes tourism
in domestic country. It raises the supply of foreign currency. Its reverse happens when price of a
foreign currency falls, i.e. tourism is discouraged and supply of foreign currency falls.

EQUILIBRIUM RATE OF EXCHANGE

Equilibrium exchange rate occurs where supply of and

demand for exchange is equal to each other. It is the
flexible rate of exchange. The adjoining figure illustrates
determination of equilibrium exchange rate.
Equilibrium is determined at the point ‘E’ where both
demand curve & supply curve intersect each other. DD is
the demand curve & SS is the supply curve. The demand
curve is downward sloping which shows inverse relation
between price & quantity demanded of foreign exchange.
Supply curve is upward sloping which shows direct
relationship between the rate and demand of foreign
exchange.
Equilibrium exchange rate is OR and equilibrium quantity
isChange
OQ. in exchange rate:
Suppose there is an increase in India’s demand for US dollars, supply remaining the same then it will
cause the demand curve DD shift to D’D’. The resulting intersection will be at a higher exchange rate
i.e. exchange rate will rise from OR to OR1. It shows depreciation of Indian Currency because more
rupees are required to buy 1 US$. Thus, depreciation of currency means a fall in the price of home
currency.
Similarly, if there is an increase in supply of US dollars will cause supply curve SS shift to S’S’ and as a
result exchange rate will fall from OR to OR2. It indicates appreciation of Indian Currency. Thus,
appreciation means a rise in price of home currency.

CURRENCY DEPRECIATION VS CURRENCY

APPRECIATION
 Currency depreciation: It refers to decrease in the value of domestic currency in terms of foreign
currency. It makes the domestic currency less valuable and more of it is required to buy foreign
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currency. It happens when demand of a currency increases without any change in supply. For
example: if demand for US dollars increases, supply remaining the same, the exchange rate will
raise. It implies appreciation of US dollars or depreciation of Indian Rupees.
Implication: Its implication is that with the same amount of dollars, more goods can be purchased from
India. This means Indian goods become cheaper for America. This may result in increase of exports
from India to America.
 Currency appreciation: It refers to increase in the value of domestic currency in terms of foreign
currency. It makes the domestic currency more valuable and less of it is required to buy foreign
currency. It happens when supply of a currency increases without any change in demand. For
example: If supply of US dollars increases, demand remaining the same, and the exchange rate will
fall. It implies appreciation of Indian Rupees or depreciation of US dollars.
Implication: It implies strengthening of Indian Rupee. It means with the same amount of Rupees more
goods can be purchased from US. This may result in increase of imports by India from US.

DEVALUATION & REVALUATION

Devaluation refers to reduction in the value of domestic currency by the government. On the other hand,
revaluation refers to increase in the value of domestic currency by the government. It happens under a
fixed exchange rate system. The implications of devaluation & depreciation will be the same since they
both mean the same thing. Likewise the implications of revaluation & appreciation will be the same.

MEANING OF BALANCE OF PAYMENT (BOP)

Balance of payment refers to the statement of accounts recording all economic transactions of a given
country with rest of the world. Each country enters in to economic transactions with other countries of
the world. As a result, it receives payments from and makes payments to other countries. BOP is a
statement of account of these receipts & payments. It involves inflow & outflow of foreign exchange in
a year. It is like a typical business account and is based on double entry system which has two aspects
i.e. credit & debit. Any transaction which brings in foreign currency (i.e. exports) is recorded on credit
side whereas any transaction which causes a country to lose foreign exchange (i.e. imports) is recorded
on debit side. Similarly, borrowing from ROW is a credit item while lending is a debit item. The main
purpose of BOP account is to know international economic position of a country & help the government
make appropriate trade & payment policies.
Features of BOP:
1. It keeps a systematic record of receipts & payments of a country with other countries.
2. It is a statement of account for a given period of time, generally one year.
3. It includes all transactions of all the three items, i.e. visible, invisible & capital transfers.
4. It is maintained as per the double entry system. In accounting sense total debit will always be
equal to credit i.e. BOP will always be in equilibrium. But in economic sense, if receipts are
larger then there is surplus BOP and if payments are larger there is deficit in BOP.

ECONOMIC TRANSACTIONS IN BOP

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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

Economic transactions can be classified in to the following:

1. Visible items: It includes all types of physical goods exported / imported. These are visible as
these are made of some matter or material and can be seen, touched or measured.
2. Invisible items: It includes all types of services, investment income and unilateral transfers.
Services include shipping, banking, insurance, travel services; consultancy services etc.
investment income includes interest, profit, dividend & royalties. Unilateral transfers includes
gifts, donations etc.
3. Capital transfers: These are concerned with capital receipts & capital payments.

MEANING OF BALANCE OF TRADE (BOT)

It is the difference between the value of exports and imports of material goods. It shows visible trade
transactions.
BOT = Value of goods exported – Value of goods imported
If value of goods exported is more the value of goods imported then it called favourable / positive BOT.
Thus, BOT shows a surplus. In case the value of goods imported is more than value of goods exported
then it is called unfavourable / adverse / negative BOT. Then BOT is called in deficit. If value of
exports is equal to value of imports then BOT is said to be balanced or in equilibrium. It is a narrower
concept as compared to BOP.

COMPONENTS OF BOP
BOP account is divided into two accounts i.e. current account & capital account. The capital account
records transactions representing foreign financial assets & liabilities.
1. Current Account: The current account of BOP records transactions relating to exchange of
goods & services and unilateral transfers. It includes record of:
(a) Export & import of goods / Merchandise (visible items): It includes export & import of
visible items like wheat, rice, machinery etc. Movement of goods between countries is
known as visible trade because the movement is open and can be verified by custom officials.
Exports are recorded as credits and imports are recorded as debits.
The net balance of visible trade, i.e. export minus import of goods is called balance of
visible trade. If exports are more than imports then there is trade surplus and if imports are
more than exports then there is trade deficit.
(b) Export & import of services (invisible items): Under this head, following types of services
are included:
(i) Shipping, Insurance, Banking, Tourism & other miscellaneous services: Services
include shipping, tourism, insurance & other miscellaneous services like management
fees, subscription to journals, telephone services etc. Payments are either received or
made for the use of these services. When services are rendered to non-residents these
are recorded on the credit side as they result in the inflow of foreign exchange. When
these are rendered to the residents by the non-residents these are recorded on debit
side as they result in outflow of foreign exchange.
(ii) Investment income: When foreign companies make investment in India’s industry
and trade, the profit made by them in India have to be paid to their shareholders in the

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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

form of dividend. Similarly, interest has to be paid to foreign credits for money
borrowed in the past. Thus dividend and interest payments result in outflow of foreign
exchange. In the same way, India may receive dividend & interest payments which
result in inflow of foreign exchange.
(iii) Unilateral transfers: These are unrequited transfers or unilateral transfers between
residents & non-residents. These can be private which include gifts, donations etc. or
official which include donations, grants in cash by foreign governments, contribution
from UN, WHO etc.
The net balance of invisible trade, i.e. export & import of services is termed as balance of
invisible trade.
Balance of current account: It is equal to the difference between the sum of credits and the
sum of debits on current account. It can be negative or positive. The sum of Net visible and
Net invisible gives current account balance which can show surplus or deficit. The current
account balance is transferred to capital account.
2. Capital Account: It records international transactions which affect assets & liabilities of
domestic country with rest of the world. It includes the following:
(a) Borrowings & lending: Government of a country may borrow from another government; a
firm may issue stocks abroad or a bank may float a loan in a foreign currency. In all these
instances, the said country will acquire foreign currency and these will be recorded as credit
items. Debit items will comprise lending to abroad by private individuals and institutions,
governments etc. and repayments of foreign loans.
(b) Changes in foreign exchange reserves: The official reserves of the country may be
increased or decreased with a view to finance government expenditure abroad. Reduction in
reserves implies purchase of foreign exchange while increase in reserves implies sale of
foreign exchange. By changing the reserves, the government is changing its supply / demand
status of foreign exchange. This may be done with a view to affect the exchange rate in the
international money market.
Balance of capital account: It is the difference between the sum of credits and sum of debits on
capital account. It can be positive or negative.
Balance on capital account = Sum of credit items – Sum of debit items

Difference between BOT and BOP

BOT BOP
1. It records transactions related to goods 1. It records transactions related to both
only. goods & services.
2. It does not record transactions of capital 2. It also records transactions of capital
nature. nature.
3. It is a narrow concept since it is a part 3. It is a broad concept and it includes BOT.
of current account of BOP.
4. It is an indicator of economic relations 4. It is an indicator of economic performance
of a country. of an economy.

AUTONOMOUS & ACCOMMODATING ITEMS IN BOP

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NOTES BY SUMAN (MA ECONOMICS, B.ED PGDVES, AN AUTHOR, CONTENT WRITER
AND EX-PRINCIPAL SPS

Autonomous items: These refer to international economic transactions that take place due to economic
motives like profit maximization. They have nothing to do with foreign exchange payments. Since such
transactions are independent of the state of country’s BOP i.e. irrespective of whether BOP is favourable
or unfavourable, they are, therefore called autonomous items. These items are often called ‘above the
lines items’ in BOP.
Surplus of deficit in BOP: BOP is in deficit if the autonomous receipts are less than autonomous
payments and it is in surplus if autonomous receipts are more than autonomous payments.
Example: if a foreign company is making investments in India with the aim of earning profit then such
a transaction is independent of country’s BOP situation. Autonomous transactions take place in both
current (e.g. exports & imports) and capital accounts (e.g. receipts & repayments of loans).
Accommodating item: These refer to the transactions that are undertaken in order to maintain the
‘balance’ in BOP account. These items are also known as ‘below the line items’. Accommodating
transactions are compensating capital transactions which are meant to correct the disequilibrium in
autonomous items of balance of payments. For example: if there is a current account deficit in BOP,
then this deficit is settled by capital inflow from abroad. Such a borrowing is an accommodating item
because it is undertaken to cover deficit. Other sources to meet deficit are: foreign reserves, borrowings
from IMF or foreign monetary authorities.

DISEQUILIBRIUM IN BOP
BOP is said to be in disequilibrium when BOP deficits or surplus are all of large magnitude and increase
over years. Equilibrium in BOP is achieved when the net balance of all receipts and payment is zero.
When the net balance is positive it is disequilibrium with surplus balance. On the other hand, when the
net balance is negative it is disequilibrium with deficit.
Causes of disequilibrium:
1. Inflation: Changes in price and cost structure of a country’s export industries affect the volume
of exports and the balance of payments position. Increase in prices due to higher wages, higher
prices of raw materials etc. makes exports costlier. It results in deficit in BOP.
2. Changes in foreign exchange rate: if the external value of currency of a country is increased,
imports become cheaper and exports become dearer. As a result, imports rise and exports fall.
3. Fall in demand: When the demand for a country’s goods falls in foreign markets, exports reduce
which results in adverse balance of payments.
4. Population explosion: In underdeveloped countries, aggregate consumption demand rises due to
rapid increase in population. This result in fall in export surplus and adverse BOP.
5. Political factors: Political instability of a country has an adverse effect on BOP of a country.
International relations of a country may be cordial or full of tension. These have their favourable
or unfavourable impact on the BOP of a country.
6. Social factors: Sometimes, people of underdeveloped countries try to imitate the consumption
pattern of the people of developed countries. Therefore, due to demonstration effect i.e. changes
in tastes, preferences, fashion etc., their imports increase and results in disequilibrium.

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