ECONOMICS HAND BOOK

For

II PUC

MICRO ECONOMICS

&
MACRO ECONOMICS

(NCERT Syllabus 2018-19)

With

P.U. Board Question Bank (2019-20)

By:
D.K PU Economics Association,
GPUC, Carstreet, Mangalore, D.K.
Ph. No.: 9844671258.
Second Edition: June, 2020

Price - ₹ 120/-

Editorial Members:
1. M. Anantha Moodithaya (M.A.)
Lecturer in Economics,
Pompei P.U. College, Thalipady,
Kinnigoli, D.K.
Ph. No.: 9480267051

2. Vishnu Moorthy Mayya M. (BSc., M.A., M.Ed.)

Lecturer in Economics,
Govt. P.U. College, Sajipamooda,
Bantwal, D.K.
Ph. No.: 9844671258

3. Dr. Abdul Razak K. (M.A., B.Ed., MBA, M.Phil., PhD.)

Lecturer in Economics,
Govt. P.U. College, Krishnapura,
Katipalla, D.K.
Ph. No.: 9482254627

4. Chandru M. N. (M.A.)
Lecturer in Economics,
Govt. P.U. College, Carstreet,
Mangaluru, D.K.
Ph. No.: 6360550825

5. Joseph Peter Nazareth (M.A., B.Ed.)

Lecturer in Economics,
St. Joseph’s P.U. College, Bajpe,
Mangaluru, D.K.
Ph. No.: 7760028430

6. Sadana (M.A.)
Lecturer in Economics,
B.E.M aided P.U. College, Carstreet,
Mangaluru, D.K.
Ph. No.: 9480432773

7. Shobha Sharma (M.A.Economics, M.A. English, B.Ed.)

Lecturer in Economics,
Govt. P.U. College, Chelairu,
Mangaluru, D.K.
Ph. No.: 9980615490
 PREFACE

Under the valuable guidance of The Deputy Director of Pre-University Department

D.K. and D.K. PUC Economics Lecturers’ Association we are glad to introduce the Economics

Handbook for II PUC. The handbook is prepared according to the NCERT Syllabus 2018-19

with Revised Question Bank (2019-2020) by a team of senior economics PUC lecturers. The

association expresses its deep sense of gratitude to these lecturers for their valuable time and

co-operation.

We hope that this handbook is useful to the lecturers regarding the syllabus, blueprint,

model question paper and question bank, also this may help the students to score good marks

in the subject.

We are thankful to all the lecturers for their guidance, encouragement and support.

President and Members

D.K. PU Economic Association

 Table of Contents

Chapters Content Page No.

Part-I Micro Economics
1. Introduction 1
2. Theory of Consumer Behaviour 8
3. Production and Costs 27
4. The Theory of the Firm Under Perfect Competition 39
5. Market Equilibrium 49
6. Non-Competitive Markets 59

Part-II Macro Economics

1. Introduction 70
2. National Income Accounting 77
3. Money and Banking 91
4. Determination of Income and Employment 103
5. Government Budget and The Economy 114
6. Open Economy Macroeconomics 125

Instructions 135
Design of the Question Paper 136
Distribution of Marks 137
Blue Print 138
Department Model Question Paper 2019-20 139
 PART-I
MICRO ECONOMICS
 Chapter-1: Introduction

A Simple Economy:
People in the society need many goods and services in their everyday life including
food, clothing, shelter, transport facilities like roads and railways, postal services and various
other services like that of teachers and doctors.
 Goods: Goods we means physical, tangible objects used to satisfy people’s wants and
needs. e.g.: food, clothing, etc.
 Services: The term services which captures the in tangible satisfaction of wants and
needs. e.g.: services of doctors and teachers, transport services, postal services etc.
 Resources: By resources we mean those goods and services which are used to produce
other goods and services. e.g.: Land, labour, tools and machinery etc.
 For example, the family farm can produce corn, use part of the produce for
consumption purposes and procure clothing, housing and various services in exchange
for the rest of the produce.
 The weaver can get the goods and services that she wants in exchange for the cloth she
produces in her yarn.
 The teacher can earn some money by teaching students in the school and use the money
for obtaining the goods and services that she wants.
 The labourer also can try to fulfil her needs by using whatever money she can earn by
working for someone else.
 Each individual can thus use her resources to fulfil her needs. It goes without saying
that no individual has unlimited resources compared to her needs. The scarce resources
of the society have to be allocated properly in the production of different goods and
services in keeping with the likes and dislikes of the people of the society.
 Every society has to face scarcity of resources, which have alternative uses. The scarcity
of the resources that give rise to the problem of choice. The scarce resources of an
economy have competing usages.

Central Problems of an Economy:

The problems of an economy are:
1) What is produced and in what quantities?
2) How are these goods produced?
3) For whom are these goods produced?

1
 Let us look in detailed at each one of the above…
1) What is produced and in what quantities?
Every society must decide on how much of each of the many possible goods and
services it will produce.
 Whether to produce more of food, clothing, housing, or to have more of luxury
goods.
 Whether to have more agricultural goods or to have industrial products and
services
 Whether to use more resources in education and health or to use more resources
in building military services.
 Whether to have more of basic education or more of higher education.
 Whether to have more of consumption goods or to have investment goods which
will boost production and consumption tomorrow.
2) How are these goods produced?
Every society has to decide on how much of which of the resources to use in the
production of each of the different goods and services.
 Whether to use more labour or more machines (problem of techniques).
 Which of the available technologies to adopt in the production of each of the
goods?
3) For whom are these goods produced?
 How should the product of the economy be distributed among the individuals
in the economy? (Problem of distribution).
 Who gets more and who gets less?
 Who gets how much of the goods that are produced in the economy?
 Whether or not to ensure a minimum amount of consumption for everyone in
the economy.
Thus the allocation of scarce resources and distribution of final goods and services are
the central problems of an economy.

Production Possibility Set:

The collection of all possible combination of the goods and services that can be
produced form a given amount of resources and a given stock of technological knowledge is
called the production possibility set of the economy.

2
Explanation of Production Possibility Frontier:
Every society has to determine how to allocate its scarce resources to different goods
and services. An allocation of the scarce resources of the economy gives rise to a particular
combination of different goods and services.
Production possibility frontier:
It gives the combination of given amount of resources (corn and cotton) that can be
produced when the resources of the economy are fully utilised. From the production possibility
set we can get the curve. This curve is called the production possibility frontier.
It gives the combinations of cotton and corn that can be produced when the resources
of the economy are fully utilized.
This can be graphically represented as follows:
Table: Production Possibilities
Possibilities Corn Cotton
A 0 10
B 1 9
C 2 7
D 3 4
E 4 0

As per the above graph, the points lying strictly below the production possibility curve
represents a combination of cotton and corn that will be produced when all or some of the
resources are either underemployed or are utilized in a wasteful fashion.
 Opportunity Cost: An opportunity cost is the cost of having a little more of one good
in terms of the amount of the other good that has to be forgone. This is known as the
opportunity cost of an additional unit of the goods. Opportunity cost is also called the
economic cost.
Organisation of Economic Activities:
1. Centrally planned economy
2. Market planned economy
1) Centrally Planned Economy:
In centrally planned economy, the Government takes decisions about the allocation
of resources in accordance with the predetermined goals and objectives to attain maximum
social welfare. Government decides what to produce, how to produce and what prices are to be
fixed.

3
 A planned economy also called as socialistic economy is that economy where the
economic activities are controlled by the central Government. Here, the Government takes
decisions about the allocation of resources in accordance with objectives to attain economic
and social welfare. Example, Russia, China, North Korea etc.
 The central authority may try to achieve a particular allocation of resources and a
consequent distribution of the final combination of goods and services which is thought
to be desirable for a society as a whole.
 If some people in the economy get so little a share of the final mix of goods and services
produced in the economy that their survival is at stake, then the central authority may
intervene and try to achieve an equitable distribution of the final mix of goods and
services
2) Market Economy:
In a market economy all economic activities are organised through the market. A
market is a set of arrangements where economic agents can freely exchange their endowments
and products with each other.
 A market economy also known as capitalistic economy is that economy in which the
economic decisions are undertaken on the basis of market mechanism by the private
entrepreneurs. It functions on demand and supply conditions. In USA, Japan, Australia,
UK and other countries we can see Market Economic systems.
 In market economy, private individuals own the factors of production. Here, the profit
is the main goal of business. There is least intervention of Government.
 Price mechanism plays a major role in market economy. It is a balancing wheel of the
market mechanism. Prices coordinate decisions of the producers and consumers. The
price is determined by demand and supply in the market. No individual organization or
Government is responsible for the production and distribution or pricing of goods. All
depend on market mechanism.
 Thus, in a market system, the central problems regarding how much and what to
produce are solved through the coordination of economic activities brought about by
the price signals.
 In reality, all economies are mixed economies where some important decisions are
taken by the government and the economic activities are by and large conducted
through the market.

4
Positive Economics:
In positive economic analysis we study how the different mechanisms function and
figure out the outcomes which are likely to result under each of these mechanisms.

Normative Economics:
In normative economics we try to understand whether the different mechanisms are
desirable or not. We also try to evaluate the mechanisms by studying how desirable the
outcomes resulting from them are.

Difference between Micro and Macro Economics:

Traditionally, the subject matter of economics have been studied under two broad
branches:
1) Microeconomics
2) Macroeconomics
1) Microeconomics:
 In microeconomics, we study the behaviour of individual economics agents in the
markets for different goods and services.
 It tries to figure out how prices and quantities of goods and services are determined
through the interaction of individuals in these markets.
2) Macroeconomics:
 In macroeconomics, we try to get an understanding of the economy as a whole by
focusing our attention on aggregate measures such as total output, employment and
aggregate price level.
 Some important questions that are studied in macroeconomics are:
 What is the level of total output in the economy?
 How is the total output determined?
 How does the total output grow over time?
 Are the resources of the economy (labour) fully employed?
 What the reasons behind the unemployment of the resources?
 Why do prices rise?
 Thus, instead of studying the different markets as in done in microeconomics, in
macroeconomics we try to study the behaviour of aggregate or macro measures of the
performance of the economy.

****
5
6
7
 Chapter-2: Theory of Consumer Behaviour

Introduction:
The consumer has to decide how to spend her income on different goods. Economists
call this the problem of choice. Most naturally, any consumer will want to get a combination
of goods that gives his maximum satisfaction.
A consumer usually decides his demand for a commodity on the basis of utility (or satisfaction)
that he derives from it. The two different approaches that explain consumer behaviour are:
1. Cardinal Utility Analysis.
2. Ordinal Utility Analysis.
1. Cardinal Utility Analysis:
Cardinal utility analysis assumes that level of utility can be expressed in numbers. For example,
we can measure the utility derived from a shirt and say, this shirt gives me 50 units of utility.
2. Ordinal Utility Analysis:
The consumer does not measure utility in numbers, though he often ranks various consumption
bundles this is called Ordinal utility analysis.
 Utility: Utility of a commodity is its want-satisfying capacity. The more the need of a
commodity or the stronger the desire to have it, the greater is the utility derived from the
commodity.
 Utility subjective: a Different individuals can get different levels of utility from the same
commodity. For example, someone who likes chocolates will get much higher utility from
a chocolate than someone who is not so fond of chocolates.
 Utility that one individual gets from the commodity can change with change in place
and time. For example, utility from the use of a room heater will depend upon whether the
individual is in Ladakh or Chennai (place) or whether it is summer or winter (time).

 Cardinal Utility Analysis:

Measures of Utility:
1. Total Utility (TU).
2. Marginal Utility (MU).
1. Total Utility (TU): Total utility of a fixed quantity of a commodity (TU) is the total
satisfaction derived from consuming the given amount of some commodity x. Therefore,
TUn refers to total utility derived from consuming n units of a commodity x.

8
2. Marginal Utility (MU): Marginal utility (MU) is the change in total utility due to
consumption of one additional unit of a commodity.
For example, suppose 4 bananas give us 28 units of total utility and 5 bananas give us 30 units
of total utility. Consumption of the 5th banana has caused total utility to increase by 2 units (30
units minus 28 units).
Therefore, marginal utility of the 5th banana is 2 units.
MU5 = TU5 – TU4 = 30 – 28 = 2
In general, MUn = TUn – TUn-1, where subscript n refers to the nth unit of the
Commodity.
Relation between TU and MU:
Total utility and marginal utility can also be related in the following way:
TUn = MU1 + MU2 + … + MUn-1 + MUn
TUn = ∑ MUn
This means that TU derived from consuming n units of bananas is the sum total of
marginal utility.

Law of Diminishing Marginal Utility:

Law of Diminishing Marginal Utility states that “marginal utility from consuming each
additional unit of a commodity declines as its consumption increases, while keeping
consumption of other commodities constant”
Values of marginal and total utility derived from consumption of various amounts of a
commodity
Units Total Utility Marginal Utility
(TU) (MU)
1 12 12
2 18 6
3 22 4
4 24 2
5 24 0
6 22 -2

The table and the Graph shows, an imaginary example of the values of marginal and
total utility derived from consumption of various amounts of a commodity. Usually, it is seen
that the marginal utility diminishes with increase in consumption of the commodity. This
happens because having obtained some amount of the commodity, the desire of the consumer
to have still more of it becomes weaker.

9
 The values of marginal and total utility derived from consumption of various amounts of a
commodity.
 MU becomes zero at a level when TU remains constant. In the example, TU does not
change at 5th unit of consumption and therefore MU5= 0.
 When, MU5 = 0, TU starts falling and MU becomes negative.

 Ordinal Utility Analysis:

Indifference Curve:
The consumer is said to be indifferent on the different bundles because each point of
the bundles give the consumer equal utility. Such a curve joining all points representing bundles
among which the consumer is indifferent is called an indifference curve.
All the points lying on an indifference curve provide the consumer with the same level of
satisfaction.

A consumer’s preferences over the set of available bundles can often be represented
diagrammatically. We have already seen that the bundles available to the consumer can be
plotted as points in a two dimensional diagram. The points representing bundles which give
the consumer equal utility can generally be joined to obtain a curve IC.
All the points such as A, B, C and D lying on an indifference curve provide the
consumer with the same level of satisfaction. It is clear that when a consumer gets one more
banana, he has to forego some mangoes, so that his total utility level remains the same and he
remains on the same indifference curve. Therefore, indifference curve slopes downward.

Marginal Rate of Substitution (MRS):

The amount of commodity X that the consumer has to forego, in order to get an
additional commodity Y, her total utility level being the same, is called marginal rate of

10
substitution (MRS). In other words, MRS is simply the rate at which the consumer will
substitute commodity X for commodity Y, so that her total utility remains constant.
So,
∆Y
MRS = | |
∆X
Where, ∆Y = change in commodity Y, ∆X = change in commodity X.

Shape of Indifference Curve:

The law of Diminishing Marginal Rate of Substitution causes an indifference curve to
be convex to the origin. This is the most common shape of an indifference curve.

When the two commodities are perfect substitutes for the consumer and indifference
curve depicting these will be a straight line. In the figure below, it can be seen that consumer
sacrifices the same number of five-rupee coins each time he has an additional five-rupee note.
Example: A five rupee coin and a five rupee note are perfect substitutes.

Indifference Map:
A family (or group) of indifference curves is called an indifference map of the
consumer.

11
 The arrow indicates that bundles on higher indifference curves are preferred by the
consumer to the bundles on lower indifference curves.

Monotonic Preferences:
A consumer’s preferences are monotonic if and only if between any two bundles, the
consumer prefers the bundle which has more of at least one of the goods and no less of the
other good as compared to the other bundle. Preferences of this kind are called monotonic
preferences.
Monotonicity of preferences imply that between any two indifference curves, the bundles on
the one which lies above are preferred to the bundles on the one which lies below.

Features of Indifference Curve:

The main features of the indifference curve are as follows:
1. Indifference curve slopes downwards from left to right.
2. Higher indifference curve gives greater level of utility.
3. Two indifference curves never intersect each other.

1. Indifference curve slopes downwards from left to right:

An indifference curve slopes downwards from left to right because, the consumer in
order to have more of one product, he has to forego some units of other product. This can
be explained with the help of diagram.

12
 The indifference curve slopes downward. An increase in the amount of bananas along
the indifference curve is associated with a decrease in the amount of mangoes. If ∆ x 1 > 0
then ∆ x2 < 0.
2. Higher indifference curve gives greater level of utility:
Combinations A, B and C consist of same quantity of mangoes but different quantities
of bananas. Since combination B has more bananas than A, B will provide the individual a
higher level of satisfaction than A.
Therefore, B will lie on a higher indifference curve than A, depicting higher
satisfaction. Likewise, C has more bananas than B (quantity of mangoes is the same in both
B and C).
Therefore, C will provide higher level of satisfaction than B, and also lie on a higher
indifference curve than B.

As long as marginal utility of a commodity is positive, an individual will always prefer

more of that commodity, as more of the commodity will increase the level of satisfaction
i.e., IC1 ˂ IC2 ˂ IC3.
3. Two indifference curves never intersect each other:
Two indifference curves intersecting each other will lead to conflicting results.
 To explain this, let us allow two indifference curves to intersect each other as shown
in the figure. As points A and B lie on the same indifference curve IC1, utilities
derived from combination A and combination B will give the same level of
satisfaction.
 Similarly, as points A and C lie on the same indifference curve IC 2, utility derived
from combination A and from combination C will give the same level of
satisfaction.

13
 From this, it follows that utility from point B and from point C will also be the
same. But this is clearly an absurd result, as on point B, the consumer gets a greater
number of mangoes with the same quantity of bananas.
So, consumer is better off at point B than at point C. Therefore, it is clear that
intersecting indifference curves will lead to conflicting results. Thus, two indifference curves
cannot intersect each other.

Difference between Budget Set and Budget Line:

Budget Set:
The budget set is the collection of products that the consumer can buy with his
income(M) at the prevailing market prices P1and P2. The Budget set is also known as
opportunity set. It includes all the bundles (X1, X2) (all possible combination of two goods)
which the consumer can purchase with his given level of income.
The budget equation can be written as follows:

P1X1 + P2 X2 ≤ M.

Budget Line:
The line consists of all bundles of goods which cost exactly equal to the money income
of consumer is called budget line. It represents all bundles which costs entire income of
consumer. It slopes negatively.

Budget Set Budget Line

 It is a collection of all bundles  It is locus of different combinations
available to a consumer at the of the two goods which the consumer
existing price at his given level of consumes and whose price exactly
income. equals his income.
 It is also known as opportunity set.  It is also known as Price line.

14
Explanation of the budget set with the help of a diagram:
The budget set is the collection of products that the consumer can buy with his
income(M) at the prevailing market prices P1 and P2. The Budget set is also known as
opportunity set. It includes all the bundles (X1, X2) (all possible combination of two goods)
which the consumer can purchase with his given level of income.
The budget equation can be written as follows:
P1X1 + P2 X2 ≤ M.
Consider, for example, a consumer who has Rs.20 and suppose, both the goods are
priced at Rs.5 and are available only in integral units. The bundles that this consumer can afford
to buy are; (0,0), (0,1), (0,2), (0,3), (0,4), (1,0), (1,1), (1,2), (1,3), (2,0), (2,1), (2,2), (3,0), (3,1)
and (4,0).

From the above graph,

 All bundles in the positive quadrant which are on or below the line are included in the
budget set. The equation of the line is
p1x1 + p2x2 = M
 The line consists of all bundles which cost exactly equal to M. This line is called the budget
line.
 Points below the budget line represent bundles which cost strictly less than M.
 The budget line is a straight line with horizontal intercept M/p1, represents the bundle that
the consumer can buy if he spends his entire income on bananas.
 Vertical intercept M/p2 represents the bundle that the consumer can buy if he spends his
entire income on mangoes.
𝐩𝟏
 The slope of the budget line is − .
𝐩𝟐

15
Derivation of the Slope of the Budget Line:
The slope of the budget line measures the quantity of change in one product
required per unit of change in another product along the budget line.
For example, the amount of change in mangoes (∆x2) required per unit of change in
bananas(∆x1) along the budget line is the derivation of slope of the budget line. It can be
represented in diagram as follows:

Let us consider two points (x1, x2) and (x1+Δx1, x2+Δx2) on the budget line. It will be
as follows:
Suppose, the income = M. Prices of x1 and x2 are P1 and P2 respectively,
At point x1, x2: P1X1 + P2 X2 =M …….. (1)
At point (x1+Δx1, x2+Δx2): P1 (x1 + Δx1) + P2 (x2+Δx2) = M ……… (2)
P1x1 + P1Δx1 + P2x2 + P2Δx2 = M ……... (3)
Subtracting (1) from (3), we get,
P1Δx1+ P2Δx2=0
P2Δx2 = -P1Δx1
Δx2/Δx1 = -P1/P2
Therefore, the slope of the budget line is -P1/P2.
This means, the Indifference curve is negatively sloped i.e., it slope downwards. An
increase in the amount of bananas along the indifference curve is associated with a decrease in
the amount of mangoes.

Optimal Choice of the Consumer:

In economics, it is generally assumed that the consumer is a rational individual. A
rational individual clearly knows what is good or what is bad for him, and in any given
situation, he always tries to achieve the best for himself.

16
Thus, not only does a consumer have well-defined preferences over the set of available bundles,
he also acts according to his preferences. From the bundles which are available to him, a
rational consumer always chooses the one which gives him maximum satisfaction.
 The optimum point would be located on the budget line. A point below the budget line
cannot be the optimum. Compared to a point below the budget line, there is always some
point on the budget line which contains more of at least one of the goods and no less of the
other, and is, therefore, preferred by a consumer whose preferences are monotonic.
 Points above the budget line are not available to the consumer. Therefore, the optimum
(most preferred) bundle of the consumer would be on the budget line.
 The point at which the budget line just touches (is tangent to), one of the indifference curves
would be the optimum.

From the graph,

 The consumer’s optimum at point B(x1*, x2*), the budget line is tangent to the
indifference curve IC2. The first thing to note is that the indifference curve just touching
the budget line is the highest possible indifference curve given the consumer’s budget
set.
 Bundles on the indifference curves IC3, are not affordable.
 Points A and C, on the indifference curves IC1, are certainly inferior to the point B on
the indifference curve IC2, just touching the budget line.
 Any other point on the budget line lies on a lower indifference curve and hence, is
inferior to B(x1*, x2*).
 Therefore, B (x1*, x2*) is the consumer’s optimum choice, the point at which the budget
line just touches (is tangent to) IC2 indifference curves.
Law of Demand:
Law of Demand states that other things being equal, there is a negative relation between
demand for a commodity and its price. In other words, when price of the commodity increases,

17
demand for it falls and when price of the commodity decreases, demand for it rises, other
factors remaining the same.

Demand Curve:
The consumer’s demand for a good as a function of its price can be written as
X = ƒ(P)
Where, X denotes the quantity and P denotes the price of the good.
The graphical representation of the demand function is called the demand curve.
The relation between the consumer’s demands for a good and the price of the good is likely to
be negative in general i.e. demand curve is sloping downwards. In other words, the amount of
a good that a consumer would optimally choose is likely to increase when the price of the good
falls and it is likely to decrease with a rise in the price of the good.
The demand function can also be represented graphically as shown in the figure below:

Linear Demand Curve:

A linear demand curve can be written as:
d(p) = a – bp
Where, a is the vertical intercept, –b is the slope of the demand curve. At price 0, the
demand is a, and at price equal to a/b, the demand is 0.

18
Normal and Inferior Goods:
Normal Goods:
These are the goods for which the demand increases with the increase in the income of
consumer. Example for normal goods are food, cloths, electronic goods, luxury goods etc.
There is a positive relationship between income and demand. Here the demand curve shifts
towards right if the income of consumer increases.
Inferior Goods:
These are the goods for which the demand decreases with the increase in the income of
consumer. Example for inferior goods are low quality of goods like unbranded products.
There is an inverse relationship between income and demand. Here the demand curve shifts
towards left if the income of consumer increases.

Giffen Goods:
A rise in the purchasing power (income) of the consumer can sometimes induce the
consumer to reduce the consumption of a good.
In such a case, the substitution effect and the income effect will work in opposite
directions. The demand for such a good can be inversely or positively related to its price
depending on the relative strengths of these two opposing effects.
If the substitution effect is stronger than the income effect, the demand for the good and
the price of the good would still be inversely related. However, if the income effect is stronger
than the substitution effect, the demand for the good would be positively related to its price.
Such a good is called a Giffen good.

Substitutes and Complements:

Substitute goods: These are alternative goods available to satisfy our wants. If the price of a
product increases, the demand for its substitute also increases. Example for substitute goods
are Tea and Coffee, Colgate and Pepsodant, etc. Here the demand curve shifts to the right in
case of price rise. Price and demand move in same direction.

Complementary goods: These are the goods which are consumed together. If the price of a
product increases, the demand for its complementary good decreases. Example for
complementary goods are Pen and Ink, Shoes and socks etc. Here the demand curve shifts to
left in case of price rise. Price and demand move in opposite directions.

19
Shifts in the Demand Curve:
The shift in demand curve takes place when there is a change in some factor, other than
the price of the commodity. The factors causing sift in demand curve are income, normal goods
and inferior goods, substitutes and compliments, change in taste and preferences.

The demand curve was drawn under the assumption that the consumer’s income, the
prices of other goods and the preferences of the consumer are given.
 For the prices of other goods and the preferences of a consumer, if the income
increases, the demand for the good at each price changes, and hence, there is a shift in the
demand curve. For normal goods, the demand curve shifts rightward and for inferior goods,
the demand curve shifts leftward.
 For the consumer’s income and her preferences, if the price of a related good changes,
the demand for a good at each level of its price changes, and hence, there is a shift in the
demand curve. If there is an increase in the price of a substitute good, the demand curve
shifts rightward. On the other hand, if there is an increase in the price of a complementary
good, the demand curve shifts leftward.
 The demand curve can also shift due to a change in the tastes and preferences of the
consumer.
 If the consumer’s preferences change in favour of a good, the demand curve for
such a good shifts rightward.
 On the other hand, the demand curve shifts leftward due to an unfavourable change
in the preferences of the consumer.
 For example, the demand curve for ice-creams, is likely to shift rightward in the
summer because of preference for ice-creams goes up in summer.
 Revelation of the fact that cold-drinks might be injurious to health can adversely
affect preferences for cold-drinks. This results in a leftward shift in the demand
curve for cold-drinks.

20
Movements along the Demand Curve:
 The demand function is a relation between the amount of the good and its price when other
things remain unchanged.
 The demand curve is a graphical representation of the demand function. At higher prices,
the demand is less, and at lower prices, the demand is more.
 Thus, any change in the price leads to movements along the demand curve. On the other
hand, changes in any of the other things lead to a shift in the demand curve.

Movement along the Demand Curve

Market Demand:
The market demand for a good can be derived from the individual demand curves.
Suppose there are only twoconsumers in the market for a good.
Suppose at price p’, the demand of consumer 1 is q1’ and that of consumer 2 is q2’. Then, the
market demand of the good at p’ is q’1 + q’2.
̂, if the demand of consumer 1 is 𝒒
Similarly, at price 𝒑 ̂𝟏 and that of consumer 2 is 𝒒
̂𝟐 , the
̂ is 𝒒
market demand of the good at 𝒑 ̂𝟏 + 𝒒
̂𝟐 .
Thus, the market demand for the good at each price can be derived by adding up the demands
of the two consumers at that price. If there are more than two consumers in the market for a
good, the market demand can be derived similarly.

21
 The market demand curve of a good can also be derived from the individual demand
curves graphically by adding up the individual demand curves horizontally as shown in Figure.
This method of adding two curves is called horizontal summation.
Example: A market where there are two consumers and the demand curves of the two
consumers are given as:
d1(p) = 10 – p
d2(p) = 15 – p
Market demand = d (p) = 25 – 2p

Price Elasticity of Demand:

Price elasticity of demand is a measure of the responsiveness of the demand for a good
to changes in its price. Price elasticity of demand for a good is defined as the percentage
change in demand for the good divided by the percentage change in its price.
Price elasticity of demand for a good eD =
Percentage change in demand for the good
eD =
Percentage change in price of the good

∆𝐐 𝐏
eD = ∆𝐏 𝐱 𝐐

1) eD = 0; Vertical demand curve is perfectly inelastic.

2) eD = ∞; A horizontal demand curve is perfectly elastic.

3) |eD| = 1; This demand curve is called the unitary elastic demand curve.

22
Solution for Project Oriented Question:
 A consumer wants to consume two goods. The Price of bananas is Rs.5 and price of
mangoes is Rs.10. The consumer income is Rs. 40.
a) How much bananas can she consume if she spend her entire income on that good?
b) How much mangoes can she consume if she spend her entire income on that good?
c) Is the slope of budget line is downward or upward?
d) Are the bundles on the budget line equal to the consumers’ income or not?
e) If you want to have more of banana you have to give up mangoes. Is it true?
Answer:
Money income M = Rs. 40
Price of Bananas P1 = Rs. 5
Price of Mangoes P2= Rs. 10
(a) No. of Bananas = 40/5 = 8
(b) No. of Mangoes = 40/10 = 4
(c) Slope of budget line is downward.
(d) Yes, the bundles on the budget line are equal to the consumer’s income.
(e) True. If we want to have more of banana we have to give up mangoes.

****

23
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 Chapter-3: Production and Costs

Introduction:
Production is the process by which inputs are transformed into ‘output’. Production is
carried out by producers or firms.
A firm acquires different inputs like labour, machines, land, raw materials etc. It uses
these inputs to produce output. This output can be consumed by consumers, or used by other
firms for further production.
In order to acquire inputs a firm has to pay for them. This is called the cost of
production. Once output has been produced, the firm sell it in the market and earns revenue.
The difference between the revenue and cost is called the firm’s profit. We assume that the
objective of a firm is to earn the maximum profit that it can.

Production Function:
The production function of a firm is a relationship between inputs used and output
produced by the firm. For various quantities of inputs used, it gives the maximum quantity of
output that can be produced.
A production function is defined for a given technology. It is the technological
knowledge that determines the maximum levels of output that can be produced using
different combinations of inputs.
If the technology improves, the maximum levels of output obtainable for different input
combinations increase. We then have a new production function.
The inputs that a firm uses in the production process are called factors of production.
In order to produce output, a firm may require any number of different inputs. However, for
the time being, here we consider a firm that produces output using only two factors of
production – labour and capital.
The production function, therefore, tells us the maximum quantity of output (q) that can
be produced by using different combinations of these two factors of productions- Labour (L)
and Capital (K).
We may write the production function as:
q = ƒ(L,K)
Where, L is labour and K is capital and q is the maximum output that can be produced.

27
Isoquant:
An isoquant is the set of all possible combinations of the two inputs that yield the
same maximum possible level of output. Each isoquant represents a particular level of output
and is labelled with that amount of output.

In the above diagram, we place L on the X axis and K on the Y axis.

 We have three isoquants for the three output levels, namely q = q1, q = q2 and q = q3.
 Two input combinations (L1, K2) and (L2, K1) give us the same level of output q1.
 If we fix capital at K1 and increase labour to L3, output increases and we reach a higher
isoquant, q = q2.
 When marginal products are positive, with greater amount of one input, the same level
of output can be produced only using lesser amount of the other.
 Therefore, isoquants are negatively sloped.
The Short Run and The Long Run:
In the short run: at least one of the factor – labour or capital – cannot be varied, and therefore,
remains fixed. In order to vary the output level, the firm can vary only the other factor. The
factor that remains fixed is called the fixed factor whereas the other factor which the firm can
vary is called the variable factor.
In the long run: all factors of production can be varied. A firm in order to produce different
levels of output in the long run may vary both the inputs simultaneously. So, in the long run,
there is no fixed factor.
 For different production processes, the long run periods may be different. It is not
advisable to define short run and long run in terms of say, days, months or years.
 We define a period as long run or short run simply by looking at whether all the inputs
can be varied or not.

28
Total Product, Average Product and Marginal Product:
Total Product (TP): It is the relationship between the variable input and output, keeping all
other inputs constant, is referred to as Total Product (TP) of the variable input. This is also
sometimes called total return or total physical product of the variable input.
The total product is the total sum of the marginal product:
TPL=∑MPL
For example, TPL= 10+14+16+10+6+1
= 57

Average Product (AP): Average product is defined as the output per unit of variable input. It
is calculated as:
TPL
APL= = 24/2 = 12
L
Marginal Product (MP): Marginal product of an input is defined as the change in output per
unit of change in the input when all other inputs are held constant.
Change in Output ∆TPL 24-10
MPL= = = =14
Change in Input ∆L 2-1
Or
MPL= (TP at L units) – (TP at L – 1 unit)
Change in TP = 24 -10 = 14
Change in L = 1

Total Product, Marginal product and Average product

Labour TP MP1 AP1
0 0 - -
1 10 10 10
2 24 14 12
3 40 16 13.33
4 50 10 12.5
5 56 6 11.2
6 57 1 9.5

The Law of Diminishing Marginal Product:

The law of diminishing marginal product is that “the marginal product of a factor
input initially rises with its employment level. But after reaching a certain level of
employment, it starts falling”.

29
 From the above graph, placing labour on the X-axis and output on the Y-axis, we get
the curves as shown. TP, AP and MP curves are plotted.
 TP increases as labour input increases. But the rate at which it increases is not constant.
 The rate at which TP increases, is shown by the MP.
 Notice that the MP first increases and then begins to fall.
 This tendency of the MP to first increase and then fall is called the law of variable
proportions.
Why does this happen?
Factor proportions represent the ratio in which the two inputs are combined to produce
output. As we hold one factor fixed and keep increasing the other, the factor proportions
change.
Initially, as we increase the amount of the variable input, the factor proportions become
more and more suitable for the production and marginal product increases. But after a certain
level of employment, the production process becomes too crowded with the variable input.
Each additional labour is now proportionally less. The marginal product begins to fall.

Shapes of Total Product, Marginal Product and Average Product Curves:

Total Product Curve (TPL):
We measure units of labour along the horizontal axis and output along the vertical axis.
With L units of labour, the firm can at most produce q1 units of output.

Figure shows the shape of the total product curve for a

typical firm. When all other inputs are held constant, it
shows the different output levels obtainable from
different units of labour.

30
Marginal Product (MPL) and Average Product (APL) curve:
According to the law of variable proportions, the marginal product of an input initially
rises and then after a certain level of employment, it starts falling. The MP curve therefore,
looks like an inverse ‘U’-shaped curve as in the figure.

 For the first unit of the variable input, one can easily check that the MP and the AP are
same. Now as we increase the amount of input, the MP rises. AP being the average of
marginal products, also rises, but rises less than MP. Then, after a point, the MP starts
falling. However, as long as the value of MP remains higher than the value of the AP, the
AP continues to rise.
 Once MP has fallen sufficiently, its value becomes less than the AP and the AP also starts
falling. So AP curve is also inverse ‘U’-shaped.
 As long as the AP increases, it must be the case that MP is greater than AP. Otherwise, AP
cannot rise. Similarly, when AP falls, MP has to be less than AP. It, follows that MP curve
cuts AP curve from above at its maximum.
The following table gives the TP schedule of labour. Calculation of the corresponding Average
product and marginal product schedules.
TPL 0 15 35 50 40 48
L 0 1 2 3 4 5

L TPL MPL APL

0 0 - -
1 15 15 15
2 35 20 17.2
3 50 15 16.66
4 40 -10 10
5 48 8 9.6

31
Returns to Scale:
The returns to scale can happen only in the long run as both the factors (Labour and
Capital) can be changed. One special case in the long run occurs when both factors are
increased by the same proportion, or factors are scaled up.
Constant returns to scale (CRS): When a proportional increase in all inputs results in an
increase in output by the same proportion, the production function is said to display Constant
returns to scale (CRS).
Increasing Returns to Scale (IRS): When a proportional increase in all inputs results in an
increase in output by a larger proportion, the production function is said to display Increasing
Returns to Scale (IRS).
Decreasing Returns to Scale (DRS): DRS holds when a proportional increase in all inputs
results in an increase in output by a smaller proportion.

Cost Function:
The cost function describes the least cost of producing each level of output given prices
of factors of production and technology.
Cobb-Douglas Production Function: Consider a production function
q = x1α x2β
Where, α and β are constants. The firm produces q amount of output using x 1 amount
of factor 1 and x2 amount of factor 2. This is called a Cobb-Douglas production function.

Short Run Costs:

Types of Short run costs are:
1. Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC).
2. Short Run Average Cost (SAC) = Average Fixed Cost (AFC) + Average Variable
Cost(AVC).
3. Short Run Marginal Cost (SMC).
Various Concepts of Costs
Output
TFC + TVC = TC AFC + AVC = SAC SMC
(units)(q)
0 20 0 20 - - - -
1 20 10 30 20 10 30 10
2 20 18 38 10 9 19 8
3 20 24 44 6.67 8 14.67 6
4 20 29 49 5 7.25 12.25 5
5 20 33 53 4 6.6 10.6 4

32
 Total Fixed Cost (TFC):
The cost that a firm incurs to employ these fixed inputs is called the total fixed cost
(TFC).
Example: Rent, salaries of the permanent employees, etc.
Whatever amount of output the firm produces, this cost remains fixed for the firm.
From the table: TFC = 20.

 Total Variable Cost (TVC):

The cost that a firm incurs to employ these variable inputs is called the total variable
cost (TVC).
Example: Purchase of raw materials, fuel, etc.
From the table: TVC = 10

 Total Cost (TC):

Adding the fixed and the variable costs, we get the total cost (TC) of a firm.
TC = TFC + TVC
E.g.: TC = 20 + 10 = 30

 Average Fixed Cost (AFC):

It is the fixed cost per unit of output. In other words, it is average expenses incurred on
a single unit of output produced.
𝐓𝐅𝐂
AFC =
𝐪
E.g.: AFC = 20/1 = 20

 Average Variable Cost(AVC):

It is a variable cost for per unit of output. It can be calculated by dividing total variable
cost by the total units of output.
𝐓𝐕𝐂
AVC =
𝐪
E.g.: AVC = 10/1 = 10

 Short Run Average Cost (SAC):

It is the total cost per unit of output.
SAC = AFC + AVC
E.g.: SAC= 20 + 10 = 30

33
 Short Run Marginal Cost (SMC):
It is defined as the change in total cost per unit of change in output.
Change in Total Cost ∆TC 30-20
SMC= = = =10
Change in Output ∆q 1

Long Run Costs:

In the long run, all inputs are variable. There are no fixed costs. The total cost and the
total variable cost therefore, coincide in the long run.
Types of Long Run costs:
1. Long run average cost (LRAC): It is defined as cost per unit of output.
𝐓𝐂
LRAC =
𝐪

2. Long run marginal cost (LRMC): It is the change in total cost per unit of change in
output.
When output changes in discrete units, then, if we increase production from q1–1 to q1
units of output, the marginal cost of producing q1th unit will be measured as;
LRMC = (TC at q1 units) – (TC at q1 – 1 units)

Shapes of the Long Run Cost Curves:

IRS implies that if we increase all the inputs by a certain proportion, output increases
by more than that proportion. In other words, to increase output by a certain proportion, inputs
need to be increased by less than that proportion. With the input prices given, cost also increases
by a lesser proportion.
DRS implies that if we want to increase the output by a certain proportion, inputs need
to be increased by more than that proportion. As a result, cost also increases by more than that
proportion. So, as long as DRS operates, the average cost must be rising as the firm increases
output.
CRS implies a proportional increase in inputs resulting in a proportional increase in
output. So the average cost remains constant as long as CRS operates. It is argued that in a
typical firm IRS is observed at the initial level of production. This is then followed by the CRS
and then by the DRS. Accordingly, the LRAC curve is a ‘U’-shaped curve. Its downward
sloping part correspond to IRS and upward rising part corresponds to DRS. At the minimum
point of the LRAC curve, CRS is observed.

34
 For the first unit of output, both LRMC and LRAC are the same. Then, as output
increases, LRAC initially falls, and then, after a certain point, it rises. As long as average cost
is falling, marginal cost must be less than the average cost. When the average cost is rising,
marginal cost must be greater than the average cost. LRMC curve is therefore a ‘U’-shaped
curve. It cuts the LRAC curve from below at the minimum point of the LRAC.

Figure shows the shapes of the long run marginal cost and the long run average cost
curves for a typical firm.
 LRAC reaches its minimum at q1. To the left of q1, LRAC is falling and LRMC is
less than the LRAC curve.
 To the right of q1, LRAC is rising and LRMC is higher than LRAC.
A firm’s SMC schedule is shown in the following table. TFC is Rs.100. Calculation of
TVC, TC, AVC and SAC schedules of the firm:

Q 0 1 2 3 4 5 6
SMC - 500 300 200 300 500 800

Q SMC TFC TVC=∑SMC TC=TFC+TVC AFC=TFC/Q AVC=TVC/Q SAC=AFC+AVC

0 - 100 0 100 - - -
1 500 100 500 600 100 500 600
2 300 100 800 900 50 400 450
3 200 100 1000 1100 33.33 333.33 366.66
4 300 100 1300 1400 25 325 350
5 500 100 1800 1900 20 360 380
6 800 100 2600 2700 16.67 433.33 450

****
35
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 Chapter-4: The Theory of the Firm under Perfect Competition

Perfect Competition Market:

Perfect competition is a type of market in which we find a large number of sellers selling
homogeneous products.
Features of perfect competition are:
1) A large number of sellers and buyers: Since there are a large number of sellers in
Perfect competition a firm can neither regulate the supply nor influence the price. In the
same way single buyer cannot regulate demand and price of a product. Since there are
a large number of buyers single buyer cannot influence price by regulating market
demand.
2) Homogeneous or identical goods: Products sold by sellers under Perfect competition
is same or identical in taste, size, colour, chemical content etc.
3) Each buyer and seller in perfect competition is a price taker and not price maker:
A seller under Perfect competition has to sell his product at prevailing market price. At
that price he can sell as many units of goods as he wants to sell. In the same may a
buyer under Perfect competition has to buy products at prevailing market price.
4) Perfect information: Firms and buyers under Perfect competition have perfect
information about the price prevailing in the market. If a certain firm raises its price
above the market price, it loses all its buyers, since the products sold by different sellers
are homogeneous and all buyers have perfect knowledge about prevailing market price.
5) Free entry and exit: Entry into the market as well as exit from the market are free for
firms.
Revenue:
 Total Revenue (TR): Total revenue is the revenue earned from the sale of all units of a
product. A firm gets revenue by the sale of good that it produces in the market.
Total revenue of a firm can be defined as the market price of a good (p) multiplied by
Quantity of output it sold (q).
TR= pxq
Where, TR = Total revenue, p = Price, q = Firm’s output.

 Average Revenue (AR): Average Revenue of a firm can be defined as total revenue per
unit of output.
Suppose that firm’s output is q and market price is p,

39
 Then, Total Revenue (TR) = pxq.
So,
𝐓𝐑
AR=
𝐪

Where, AR=Average Revenue, TR=Total Revenue, q=firm’s output.

 Marginal revenue (MR): It can be defined as increase in total revenue due to the
production of additional unit of a good.
Change in Total Revenue
Marginal Revenue (MR)= =∆TR/∆q
Change in Quantity
For the perfectly competitive firm, MR=AR=p
In other words, for a price-taking firm, marginal revenue equals the market price.

Explanation of Total Revenue (TR) and Average Revenue of a Firm under

Perfect Competition, with the help of a diagram:
 Total Revenue (TR): Total revenue is the revenue earned from the sale of all units of a
product. A firm gets revenue by the sale of good that it produces in the market.
Total revenue of a firm can be defined as the market price of a good (p) multiplied by
Quantity of output it sold (q).
TR= pxq
Where, TR = Total revenue, p = Price, q = Firm’s output.

 Average Revenue (AR): Average Revenue of a firm can be defined as total revenue per
unit of output.
Suppose that firm’s output is q and market price is p,
Then, Total Revenue (TR) = pxq.
So,
𝐓𝐑 𝐩𝐱𝐪
AR= = =p
𝐪 𝐪

Where, AR=Average Revenue, TR=Total Revenue, q=firm’s output.

In other words, for a price-taking firm, average revenue equals the market price.
Example,
The total revenue, marginal revenue and average revenue schedules in the
following table when the market price of each unit of goods is Rs. 10.

40
 Quantity Sold (q) TR=pxq MR=∆TR/∆q AR=TR/q
0 0 - -
1 10 10 10
2 20 10 10
3 30 10 10
4 40 10 10
5 50 10 10

Total Revenue Curve (TR):

The total revenue curve of a firm shows the
relationship between the total revenue that the firm
earns and the output level of the firm. The slope of the
curve, Aq1/Oq1, is the market price (p).
Therefore,
The slope of the straight line is Aq1/Oq1 = p.

Average Revenue Curve (AR):

Here, we plot the average revenue or market
price (y-axis) for different values of a firm’s output (x-
axis). Since the market price is fixed at p, we obtain a
horizontal straight line that cuts the y-axis at a height
equal to p. This horizontal straight line is called the
price line.
It is also the firm’s AR curve under perfect
competition the price line also depicts the demand curve facing a firm.

A Firm’s Profit:
A firm’s profit can be defined as the difference between its Total Revenue (TR) and
its Total Cost (TC).
It can be written as below,
Profit (π) =TR - TC.

41
Conditions needed for Profit by a Firm under perfect competition (Profit
maximization of a firm):
Every firm under perfect competition wants to maximize its profit. If there is positive
level of output, q0, at which profit is maximized, then three conditions must be fulfilled. The
three conditions are as follows:
1. P or market price is equal to MC or P=MC.
2. MC or Marginal cost is non- decreasing at q0.
3. For the firm to continue to produce,
a. In the short run, price must be greater than the average variable cost (p > AVC).
b. In the long run, price must be greater than the average cost (p > AC).
Condition–1: P or market price is equal to MC or P=MC.
 A profit maximizing firm will not produce at an output level where market price
exceeds MC (P>MC) or MC exceeds Market price (MC>P).
 As long as P>MC a firm under perfect competition continues to expand its output
level till market price equals marginal cost.
 If it continues to expand its output level even afterwards marginal cost exceeds price
and the firm incurs loss.
 In other words, profits are maximum at the level of output (which we have called
q0) for which MR = MC. Therefore, MR=MC=P.
Condition 2: MC or Marginal cost is non- decreasing at q0.
As shown in the figure below at the output level q1, P=MC. However, MC curve is
downward sloping. We argue that q1 cannot be a profit maximizing output level.
For all output levels slightly to the left of q1, the P is lower than MC. It implies that the
firm’s profit at an output level slightly greater than q1 exceeds that corresponding to the level
of output q1. So q1 cannot be a profit maximizing output level.

42
The shutdown point:
In the short run the point where SMC cuts minimum point of AVC is called the
shutdown point.
In the short run, below the shutdown point there will be no production.
In the long run, shutdown point is the minimum point of LRAC (long run average cost) curve.

The normal profit and break-even point:

 The profit level which is just enough to cover the explicit and opportunity cost of a firm is
called the normal profit.
 In other words when Total Revenue earned by a firm equals its Total Cost its profit becomes
normal profit or zero profit.
 If a firm earns that profit which is over and above the normal profit, it is called super-
normal profit.
 Break-even point of a firm is that point on the supply curve at which a firm earns normal
profit.

Opportunity Cost:
Opportunity cost of any activity is the gain sacrificed or forgone from the second
best activity.
Example: Suppose we have rupees 1000/-which we decide to invest in our family business. If
we do not invest this money, we can deposit it in either bank -1 or bank- 2. In that case we get
an interest rate of 10% or 5% respectively.
Hence the maximum benefit that we may get from other alternative activity is the
interest from bank -1. Hence the opportunity cost of investing the money in our family business
is therefore the amount of forgone interest from the bank -1.

Supply Curve of a Firm:

The supply curve of a firm shows the levels of output that the firm chooses to produce
corresponding to different values of the market price, again keeping technology and prices of
factors of production unchanged.

Supply curve of the firm in the short–run:

The supply curve of a firm represents the output levels which a firm produces
corresponding to different market prices. We distinguish between short- run supply curve and
the long run supply curve.
43
 The graph helps us to understand how to derive a firm’s short -run supply curve. Here we
split this derivation into two parts.
a) We first determine a firm’s profit maximizing level of output when the market price is
greater than or equal to the minimum AVC.
b) Afterwards, we determine the firm’s profit maximizing level of output when the market
price is less than the minimum AVC.
Case 1: Price is greater than or equal to the minimum AVC:
Let us suppose the market price is p1 and it exceeds the minimum AVC. Here we start
out by equating p1 with SMC on the rising part of SMC curve. At p1 output level becomes q1.
AVC at q1 does not exceed market price p1. Here, 3 conditions needed for profit maximization
of a firm are fulfilled (1) MC =MR at q0. 2) MC is not decreasing at q0. 3) P ≥ AVC at q0).

Case 2: Price is less than minimum AVC:

Assume that market price is p2, which is less than minimum AVC. We understand from
the figure that for all positive output levels, AVC exceeds p2. So, when market level is p2, the
firm produces zero output. From above details we can arrive at an important conclusion.
Short run supply curve of a firm is the rising part of SMC curve from and above the
minimum AVC and for all prices less than Minimum AVC output level remains zero. In the
figure, the bold line represents firm’s supply curve in the short run.

44
Determinants of a firm’s supply curve:
The determinants of a firm’s supply curve are:
1. Technological progress.
2. Prices of inputs.
1. Technological progress: As a result of an organizational innovation by the firm the same
levels of capital and labour now produce more unit of output. In other words to produce a
given level of output, the organizational innovation allows the firm to use lesser units of
inputs. Technological progress shifts the supply curve of the firm to the right.
2. Prices of inputs: A change in input price also affects supply curve of a firm. If the price
of an input say, the wage rate of labour increases, production cause rises. As a result of
increase in the firm’s marginal cost at any level of output, its supply curve shifts to the left
since MC curve shifts leftward. Now firm supplies lesser units of output.
Unit Tax:
A unit tax is a tax which government imposes per unit sale of output.
Impact of unit tax on supply:
For example, let us assume that the unit tax imposed by the government is rupees 2.
Then if the firm produces and sells 100 units of the good, the total tax which the firm has to
pay to the government is 100 ×Rs 2=Rs. 200.
Unit tax shifts the supply curve left wards. It means after the imposition of tax firm
supplies lesser units of output.

Market supply curve:

The market supply curve represents levels of the output which firms in the market
produce in aggregate corresponding to different market prices. In other words market supply
curve is the summation of the supplies of individual firm’s at different, market prices.
Let us construct the market supply curve with just two firms in the market–firm ‘a’ and
firm ‘b’. Suppose that two firm’s have different cost structures. Firm ‘a’ will not produce
anything if the price is below 𝑝
̅̅̅1 . While firm ‘b’ will not produce anything if the market price
is less than ̅̅̅.
𝑝2 Again assume that ̅̅̅
𝑝2 is greater than 𝑝
̅̅̅.
1

45
 The Market Supply Curve Panel. (a) Shows the supply curve of firm 1. Panel (b) shows
the supply curve of firm 2. Panel (c) shows the market supply curve, which is obtained by
taking a horizontal summation of the supply curves of the two firms.
The interpretation of S2 (p) is identical to that of S1 (p), and is, hence, omitted. Now,
the market supply curve, Sm (p), simply sums up the supply curves of the two firms; in other
words:
Sm(p) = S1(p) + S2(p)

 When the supply curve is vertical the elasticity of supply is zero.

Price Elasticity of Supply:

The price elasticity of supply of a good measures the responsiveness of quantity supplied
to changes in the price of the good.
The price elasticity of supply, denoted by eS, is defined as follows:

Percentage change in quantity supplied

Price elasticity of supply, eS=
Percentage change in price

∆𝑄 𝑃
eS= X
∆𝑃 𝑄

Where ∆Q= change in quantity of the good supplied, ∆P= change in price of a good, P=price
of a good and Q=quantity supplied.

****

46
47
48
 Chapter-5: Market Equilibrium.

In perfect competition buyers and sellers are price takers.

 Market Equilibrium: An equilibrium can be defined as a situation in which the plans
are all consumers a firm’s in the market match and market clears.
 Equilibrium Price: The price at which equilibrium is reached is called equilibrium
price.
 Equilibrium quantity: It is the quantity which is bought and sold at equilibrium price.
Difference between excess demand and excess supply:
If at a price market supply is greater than market demand, there is an excess supply in
the market.
If at a price market demand exceeds market supply, there is an excess demand.
From the time of Adam Smith (1723-1790), it has been maintained that in a perfectly
competitive market a ‘Invisible Hand’ is at play which changes price whenever there is
imbalance in the market. Our intuition also tells us that this ‘Invisible Hand’ should raise the
prices in case of ‘excess demand’ and lower the prices in case of ‘excess supply’.

Market equilibrium with fixed number of firms:

Here the equilibrium price is determined by the intersection of market demand curve
and market supply curve.
Figure illustrates equilibrium for a perfectly competitive market when there are fixed
number of firm’s. SS denotes the market supply curve and DD denotes market demand curve
for a commodity.
Graphically, an equilibrium point is a point where the market demand curve intersects
the market supply curve. At equilibrium market demand equals market supply. At any other
point either there is excess demand or there is excess supply.

49
 In the figure, if the prevailing price is p1, the market demand is q1, the market supply is
q1’.Hence there is excess demand (q1’ q1). Similarly, if the market price is p2, the market supply
(q2) will exceed market demand (q2’).
At p*, market demand equals market supply. So p* is the equilibrium price and
corresponding quantity q* is the equilibrium quantity.

The demand and supply curves of wheat are given by the following equations:
Demand for wheat. qD = 200-P and supply of wheat qS= 120+ P
Here qD= quantity demanded, qS=quantity supplied and P= price of wheat per kg in rupees.
At equilibrium qD=qS
So, 200-P=120+P
200-120=P+P
80=2P
P=80/2=40
a) Equilibrium price P= Rs. 40.
b) The equilibrium quantity is obtained by substituting the equilibrium price P=40 into
either the demand or the supply curve’s equation.
So,
qD =200-P qS=120+P
qD = 200-40 qS=120+40
qD =160 qS =160
qD=qS
c) At a price less than equilibrium price P.
Say P= Rs. 25
qD=200-P qS =120+ P
qD=200-25 qS =120+25
qD=175 qS =145
qD > q S
d) At a price greater than equilibrium price P.
Say P= Rs. 45
qD=200-P qS =120+ P
qD=200-45 qS =120+45
qD=155 qS =165
qD ˂ qS

50
Wage determination in the labour market:
By labour we mean the hours of work provided by labourer.
The wage rate is determined by the intersection of the demand and supply curves of
labour where the demand for labour equals supply of labour.
The graph shows wage is determined at the point where the labour demand and supply
curves intersect.

Marginal Product of Labour (MRPL):

 Wage rate (W) is the extra cost of hiring one more unit pf labour.
 Marginal Product (MPL) can be defined as the extra output produced by one more unit of
labour.
 Marginal Revenue (MR) is the additional earning of a firm by selling each extra unit of
output.
 Hence for each extra unit of labour, he gets an additional benefit equal to marginal revenue
times marginal product which is called Marginal Product of Labour (MRPL).
So,
W= MRPL and
MRPL = MR x MPL

Simultaneously shifts of Demand and Supply:

Simultaneously shifts of Demand and Supply curves in four possible ways:
1. Both supply and demand curves shifts rightwards.
2. Both supply and demand curves shifts leftwards.
3. Supply curve shifts leftward and demand curve shifts rightward.
4. Supply curve shifts rightward and demand curve shifts leftward.
The impact on equilibrium price and quantity in all the above cases are listed in table.

51
 Shift In Shift in Quantity Price
supply Demand
Leftward Leftward Decreases May Increase, Decrease
or remain unchanged
Rightward Rightward Increases May Increase, Decrease
or remain unchanged
Rightward Leftward May Increase, Decrease Decreases
or remain unchanged
Leftward Rightward May Increase, Decrease Increases
or remain unchanged

Simultaneous shifts of Demand and Supply curves in 4 possible ways are represented in the
diagram below.

In the figure (a) it can be understood that due to rightward shifts in both demand and
supply curves, the equilibrium quantity increases but the equilibrium price remains the same
and in figure (b) equilibrium quantity remains unchanged but price decreases because of
leftward shift in demand curve and a rightward shift in supply curve.

Implication of Free Entry and Exit of a Firm on Market Equilibrium:

Here, for simplicity, we assume that all the firms in the market are identical. This
assumption implies that in equilibrium no firm earns supernormal profit or incurs loss by
remaining in production; in other words, the equilibrium price will be equal to the minimum
average cost of the firms.
 Suppose, at the prevailing market price, each firm is earning supernormal profit. The
possibility of earning supernormal profit will attract some new firms. As new firms
enter the market supply curve shifts rightward. However, demand remains unchanged.

52
 This causes market price to fall. As prices fall, supernormal profits are eventually wiped
out. At this point, with all firms in the market earning normal profit, no more firms
will have incentive to enter.
 Similarly, if the firms are earning less than normal profit at the prevailing price, some
firms will exit which will lead to an increase in price, and with sufficient number of
firms, the profits of each firm will increase to the level of normal profit. At this point,
no more firm will want to leave since they will be earning normal profit here. Thus,
with free entry and exit, each firm will always earn normal profit at the prevailing
market price.
 Therefore, free entry and exit of the firms imply that the market price will always be
equal to the minimum average cost, that is P = min AC.

Price Determination with Free Entry and Exit. With free entry and exit in a perfectly
competitive market, the equilibrium price is always equal to min AC and the equilibrium
quantity is determined at the intersection of the market demand curve DD with the price line
P= min AC.

Applications of supply –demand analysis:

 Price ceiling: Price ceiling is the government imposed upper limit on the price of a
good or service. It is generally imposed on necessary items like rice, wheat, kerosene,
sugar etc. It is fixed below the market determined price because some section of the
population is not able to afford these goods.
Often it becomes necessary for the government to regulate the prices of certain
goods and services when their prices are either too high or too low when comparison to
the expected levels.
Let us examine the effects of price ceiling on market equilibrium through the example
of market for wheat. Figure shows the market supply curve SS and the market demand
curve DD for wheat.

53
 Effect of Price Ceiling in Wheat Market. The equilibrium price and quantity are p*
and q* respectively. Imposition of price ceiling at pc gives rise to excess demand in the
wheat market.
Hence, though the intention of the government was to help the consumers, it could
end up creating shortage of wheat. Ration coupons are issued to the consumers so that no
individual can buy more than a certain amount of wheat and this stipulated amount of
wheat is sold through ration shops which are also called fair price shops.
 Price Floor: The government imposed lower limit on the price that can be charged for a
particular good or service is known as price floor. Fall in price below a particular level is
not desirable in case of certain goods. Hence the government sets the floors or minimum
prices for these goods and services.
Well known examples for Price Floor are:
1. Agricultural price support programmes: The government imposes a lower limit
on the purchase price for some of the agricultural goods through an agricultural
price support programme.
2. The minimum wage legislation: the minimum wage legislation, the government
ensures that the wage rate of the labourers does not fall below a particular level and
here again the minimum wage rate is set above the equilibrium wage rate.

54
 Effect of Price Floor on the Market for Goods. The market equilibrium is at (p*,
q*). Imposition of price floor at pf gives rise to an excess supply.

Points to remember:
 In perfect competition buyers and sellers are price takers.
 A situation where plans of all consumers and firms in the market match is Equilibrium
situation.
 The firms earn super normal profit as long as the price is greater than the minimum of
average cost.
 In a perfectly competitive market, equilibrium occurs when market demand equals market
supply.
 In labour market households are the suppliers of labour.
 Possibility of supernormal profit attracts new firms.

****

55
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57
58
 Chapter-6: Non Competitive Market

Introduction: This chapter examines the market structures of monopoly, monopolistic

competition and oligopoly.

Monopoly (Simple Monopoly in the commodity market):

A market situation where there is a single seller selling a product which has no close
substitutes is called monopoly. E.g.: Indian Railway
Features of monopoly market (Requirements of a monopoly market structure):
1. Single seller (Producer)
2. Restriction on the entry of new firms
3. Absence of close substitute
4. Price discrimination or uniform price

In order to examine the difference in the equilibrium resulting from a monopoly in the
commodity market as compared to other market structures, we also need to assume that all
other markets remain perfectly competitive.
In particular, all the consumers are price takers; and that the markets of the inputs used in
the production of this commodity are perfectly competitive both from the supply and demand
side.

Market Demand Curve for a Monopoly Firm:

A graphical representation of market demand schedule is called market demand curve.
 The monopoly firm’s decision to sell a larger quantity is possible only at a lower price.
Conversely, if the monopoly firm brings a smaller quantity of the commodity into the
market for sale it will be able to sell at a higher price.
 Thus, for the monopoly firm, the price depends on the quantity of the commodity sold.
The same is also expressed by stating that price is a decreasing function of the quantity
sold.
 Thus, for the monopoly firm, the market demand
curve expresses the price that consumers are willing
to pay for different quantities supplied.
 Market demand curve of monopoly market can be
explain with the help of following diagram.

59
 In the above diagram OX axis represent output, OY axis represent Price. DD is demand
curve of a monopoly firm it slopes negatively as shown in the diagram.
In the diagram if the market price is at p0 consumers are willing to purchase the quantity q0.
On the other hand if the market price is at the lower level p1, consumers are willing to buy a
higher quantity q1. That is, price in the market affects the quantity demanded by the consumers.
The monopoly firm’s decision to sell a larger quantity is possible only at lower price.

 Average Revenue (AR):

The revenue per unit of commodity sold is called Average Revenue.
𝐓𝐑
Mathematically, 𝐀𝐑 = 𝐪

Here, TR = pxq = Total revenue.

q = Quantity.
p = Price of a commodity.

 Marginal Revenue (MR):

The additional revenue generated from the sale of an additional unit of output is called
Marginal Revenue.

The relationship between AR and MR of a monopoly market:

The relationship between AR and MR can be explained with the help of following diagram:

In the above diagram, OX axis represents Output, OY axis represents AR and MR.
When firms can increase their volume of sales only by decreasing the price, then AR falls with
the increase in sale. It means, revenue from every additional unit (MR) will be less then AR.
As a result both AR and MR curves slopes downwards from left to right.

60
 If the AR curve is less steep, the vertical distance between the AR and MR curves is
smaller. In the above diagram (a) shows a flatter AR curve. While in the diagram (b) shows a
steeper AR curve. For the same units of the commodity the difference between AR and MR in
the diagram (a) is a smaller than the difference in diagram (b).

Relationship between Marginal revenue and price elasticity of demand:

As the quantity of the commodity increases, MR becomes smaller and the value of price
elasticity of demand also becomes smaller.
1. When the MR has the positive value, Price elasticity of demand is more than 1.
2. When the MR has a negative value, Price elasticity of demand is less than 1.
3. When price elasticity is equal to 1, then it is unitary elastic.

Calculation of TR and MR from the following table:

Q (qty) 1 2 3 4 5 6 7 8 9 10
P (price) 100 90 80 70 60 50 40 30 20 10

Q P TR=PXQ MR = TRn – TRn-1

1 100 100 100
2 90 180 180-100=80
3 80 240 240-180=60
4 70 280 280-240=40
5 60 300 300-280=20
6 50 300 300-300=0
7 40 280 280-300=-20
8 30 240 240-280=-40
9 20 180 180-240=-60
10 10 100 100-180=-80

Short Run Equilibrium of a Monopoly firm:

As in the case of perfect competition, we continue to regard the monopoly firm as one
which maximizes profit. Short Run Equilibrium of a Monopoly firm can be discussed in the
following two types:
1. Zero Costs.
2. Positive Costs.

61
1. The simple case of zero cost:
This is a monopoly situation when the cost of production is zero. TC=0. This is very
rare case. Let us suppose that there is village which is situated far away from the other village.
In that village we assume there is only one well. All the village people completely depend for
their water needs on this well.
We assume this well is owned by a particular individual and he has the exclusive right
over the use of the well. The owner of the well does not allow any villager to draw water from
this well without paying for it. Thus he enjoys monopoly and can charge any price that he
wishes there is no production cost for water. That is production cost is zero.
Now we shall explain equilibrium situation. Monopoly market attains equilibrium when
the profit is maximum. Profit of a monopoly firm is given by the difference between TR and
TC.
Symbolically,
Profit 𝝅 =TR-TC

Where, 𝜋 = Profit, TR= Total revenue, TC = Total cost

Then, the profit of a monopoly firm with zero cost is 𝜋 = TR –TC
𝜋 = TR – 0
𝜋 = TR
If the TC is 0 the maximum profit is total revenue. So when total revenue (TR) is
maximum profit also reaches maximum. This situation is explain diagrammatically.

In the above diagram,

 OX axis is output, OY axis represents TR, AR, MR and also Price.
 TR represents total revenue curve, AR and MR represents Average Revenue Curve and
Marginal revenue Curve respectfully.

62
 The profit received by the firm equals the revenue received by the firm minus the cost
incurred, that is profit=TR-TC. In this case TC is zero, profit is maximum when TR is
maximum.
 The price at reach this output will be sold is the price that the consumer as a whole are
willing to pay. This is given by the market demand curve ‘D’.
 An output level of 10 units the price is Rs. 5. Since the market demand curve is the AR
curve for the monopolist firm. Rs. 5 is the average revenue received by the firm.
 The total revenue is given by the product of AR and quantity sold, i.e., Rs. 5X10 units =
Rs. 50. This is depicted by the area of the shaded rectangle in the diagram.

2. Short run equilibrium of a monopolist firm, when the cost of production is positive by
using TR and TC curves.
Short run equilibrium of a monopolist firm, when the cost of production is positive by
using TR and TC curves. The level of output where monopolist earns maximum profit is called
equilibrium situation.
According to this approach a monopoly attains its equilibrium at the point where the
difference between Total revenue (TR) and total cost (TC) is maximum. At this point monopoly
firm reaches equilibrium with maximum profit.
In short run equilibrium situation TR-TC approach is explained with the help of
following diagram

In the above diagram OX axis represents output, OY axis represents Income, Cost and
Profit.

The profit (π) received by the firm equals the total revenue (TR) - the total cost (TC).

π = TR - TC

63
 In the diagram we can see that if quantity q1 is produced, the total revenue is TR1 and the
total cost is TC1.
π = TR1 – TC1
The same π is depicted by the length of the line segment AB i.e., the vertical distance
between the TR and the TC curves at q1 level of output. It should be clear that this vertical
distance changes for different levels of output.
 When output level is less then q2, the TC curve lies above the TR curve that is TC is greater
than TR, and therefore profit is negative and the firm makes losses. The same situation exist
for output levels greater than q3.
 At the quantity of output q2 and q3 TR is equal to TC i.e., TR=TC. Here D and E are the
break-even points in the diagram.
 Hence, the firm can make positive profits only at output levels between q2 and q3, where
TR curve lies above the TC curve. The monopoly firm choose that level of output which
maximises its profit. This would be the level of output for which vertical distance between
the TR and the TC is maximum.
 If the difference between TR –TC is calculated and drawn as a graph, i.e., a, b it will look
as in the curve marked ‘profit’. It should be noticed that profit curve has its maximum
value at the level of output q0.
The market demand curve for a commodity and the total cost for a monopoly firm
producing the commodity is given by the schedule below.

Quantity Q 0 1 2 3 4 5 6 7 8
Price P 52 44 36 31 26 22 19 16 13

Quantity 0 1 2 3 4 5 6 7 8
Total cost 10 60 90 100 102 105 109 115 125

Calculation of the following:

a) The MR and MC schedules.
b) The quantity for which the MR and MC are equal.
c) The equilibrium quantity of output and equilibrium price of the commodity.
d) The total revenue, Total Cost, and Total profit in equilibrium.

64
a) The MR and MC schedules:

Quantity (Q) Price in Rs (P) TC TR=PXQ MR=TRn-TRn-1 MC

0 52 10 0 - -
1 44 60 44 44 50
2 36 90 72 28 30
3 31 100 93 21 10
4 26 102 104 11 2
5 22 105 110 6 3
6 19 109 114 4 4
7 16 115 112 -2 6
8 13 125 104 -8 10

b) The quantity for which the MR and MC are equal is 6. i.e, MR = MC = 6.

c) Equilibrium quantity is 6 and Equilibrium price is 19.

d) Total Revenue is 114 and Total cost is 109.

Profit (π) = TR-TC i.e., 114-109 = 5; therefore Profit (π) = 5.

Other Non-Perfectly Competitive Market:

Monopolistic Competition:
A market situation in which there are large number of firms which sells closely related,
but differentiated products is called monopolistic competition.
E.g. Market products like soaps, toothpaste, cool drinks etc.
Features:
1. Existence of large number of buyers and sellers: In a monopolistic competition there
will be large number of producers. Even though the number of firms are large, they will
be of smaller size.
2. Product differentiation: It refers to differentiating the products on the basis of brand,
size, colour, shape etc.
For example: There is a very large number of biscuit producing firms, But many of the
biscuits being produced are associated with some brand name and are distinguishable
from one another by these brand names and packaging and are slightly different in taste.
The consumer develops a taste for a particular brand of biscuit over time, or becomes
loyal to a particular brand for some reason, and is, therefore, not immediately willing

65
 to substitute it for another biscuit. However, if the price difference becomes large, the
consumer would be willing to choose a biscuit of another brand.
3. Downward sloping demand curve: Here AR and MR are negatively sloping elastic
demand curves. That show a small change in price can bring a greater change in
demand. If producer wants to sell its more product, he will have to lower the price.
4. Free entry and free exist of firms: In this market there is no restriction upon the firm
to enter or leave the industry. If the existing firms are earning huge profits, some new
firms may join to share the profits and in case of losses to the working firms, some of
them may exit out of the industry.

How do firms behave in oligopoly?

A market situation in which there are few firms selling homogeneous or differentiated
products is called oligopoly market.
The following points explained the behaviour of the firms in oligopoly market:
1. Few large firms: There are few firms in oligopoly market but each firm is relatively
large when compare to the size of the market. As a result each firm is in a position to
affect the total supply in the market, and thus influence the market price.
2. Firms could decide to collude with each other: At one extreme, firms could decide
to “collude” with each other to maximise collective profits. In this case the firms form
a ‘cartel’ that acts as a monopoly. The quantity supplied collectively by the industry
and the price charged are the same as a single monopolist would have done.
3. Firms could decide to compete with each other: At the other extreme firms could
decide to compete with each other. For example - a firm may lower its price a little
below the other firms in order to attract away their customers. Obviously, the other
firms would retaliate by doing the same. So the market price keeps falling as long as
firms keep undercutting each other’s price. If the process continues to its logical
conclusion, the price will have fallen till the marginal cost.

If a firm tries to reduce the price the rivals will also react by reducing their prices.
However if it tries to raise the price, other firms might not do so. It will lead to loss of customers
for the firm, which intended to raise the price. So, firms prefer non price competition instead
of price competition.

DUOPOLY: It is a market structure where there are two sellers. A duopoly is a type of
oligopoly where two firms have dominant or exclusive control over a market.

66
 It is the most commonly studied form of oligopoly due to its simplicity. Duopolies sell
to consumers in a competitive market where the choice of an individual consumer can not affect
the firm.

Points to remember:
 A market structure that produces heterogeneous products is called monopolistic
competition.
 The monopoly firm’s decision to sell a larger quantity is possible only at lower prices.
 In monopoly market the goods which are sold have no substitutes.
 The revenue received by the firm per unit of commodity sold is called average revenue.
 Competitive behaviour and competitive market structure are in general inversely related.
 With the zero production cost, when the total revenue of monopoly firm is maximum, the
profit is maximum.
 TR= p x q.
 Profit (π) = TR-TC.
 The change in TR due to the sale of an additional unit is called marginal revenue.
 When the price elasticity of demand is more than one, MR has a positive value.

****

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69
 PART-II
MACRO ECONOMICS
 Chapter 1: Introduction

Macro Economics:
In macroeconomics we usually simplify the analysis of how the country’s total
production and the level of employment are related to attributes (called ‘variables’) like prices,
rate of interest, wage rates, profits and so on, by focusing on a single imaginary commodity
and what happens to it. Macroeconomics tries to address situation facing the economy as a
whole. Macro Economics study in aggregates.

An analysis of in what way macroeconomics differs from microeconomics:

 In microeconomics, you came across individual ‘economic agents’ (see box) and the nature
of the motivations that drive them. They were ‘micro’ (meaning ‘small’) agents.
 In other words, microeconomics was a study of individual markets of demand and supply
and the ‘players’, or the decision-makers, were also individuals (buyers or sellers, even
companies) who were seen as trying to maximise their profits (as producers or sellers) and
their personal satisfaction or welfare levels (as consumers).
 Even a large company was ‘micro’ in the sense that it had to act in the interest of its own
shareholders which was not necessarily the interest of the country as a whole.
 For microeconomics the ‘macro’ (meaning ‘large’) phenomena affecting the economy as a
whole, like inflation or unemployment, were either not mentioned or were taken as given.
These were not variables that individual buyers or sellers could change.
 The nearest that microeconomics got to macroeconomics was when it looked at General
Equilibrium, meaning the equilibrium of supply and demand in each market in the
economy.
 Macroeconomics tries to address situations facing the economy as a whole.
 Macroeconomists had to study the effects in the markets of taxation and other budgetary
policies, and policies for bringing about changes in money supply, the rate of interest,
wages, employment, and output.
 Macroeconomics has, therefore, deep roots in microeconomics because it has to study the
aggregate effects of the forces of demand and supply in the markets.
 Macroeconomic policies are pursued by the State itself or statutory bodies like the Reserve
Bank of India (RBI), Securities and Exchange Board of India (SEBI) and similar
institutions.

70
Economic Agents:
Those individuals or institutions which take economic decisions are known as
economic agents.
 They can be consumers who decide what and how much to consume.
 They may be producers of goods and services who decide what and how much to produce.
 They may be entities like the government, corporation, banks which also take different
economic decisions like how much to spend, what interest rate to charge on the credits,
how much to tax, etc.

 Adam Smith is regarded as the founding father of modern economics (it was known as
political economy at that time).
 His well-known work - “An Enquiry into the Nature and Cause of the Wealth of
Nations (1776)” is regarded as the first major comprehensive book on the subject,
commonly known as “Wealth of Nations”.

Emergence of Macroeconomics:
Macroeconomics, as a separate branch of economics, emerged after the British
economist John Maynard Keynes published his celebrated book “The General Theory of
Employment, Interest and Money” in 1936. Commonly known as Keynesian Phenomenon.

Thought on classical tradition:

The dominant thinking in economics before Keynes was that all the labourers who are
ready to work will find employment and all the factories will be working at their full capacity.
This school of thought is known as the classical tradition.

The Great Depression of 1929 and the subsequent years:

 The Great Depression of 1929 and the subsequent years saw the output and employment
levels in the countries of Europe and North America fall by huge amounts. It affected other
countries of the world as well.
 Demand for goods in the market was low, many factories were lying idle, and workers were
thrown out of jobs.
 In USA, from 1929 to 1933, unemployment rate rose from 3 per cent to 25 per cent
(unemployment rate may be defined as the number of people who are not working and are
looking for jobs divided by the total number of people who are working or looking for
jobs).

71
 Over the same period aggregate output in USA fell by about 33 per cent. These events
made economists think about the functioning of the economy in a new way.
 The fact that the economy may have long lasting unemployment had to be theorised about
and explained.
 Keynes’ book was an attempt in this direction. Unlike his predecessors, his approach was
to examine the working of the economy in its entirety and examine the interdependence of
the different sectors. Thus the subject of macroeconomics was born.

Wage Rate:
There is sale and purchase of labour services at a price which is called the wage rate.
The labour which is sold and purchased against wages is referred to as wage labour.
The production units will be called firms. In a firm the entrepreneur (or entrepreneurs)
is in charge of affairs. He hires wage labour from the market, he employs the services of
capital and land as well. After hiring these inputs he undertakes the task of production. His
motive for producing goods and services (referred to as output) is to sell them in the market
and earn profits. In the process he undertakes risks and uncertainties.

Factors of Production:
The four factors of productions are land, labour, capital and entrepreneur. The
entrepreneur sells the product in the market. The money that is earned is called revenue. Part
of the revenue is paid out as rent for the service rendered by land, part of it is paid to capital
as interest and part of it goes to labour as wages. The rest of the revenue is the earning of the
entrepreneurs and it is called profit. Profits are often used by the producers in the next period
to buy new machinery or to build new factories, so that production can be expanded. These
expenses which raise productive capacity are examples of investment expenditure.

Factors of Production Rewards

1. Land 1. Rent
2. Labour 2. Wages
3. Capital 3. Interest
4. Entrepreneur 4. Profit

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Types of External Trade Sector:
There are two types of external trade sectors:
1. Exports: The domestic country may sell goods to the rest of the world. These are called
exports.
2. Imports: The economy may also buy goods from the rest of the world. These are called
imports.

The working of the Economy of a capitalist country:

A Capitalist economy can be defined as an economy in which most of the economic
activities have the following characteristics:
a) There is private ownership of means of production.
b) Production takes place for selling the output.
c) There is sale and purchase of labour service at a price called wage rate.
The examples for capitalistic countries are, a handful of countries North America, Europe and
Asia will qualify as capitalist countries.
In a capitalist country production activities are mainly carried out by capitalist
enterprises. A typical capitalist enterprise has one or several entrepreneurs. Entrepreneurs are
those who exercise control over major decisions and bear a large part of the risk associated
with the firm. They may themselves supply the capital needed to run the enterprise or they may
borrow the capital.
To carry out the production they also need natural resources. They need the most
important element of human labour to carry out production. This is called as labour. After
producing output with the help of land, labour and capital, the entrepreneur sells the product in
the market to earn money called revenue. Part of the revenue is paid out as rent for land, interest
for capital and wage for labour and keeps the rest of the revenue as profit.
Profits are often used by the producers in the next period to buy new machinery or to
build new factories, so that production can be expanded. These expenses which raise productive
capacity are examples of investment expenditure.

The Role of Government (State) and Household Sector in both developed

and developing countries:
Role of Government:
 In both the developed and developing countries, apart from capitalist sector, there is the
institution of State.

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 The role of the state includes framing laws, enforcing them and delivering justice. The State
here refers to the Government which performs various developmental functions for the
society as whole.
 It undertakes production, apart from imposing taxes and spending money on building public
infrastructure, running schools, providing health services etc. These economic functions of
the state have to be taken into account when we want to describe the economy of the
country.
Role of Household sector:
 By household we mean a single individual who takes decisions relating to her own
consumption or a group of individuals for whom the decisions relating to consumption are
jointly determined.
 Households consist of people. These people work in firms as workers and earn wages. They
are the ones who work in government departments and earn salaries or they are the owners
of firms and earn profits.
 Therefore, the market in which the firms sell their products could not have been functioning
without the demand coming from the households. Further, they also earn rent by leasing
land or earn interest by lending capital.

Points to Remember:
 The individuals or institutions which take economic decisions are economic agents.
 In 1936 British economist J. M. Keynes published his celebrated book “General theory of
employment, interest and Money”.
 All the labourers who are ready to work will find employment and all the factories will be
working at their full capacity, this school of thought is known as classical thought.
 The year of Great Depression is 1929.
 In a capitalist country production activities are mainly carried out by private enterprises.

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76
 Chapter-2: National Income Accounting

Introduction:
The study of National income is related to macro-economics. It also deals with the three
ways to calculate the national income; namely product method, expenditure method and
income method.
It describes the various sub-categories of national income. It also defines different price
indices like GDP deflator, Consumer Price Index, Wholesale Price Indices and discusses the
problems associated with taking GDP of a country as an indicator of the aggregate welfare of
the people of the country.

Some Basic Concepts of Macroeconomics:

 Final goods:
An item that is meant for final use and will not pass through any more stages of
production or transformations is called final goods. In other words, the goods which is
ready to be sold finally to the consumers for final use.
Example: The tea leaves purchased by the consumer are not consumed in that form – they
are used to make drinkable tea, which is consumed. Similarly most of the items that enter
our kitchen are transformed through the process of cooking. But cooking at home is not an
economic activity, even though the product involved undergoes transformation. Home
cooked food is not sold to the market.
However, if the same cooking or tea brewing was done in a restaurant where the cooked
product would be sold to customers, then the same items, such as tea leaves, would cease
to be final goods and would be counted as inputs to which economic value addition can
take place. Thus it is not in the nature of the good but in the economic nature of its use that
a good becomes a final good.
Therefore, the final goods can be distinguished according to its economic nature of their
use as:
1. Consumption goods: Goods like food and clothing, and services like recreation that
are consumed when purchased by their ultimate consumers are called consumption
goods or consumer goods. (This also includes services which are consumed but for
convenience we may refer to them as consumer goods.)
2. Capital goods: These goods are of durable character which are used in the production
process. Example: tools, implements and machines. While they make production of

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 other commodities feasible, they themselves don’t get transformed in the production
process. They are also final goods yet they are not final goods to be ultimately
consumed.
These are capital goods and they gradually undergo wear and tear, and thus are
repaired or gradually replaced over time.
Thus if we consider all the final goods and services produced in an economy in
a given period of time they are either in the form of consumption goods (both durable
and non-durable) or capital goods. As final goods they do not undergo any further
transformation in the economic process.
 Intermediate Goods:
A large number of products don’t end up in final consumption and are not capital goods
either. Such goods may be used by other producers as material inputs.
Examples are steel sheets used for making automobiles and copper used for making
utensils.
In other words intermediate goods are, mostly used as raw material or inputs for
production of other commodities. These are not final goods.

Factors of Production and their rewards:

The four factors of production are Land, Labour, Capital and Organisation. The rewards
of these factors of production are as follows:

Factors Rewards
Land Rent
Labour Wages
Capital Interest
Organization Profit

Difference between Stocks and Flows:

Stocks Flows
 Stocks are defined at a particular point of  Flows are defined over a period of time.
time.
 It is a constant concept.  It is a variable quantity.
 It is the quantity of economic variable which  It refers to that quantity of economic
is measured at a particular point of time. variable measured over a period of time.
 Example: How much water there is in the  Example: The amount of water which is
tank at a particular point of time is a stock flowing into the tank from the tap per
concept minute is a flow.

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Depreciation:
Depreciation is an annual allowance for wear and tear of a capital good. In other words
it is the cost of the good divided by number of years of its useful life.
A part of the capital goods produced this year goes for replacement of existing capital
goods and is not an addition to the stock of capital goods already existing and its value needs
to be subtracted from gross investment for arriving at the measure for net investment This
deletion, which is made from the value of gross investment in order to accommodate regular
wear and tear of capital, is called depreciation.
New addition to capital stock in an economy is measured by net investment or new
capital formation, which is expressed as:

Net Investment = Gross investment – Depreciation

Circular Flow of Income of an Economy:

The circular flow of income of an economy can be explained with the help of following
assumptions:
a) Existence of two sectors viz., household sector and producers.
b) Households are the owners of the factors of production.
c) Households receive income by selling the factor services.
d) There are no savings.
e) The firms produce goods to the households.
f) The economy is a closed economic system (where no Government or external trade or
savings).
The circular flow of income in a simple economy can be illustrated with the help of
following chart:

 In the above chart, the uppermost arrow A, going from the households to the firms,
represents the spending by the households to buy goods and services produced by the firms.

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 The second arrow B, going from the firms to the households is the counterpart of the arrow
above. It stands for the goods and services which are flowing from the firms to the
households.
 The two arrows at the bottom of the diagram similarly represent the factors of the
production market. The lower most arrow going from the households to the firms
symbolizes the services that the households re rendering to the firms. Using these services
the firms are producing the output.
 The arrow C, going from the firms to the households, represents the payments made by the
firms to the households for the services provided by the households.
Since the same amount of money, representing the aggregate value of goods and
services, is moving in a circular way.
 We can measure the uppermost flow (at point A) by measuring the aggregate value of
spending that the firms receive for the final goods and services which they produce.
This method will be called the expenditure method.
 If we measure the flow at B by measuring the aggregate value of final goods and
services produced by all Circular Flow of Income in a Simple Economy the firms, it
will be called product method.
 At C, measuring the sum total of all factor payments will be called income method.

Net Value Added:

The net contribution made by a firm is called its value added.
 If we include depreciation in value added then the measure of value added that we obtain
is called Gross Value Added.
 If we deduct the value of depreciation from gross value added we obtain Net Value Added.
Net Value Added = Gross Value Added – Depreciation
Inventory:
The stock of unsold finished goods, or semi-finished goods, or raw materials which
a firm carries from one year to the next is called inventory. Inventory is a stock variable.
 It may have a value at the beginning of the year; it may have a higher value at the end
of the year. In such a case inventories have increased (or accumulated).
 If the value of inventories is less at the end of the year compared to the beginning of
the year, inventories have decreased (decumulated).
We can therefore infer that

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 The change of inventories of a firm during a year ≡ production of the firm during the
year – sale of the firm during the year.
The sign ‘≡’ stands for identity. An identity always holds irrespective of what variables
we have on the left hand and right hand sides of it.

Unplanned Accumulation and decumulation of Inventories:

Unplanned accumulation of inventories: In case of unexpected fall in sales, the firm will
have unsold stock of goods which it had not anticipated. Hence there will be unplanned
accumulation of inventories.
Unplanned decumulation of inventories: If there is unexpected increase in the sales there
will be unplanned decumulation of inventories.
This can be explained with the help of following illustration:
Example 1: Suppose a firm produces T Shirts. It starts the production year with an inventory
of 100 T Shirts. During the coming year it expects to sell 1000 T shirts. Hence, it produces
1000 T shirts, expecting to keep an inventory of 100 T Shirts at the end of the year. However,
during the year, the sales of T Shirts became low unexpectedly. The firm is able to sell only
600 T Shirts. This means that the firm is left with 400 unsold T Shirts.
Unplanned accumulation of inventory = (1000-600) + 100 = 500 T shirts. The
unexpected increase of inventories by 400 T shirts is an example for unplanned accumulation
of inventories.
Example 2: On the other hand, if the sales had been more than 1000 we would have unplanned
decumulation of inventories. For instance, if the sales had been 1050, then not only the
production of 1000 T shirts will be sold, the firm will have to sell 50 T shirts out of the
inventory.
Unplanned decumulation of inventory = (1000 - 1050) + 100 = -50+100=50 T shirts.
This 50 (T shirts) unexpected reduction in inventories is an example of unexpected
decumulation of inventories.

Planned Accumulation and Decumulation of Inventories:

A planned change in inventories is the change in the stock of inventories which has
occurred in a planned way.
The planned accumulation and decumulation of inventories are explained with example
as follows:

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Example 1: Suppose a firm wants to increase the inventories from 100 T shirts to 200 T shirts
during the year. Expecting sales of 1000 T shirts during the year, the firm produces 1000 + 100
= 1100 T shirts. If the sales are actually 1000 T shirts, the firm ends up with a rise of inventories.
The new stock of inventories is 100 T shirts, which was planned by the firm. This is planned
accumulation of inventories.
Planned accumulation = (1100 – 100) + 100 = 100 + 100 = 200. The expected increase
of inventories by 100 T shirts is an example for planned accumulation of inventories.
Example 2: On the other hand, if the firm had wanted to reduce the inventories from 100 to
25, then it would produce 925 T shirts. This is because it plans to sell 1000 T shirts out of the
inventory of 100 T shirts it started with. Then the inventory at the end of the year becomes 25
T- shirts, which the firm wants. If the sales turn out to be 1000 T shirts as expected by the firm,
the firm will be left with the planned reduced inventory (decumulation) of 25 T Shirts.
Planned Decumulation = (925-1000) + 100 = -75 + 100 = 25. The expected decrease
of inventories to 25 T shirts is an example for planned accumulation of inventories.

Methods of measuring GDP:

The three methods of measuring GDP are:
a) Product or Value Added Method.
b) Expenditure Method.
c) Income Method.

A numerical example to show that all the three methods of estimating GDP
gives us the same answer:
The three methods of calculating GDP viz., Product or Value Added Method,
Expenditure method and Income Method, give us the same answer. This can be explained with
the help of numerical example as follows: The three methods of calculating GDP viz., Product
or Value Added Method, Expenditure method and Income Method, give us the same answer.
This can be explained with the help of numerical example as follows:
 Let us imagine, there are two firms X and Y.
 Suppose X use no raw material and produces cotton worth Rs.50. X sell its cotton to
firm Y, who uses it to produce cloth.
 Y sells the cloth produced to consumers for Rs.200.
 GDP in the phase of product or the value added method:
Here, value added = Sales – Intermediate goods.

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 Thus VAX = 50 – 0 = 50
VAY = 200 – 50 = 150.
Thus, GDP = VAX + VAY
= 50 + 150 = 200.
GDP distribution for firms X and Y:
Particulars Firm X Firm Y
Sales 50 200
Intermediate consumption 0 50
Value added 50 150

 GDP in the phase of Expenditure Method:

Under this method,
GDP = the sum of final expenditure/s on goods and services for end use.
= Final expenditure is the expenditure by consumers on cloth.
= 200.
 GDP in the phase of Income Method:
Under this method, GDP is obtained by adding factor payments. Let us imagine firm
X, from Rs.50 received, gives Rs.20 as wages and keeps the remaining Rs.30 as its profits.
Similarly, firm Y gives Rs.60 as wages and keeps Rs.90 as profits.
GDP = Wages + Profits
GDP = (20+60) + (30+90)
= 200
It can be stated in the following table:
Particulars Firm X Firm Y
Wages 20 60
Profit 30 90

Thus all the three methods of estimating GDP give us the same answer.

Expenditure method of measuring GDP:

Expenditure method is the alternative way to calculate the GDP by looking at the
demand side of the products. Here the aggregate value of the output in the economy by
expenditure method will be calculated in the following way.
In this method we add the final expenditures that each firm makes. Final expenditure is
that part of expenditure which is undertaken not for intermediate purposes. If the baker buys

83
Rs.50 worth of wheat from the farmers is considered as intermediate good and the final
expenditure received by the baker is 200. Then the aggregate value of output of the economy
is Rs.200 + Rs.50 = Rs.250.
Let us assume that firm i makes the final expenditure on the following accounts:
 Final consumption expenditures on the goods and services by households, denoted as Ci.
 Final investment expenditure incurred by the firms on capital goods, denoted as Ii.
 The expenditure that the Government makes on the final goods and services produced by
the firm, denoted as Gi.
 The export revenues that firm i earns by selling its goods and services abroad, denoted as
Xi.
Now the total final consumption, investment, government and export expenditures
received by the firm i. Now GDP according to the expenditure method is expressed as follows:

GDP ≡ ∑𝑵
𝒊=𝟏 𝑹𝑽𝒊 ≡ 𝑪 + 𝑰 + 𝑮 + X – M

Where, ∑𝑵
𝒊=𝟏 𝑹𝑽𝒊 = is the sum of income, C = final consumption, I = investment, G =

government and X= exports, M = Imports expenditures received by all the firms in the
economy.

Gross Value Added at market prices:

GVA at market prices = GVA at basic prices + Net product taxes

Net Value Added:

The Net value added is the deduction of depreciation from gross value added (GVA).
Net value added = GVA – Depreciation

Macro-Economic Identities:
1. GDP = Gross Domestic Product.
2. NDP = Net Domestic Product.
3. GNP = Gross National Product.
4. NNP = Net National Product.
5. PI = Personal Income.
6. PDI = Personal Disposable Income.

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1. Gross Domestic Product (GDP):
Gross Domestic Product measures the aggregate production of final goods and services
taking place within the domestic economy during a year. But the whole of it may not accrue
to the citizens of the country.
GDP at Market prices:
GDPMP = C + I + G + X – M
Where, C = Consumption Expenditure
I = Investment
G = Government expenditure
M = Imports
X-M = Net Exports
GDP at Factor cost:
GDPFC = GDPMP – NIT
Where, GDPMP = GDP at Market prices and NIT = Net Indirect Taxes

2. Net Domestic Product (NDP):

Net Domestic Product (NDP) is the value obtained from deduction of depreciation charges
from the GDP.
NDPMP= GDPMP – Depreciation

3. Gross National Product (GNP):

It refers to all the economic output produced by a nation’s normal residents, whether
they are located within the national boundary or abroad. It is defined as GDP plus factor
income earned by the domestic factors of production employed in the rest of the world
minus factor income earned by the factors of production of the rest of the world employed
in the domestic economy. Therefore,
GNPMP = GDPMP + Net factor income from abroad

4. Net National Product (NNP):

A part of the capital gets consumed during the year due to wear and tear. This wear and
tear is called depreciation. If we deduct depreciation from GNP the measure of aggregate
income that we obtain is called Net National Product. We get the value of NNP evaluated
at market prices. So,
NNPMP = GNPMP – Depreciation

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5. Personal Income (PI):
It refers to the part of National income (NI) which is received by households. It is obtained
as follows:
PI = NI – Undistributed Profits – Net interest payments made by the households –
Corporate tax + Transfer payments to the households from the Government and
firms.
6. Personal Disposable Income (PDI):
If we deduct the personal tax payments (income tax) and Non-tax payments (fines, fees)
from Personal Income, we get PDI. Therefore,
PDI = PI – Personal tax payments – Non-tax payments.

Difference between Nominal GDP and Real GDP:

Nominal GDP Real GDP
 GDP is calculated for the current year’s  GDP is calculated for the base year’s price.
price.
 It is denoted by GDP.  gdp stands for real GDP.
 Nominal GDP = Total Product x Current  Real GDP is such that the goods and
year price services are evaluated at some constant set
of prices for the base year.

For example, suppose a country only produces bread. In the year 2000 it had produced
100 units of bread, price was Rs 10 per bread. GDP at current price was Rs 1,000. In 2001 the
same country produced 110 units of bread at price Rs 15 per bread.
Therefore nominal GDP in 2001 was Rs 1,650 (=110 × Rs 15). Real GDP in 2001
calculated at the price of the year 2000 (2000 will be called the base year) will be 110 × Rs 10
= Rs 1,100.

GDP Deflator:
The ratio of nominal to real GDP is a well-known index of prices. This is called GDP
Deflator. Thus if GDP stands for nominal GDP and gdp stands for real GDP then,
GDP
GDP deflator = gdp .

Sometimes the deflator is also denoted in percentage terms. In such a case,

GDP
Deflator = × 100 per cent.
gdp

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Consumer Price Index (CPI):
Consumer Price Index (CPI) is the index of prices of a given basket of commodities
which are bought by the representative consumer.
CPI is generally expressed in percentage terms. We have two years under consideration
– one is the base year, the other is the current year. We calculate the cost of purchase of a given
basket of commodities in the base year.
We also calculate the cost of purchase of the same basket in the current year. Then we
express the latter as a percentage of the former. This gives us the Consumer Price Index of the
current year vis-´a-vis the base year.

Externalities:
An externality is a cost or benefit conferred upon second or third parties as a result
of acts of individual production and consumption. But the cost or benefit of an externality
cannot be measured in money terms because it is not included in market activities.
In other words, Externalities refer to the benefits or harms a firm or an individual causes
to another for which they are not paid or penalized. They do not have any market in which they
can be bought and sold.
There are two types of externalities, namely:
 Positive Externalities
 Negative Externalities.
Positive Externality: For example, let us imagine that there is chemical fertilizer industry. It
produces the chemical fertilizers required for agriculture. The output of the industry is taken
for counting GDP of an economy. This is positive externality.

Negative externalities: While carrying out the production the chemical fertilizer industry may
also be polluting the nearby river. This may cause harm to the people who use the water of the
river. Hence their health will be affected. Pollution also may kill fish and other organisms of
the river. As a result, the fishermen of the river may lose their livelihood. Such harmful effects
that the industry is inflicting on others, for which it will not bear any cost are called negative
externalities.

Limitations of using GDP as an index of welfare of a country:

Gross Domestic Product (GDP) is the sum total of value of goods and services created
within the geographical boundary of a country in a particular year. It gets distributed among
the people as incomes except retained earnings. So we consider that higher level of GDP of a

87
country is an index of greater well-being of the people of that country. Welfare of a country
means well-being of entire population of the country. But there are certain limitations of suing
GDP as an index of welfare of a country. They are as follows:
a) Distribution of Gross Domestic Product (GDP):
Generally, the rise in GDP will not represent increase in the welfare of the country. If
the GDP of the country is rising, the welfare may not rise as a consequence. This is because
the rise in Gross Domestic Product may be concentrated in the hands of very few individuals
or firms. For the remaining, the income may in fact might have decreased. In such a situation
the welfare of the entire country cannot be said to have improved.
b) Non-monetary exchanges:
Some of the activities in a country are not evaluated in terms of money. For instance,
the domestic services of housewife are not paid for. The exchanges which take place in the
informal sector without the help of money are called barter exchanges. In barter exchanges
goods are directly exchanged against each other. As money is not used here, these exchanges
are not registered as part of economic activity. In India, because of many remote areas, these
kinds of exchanges still take place and they are generally not counted in the GDP. Therefore,
Gross Domestic Product calculated in the standard manner may not give us a clear indication
of welfare of a country.
c) Externalities:
An externality is a cost or benefit conferred upon second or third parties as a result of
acts of individual production and consumption. In other words, externalities refer to the benefits
or harms, a firm or an individual causes to another for which they are not paid or penalized.
These do not have any market in which they can be bought and sold. But the cost or benefit of
an externality cannot be measured in money terms because it is not included in market
activities. For example, the pleasure one gets from his neighbour’s garden is an external benefit
and external cost is environmental pollution caused by industries. Both are excluded from
national income estimates.
d) Leisure and work:
One of the important things that affect the welfare of a society is leisure. But is not
included in GDP. For example, longer working hours may make people unhappy because their
leisure is reduced. On the contrary, shorter working hours per week may increase leisure and
make people happy.

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e) Manner of production:
The economic welfare also depends on the manner of production of goods and services.
If goods are produced by child labour or by exploitation of workers, then the economic welfare
cannot increase.

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90
 Chapter-3: Money and Banking

Introduction:
In an economy which consists of only one individual there cannot be any exchange of
commodities and hence there is no role for money. As soon as there is more than one economic
agent who engage themselves in transactions through the market, money becomes an important
instrument for facilitating these exchanges.
Economic exchanges without the mediation of money are referred to as barter
exchanges or barter system. However, they presume the rather improbable double
coincidence of wants. A barter system is difficult to carry forward one’s wealth under the barter
system. To solve the difficulties of barter system, the money was introduced.

Meaning of Money:
In order to smoothen the transaction, an intermediate good is necessary which is
acceptable to both the parties, i.e. buyer and seller (producers and consumers). Such a good is
called money. In other words, money is the commonly accepted medium of exchange.

Functions of Money:
The functions of money are:
a) Medium of Exchange: Money plays an important role as a medium of exchange. It
facilitates exchange of goods for money. Money has widened the scope of market
transactions.
b) Measure of Value/Unit of account: The money acts as a common measure of value.
The values of all goods and services can be expressed in terms of money.
c) Store of value: People can save part of their present income and hold the same for
future. Money can be stored for precautionary motives needed to overcome financial
stringencies.
d) Transfer of value: Money acts as a transfer of value from person to person and from
place to place. As a transfer of value, money helps us to buy goods, properties or
anything from any part of the country or the world.

Money acts as a convenient unit of account:

Money also acts as a convenient unit of account. The value of all goods and services
can be expressed in monetary units. This monetary units is called price.

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 When we say that the value of a certain wristwatch is Rs 500 we mean that the
wristwatch can be exchanged for 500 units of money, where a unit of money is rupee in this
case.
If the price of a pencil is Rs 2 and that of a pen is Rs 10 we can calculate the relative
price of a pen with respect to a pencil, viz. a pen is worth 10 ÷ 2 = 5 pencils. The same notion
can be used to calculate the value of money itself with respect to other commodities. In the
above example, a rupee is worth 1 ÷ 2 = 0.5 pencil or 1 ÷ 10 = 0.1 pen.
Thus if prices of all commodities increase in terms of money i.e., there is a general
increase in the price level, the value of money in terms of any commodity must have decreased
– in the sense that a unit of money can now purchase less of any commodity. We call it a
deterioration in the purchasing power of money.

How does money overcome the short comings of a barter system?

 Medium of Exchange: Money plays an important role as a medium of exchange. It
facilitates exchange of goods for money. It has solved the problems of barter system. Barter
exchanges become extremely difficult in a large economy because of the high costs people
would have to incur looking for suitable persons to exchange their surpluses.
 Measure of Value/Unit of account: The money acts as a common measure of value. The
values of all goods and services can be expressed in terms of money. It makes goods and
services comparable in terms of price.
 Store of value: People can save part of their present income and hold the same for future.
Money can be stored for precautionary motives needed to overcome financial stringencies.
Money solves one of the deficiencies of barter system i.e., difficulty to carry forward one’s
wealth under the barter system.
Suppose you have an endowment of rice which you do not wish to consume today
entirely. You may regard this stock of surplus rice as an asset which you may wish to
consume, or even sell off, for acquiring other commodities at some future date. But rice is
a perishable item and cannot be stored beyond a certain period. Also, holding the stock of
rice requires a lot of space. You may have to spend considerable time and resources looking
for people with a demand for rice when you wish to exchange your stock for buying other
commodities. This problem can be solved if you sell your rice for money. Money is not
perishable and its storage costs are also considerably lower.

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 Standard of deferred payments: All the credit transactions are expressed in terms of
money. The payment can be delayed or postponed. So, money can be used for delayed
settlement of dues or financial commitments.
 Transfer of value: Money acts as a transfer of value from person to person and from place
to place. As a transfer of value, money helps us to buy goods, properties or anything from
any part of the country or the world. Further, money earned in different places can be
brought or transferred to anywhere in the world.

Cashless and Digital Transactions:

A cashless society describes an economic state whereby financial transactions are not
connected with money in the form of physical bank notes or coins but rather through the
transfer of digital information (usually an electronic representation of money) between the
transacting parties.
In India government has been consistently investing in various reforms for greater
financial inclusion. During the last few years’ initiatives such as Jan Dhan accounts, Aadhar
enabled payment systems, e –Wallets, National financial Switch (NFS) and others have
strengthened the government resolve to go cashless. Today, financial inclusion is seen as a
realistic dream because of mobile and smart phone penetration across the country.

Central Bank:
Central Bank is a very important institution in a modern economy. Almost every
country has one central bank. The central bank of India is the ‘Reserve Bank of India (RBI)’,
established in 1935. It was nationalised in 1949. Sri. Shaktikanta Das is the present governor
of RBI. The headquarters of RBI is located at Mumbai.

Functions of RBI:
Central bank has several important functions. They are as follows:
1) It issues the currency of the country.
2) The currency issued by the central commercial banks, acts as a basis for credit creation.
3) It controls money supply of the country through various methods, like bank rate, open
market operations and variations in reserve ratios. It acts as a banker to the government.
4) It is the custodian of the foreign exchange reserves of the economy.
5) It also acts as a bank to the banking system, acts as a lender of last resort.

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Lender of Last Resort:
Reserve Bank is the only institution which can issue currency. When commercial banks
need more funds in order to be able to create more credit, they may go to market for such funds
or go to the Central Bank. Central bank provides them funds through various instruments. This
role of RBI, that of being ready to lend to banks at all times is another important function of
the central bank, and due to this central bank is said to be the lender of last resort.

Policy Tools to Control Money Supply:

The RBI controls the money supply in the economy in two ways:
1) Qualitative tools:
a. It controls the extent of money supply by changing the CRR.
b. By changing the bank rate.
c. Open market operations.
2) Qualitative tools:
Qualitative tools include persuasion by the Central bank in order to make commercial
banks.
a. discourage or encourage lending which is done through moral suasion,
b. Margin requirement.
c. Credit rationing.
d. Publicity.
e. Direct action and issue of directives.

The story of gold smith Lala on the process of deposit and loan (credit)
creation by commercial banks:
Once there was a goldsmith named Lala in a village. In this village, people used gold
and other precious metals in order to buy goods and services. These metals were acting as
money. People in the village started keeping their gold with Lala for safe keeping. In return for
keeping their gold, Lala issued paper receipts to people of the village and charged a small fee
from them.
Slowly, over time, the paper receipts issued by Lala began to circulate as money. This
means that instead of giving gold for purchasing wheat, some would pay for wheat or shoes or
any other good by giving the paper receipts issued by Lala. Thus, the paper receipts started
acting as money since everyone in the village accepted these as a medium of exchange.

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 Let us imagine that Lala had 100 kgs of gold, deposited by different people and he had
issued receipts corresponding to 100 kgs of gold. At this time Ramu comes to Lala and asks
for a loan of 25 kgs of gold. Now Lala can decide that everyone with gold deposits will not
come to withdraw their deposits at the same time and so he may as well give the loan to Mr.
Ramu and charge him for it. If Lala gives the loan of 25 kgs of gold, Ramu could also pay Mr.
Ali with these 25 kgs of gold and Ali could keep the 25 kgs of gold with Lala in return for a
paper receipt.
In effect, the paper receipts, acting as money, would have increased to 125 kgs now. It
seems that Lala has created money out of thin air. The modern banking system works precisely
the way Lala behaves in this example.

Requirement of reserves acts as a limit to money (credit) creation:

The RBI decides a certain percentage of deposits which every bank must keep as
reserves. This is done to ensure that no bank is over lending. This is a legal requirement and is
binding on the banks. This is called the CRR (Cash Reserve Ratio).
Cash Reserve Ratio (CRR) = Percentage of deposits which a bank must keep as cash
reserves with itself.
Statutory Liquidity Ratio (SLR) = Banks are required to keep some reserves in liquid
form in the short term.
The statutory requirement of the reserve ratio acts as a limit to the amount of credit that
banks can create.
For example, let us assume that in an economy there only one bank. Let us assume that our
bank starts with a deposit of Rs 100 made by X. The reserve ratio is 20 per cent. Thus our bank
has Rs 80 (100 – 20) to lend and the bank lends out Rs 80 to Y, which shows up in the bank’s
deposits in the next round as liabilities, making a total of Rs 180 as deposits.
Now our bank is required to keep 20 per cent of 180 i.e. Rs 36 as cash reserves. Recall
that our bank had started with Rs 100 as cash. Since it is required to keep only Rs 36 as reserves,
it can lend Rs 64 again (100 – 36 = 64). The bank lends out Rs 64 to Z.
This in turn shows up in the bank as deposits. The process keeps repeating itself till all
the required reserves become Rs 100. The required reserves will be Rs 100 only when the total
deposits become Rs 500. This is because for deposits of Rs 500, cash reserves would have to
be Rs 100 (20 per cent of 500 = 100).

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 Money Multiplier Process
Round Deposit in bank Required Reserve Loan made by bank
1 100 20.00 80.00
2 180.00 36.00 64.00
. . . .
. . . .
. . . .
. . . .
Last 500 100 400

Balance Sheet of Bank

Assets Liabilities
Reserves Rs. 100 Deposits Rs. 500
(100 + 400)
Loans Rs. 400 - -
Total Rs. 500 Total Rs. 500

Hence, requirement of reserves acts as a limit to money creation.

Money multiplier = 1/ cash reserve ratio
= 1/20% = 1/0.2 = 5
Thus, reserves of Rs 100 creates deposits of Rs (5x100) = Rs 500.

Open Market Operation:

The open market operations as one of the tools of RBI to control money supply,
refers to buying and selling of bonds issued by the Government in the open market. This
purchase and sale is entrusted to the RBI on behalf of the Government.
When RBI buys a Government bond in the open market, it pays for it by giving a
cheque. This cheque increases the total amount of reserves in the economy and thus increases
the money supply.
Similarly, selling of a bond by RBI to private individuals or institutions leads to
reduction in quantity of reserves and money supply.
There are two types of open market operations. They are as follows:
a) Outright: Outright open market operations are permanent in nature. When the RBI
buys the securities, it is without any promise to sell them later. Similarly, when the RBI
sells these securities, it is without any promise to buy them later. As a result, the
injection/absorption of the money is of permanent nature.

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 b) Repo: This is another type of operation in which the RBI buys the security with
agreement of purchase on particular date and price. This is called repo. The interest rate
at which the money is lent in this way is called repo rate.
Similarly, instead of outright sale of securities the RBI may sell the securities through an
agreement which as a specification about the date and price at which it will be repurchased.
This type of agreement is called reverse repo. The rate at which the money is withdrawn in
this manner is called the reverse repo rate.
The RBI conducts repo and reverse repo operations at various maturities like overnight, 7
days, 14 days etc. These types of operations have now become the main tool of monetary policy
of the RBI.

Bank Rate:
The RBI can influence money supply by changing the rate at which it gives loans to the
commercial banks. This rate is called the Bank Rate in India.
By increasing the bank rate, loans taken by commercial banks become more expensive;
this reduces the reserves held by the commercial bank and hence decreases money supply. A
fall in the bank rate can increase the money supply.

Demand for Money:

Money is the most liquid of all assets in the sense that it is universally acceptable and
hence can be exchanged for other commodities very easily. Demand for money balance is thus
often referred to as liquidity preference.
People desire to hold money balance broadly for two motives:
1) The Transaction Motive (MdT).
2) The Speculative Motive (MdS).
 The Transaction Motive (MdT):
Transaction motive demand for money refers to holding money to carry out
transactions. The transaction demand for money in an economy, MdT, can be written in the
following form:
MdT = kPY
Where Y is the real GDP and P is the general price level or the GDP deflator.
The above equation tells us that transaction demand for money is positively related to
the real income of an economy and also to its average price level.

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 The Speculative Motive (MdS):
Some people hold cash to invest on shares, debentures, gold, immovable properties etc.
The speculative demand for money refers to the demand for money that people hold as idle
cash to speculate with the aim of earning capital gains and profits. The speculative demand
for money can be written as follows:
Rmax – r
MdS=
r - rmin

Where, r is the market rate of interest and rmax and rmin are the upper and lower limits of
r, both positive constants. It is evident from the above equation that as r decreases from rmax
to rmin, the value of MdS increases from 0 to ∞.
 When the interest rate is very high everyone expects it to fall in future and hence anticipates
capital gains from bond-holding. Hence people convert their money into bonds. Thus,
speculative demand for money is low.
 When interest rate comes down, more and more people expect it to rise in the future and
anticipate capital loss. Thus they convert their bonds into money giving rise to a high
speculative demand for money. Hence speculative demand for money is inversely related
to the rate of interest.

The Supply of Money: Various Measures:

In a modern economy money consists mainly of currency notes and coins issued by the
monetary authority of the country. In India currency notes are issued by the Reserve Bank of
India (RBI), which is the monetary authority in India. However, coins are issued by the
Government of India.
The supply of money is the money held by the public, apart from currency notes and
coins, the balance in savings, or current account deposits, held by the public in commercial
banks is also considered money since cheques drawn on these accounts are used to settle
transactions.
Time deposits are the deposits in which money deposited is fixed for a period of time
and cannot be withdrawn before stipulated time. High rate of interest is paid. Interest rate
depends on the duration of money deposited.
Fiat Money is the money which does not have any intrinsic value. They do not have
intrinsic value like a gold or silver coin. They are also called legal tenders as they cannot be
refused by any citizen of the country for settlement of any kind of transaction.

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 Demand deposits are the deposits that are payable by the bank on demand from the
account-holder. Cheques drawn on savings or current accounts, however, can be refused by
anyone as a mode of payment. Hence, demand deposits are not legal tenders.

Legal Definitions: Narrow and Broad Money

Money supply, like money demand, is a stock variable. The total stock of money in
circulation among the public at a particular point of time is called money supply.
RBI publishes figures for four alternative measures of money supply, viz. M1, M2, M3
and M4. They are defined as follows:
M1 = CU + DD
M2 = M1 + Savings deposits with Post Office savings banks
M3 = M1 + Net time deposits of commercial banks
M4 = M3 + Total deposits with Post Office savings organisations (excluding
National Savings Certificates)
Where, CU is currency (notes plus coins) held by the public and DD is net demand
deposits held by commercial banks. The word ‘net’ implies that only deposits of the public
held by the banks are to be included in money supply.
The interbank deposits, which a commercial bank holds in other commercial
banks, are not to be regarded as part of money supply.
 M1 and M2 are known as narrow money.
 M3 and M4 are known as broad money. These measures are in decreasing order of
liquidity.
 M1 is most liquid and easiest for transactions whereas M4 is least liquid of all.
 M3 is the most commonly used measure of money supply. It is also known as aggregate
monetary resources.

High Powered Money:

The total liability of the monetary authority of the country – RBI, is called high powered
money. It consists of currency (coins and notes in circulation with the public and vault cash of
commercial banks) and deposits held by the Government of India and commercial banks with
RBI.
It is denoted by M1 i.e., M1= CU+DD. Where, CU = paper money and coins held by
the people, DD = Government and bank deposits with RBI.

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Demonetisation:
 Demonetisation was a new step taken by the Government of India on 8th November, 2016.
It was introduced to tackle the problem of corruption, black money, terrorism and
circulation of fake currency in the economy. Old currency notes of Rs.500 and Rs.1000
were no longer legal tender.
 New currency notes in denomination of Rs.500 and Rs.2000 were introduced. The public
were advised to deposit old currency notes in their bank account till 31st of March 2016
without any declaration and up to 31st March 2017 with the RBI with declaration.
 In order to avoid a complete breakdown and scarcity of cash, Government allowed
exchange of Rs.4000 old currency notes with new currency restricting to a person per day.
Further till 12th December 2016, old currency notes were acceptable as legal tender at
petrol pumps, Government hospitals and for payment of Government dues like taxes, power
bills etc.

Positive effects of demonetization:

 It improved tax compliance as a large number of people were bought in the tax ambit.
 The savings of individual were channelized into the formal financial system. As a result,
banks have more resources at their disposal which can be used to provide more loans at low
rate of interest.
 Demonetisation helps in curbing black money, reducing tax evasion and corruption will
decrease. It also help in tax administration in another way, by shifting transaction out of
the cash economy into the formal payment system.
 Now a days, households and firms have started to shift from cash payment to electronic
payments.

Negative impacts of Demonetization:

 There were long queues outside banks and ATM centres.
 There was acute shortage of currency notes.
 It had adverse effect on economic activities.

****

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 Chapter-4: Determination of Income and Employment

Introduction:
In this chapter we deal with the determination of National Income under the assumption
of fixed price of final goods and constant rate of interest in the economy. The theoretical model
used in this chapter is based on the theory given by John Maynard Keynes.
The basic objective of macroeconomics is to develop theoretical tools, called models,
capable of describing the processes which determine the values of these variables.
Specifically, the models attempt to provide theoretical explanation to questions such as
what causes periods of slow growth or recessions in the economy, or increment in the price
level, or a rise in unemployment.
It is difficult to account for all the variables at the same time. Thus, when we concentrate
on the determination of a particular variable, we must hold the values of all other variables
constant. This is a stylisation typical of almost any theoretical exercise and is called the
assumption of ceteris paribus, which literally means ‘other things remaining equal’.
You can think of the procedure as follows – in order to solve for the values of two
variables x and y from two equations, we solve for one variable, say x, in terms of y from one
equation first, and then substitute this value into the other equation to obtain the complete
solution. We apply the same method in the analysis of the macroeconomic system.

Consumption function:
The functional relationship between consumption and income is called consumption
function.
We can describe this function as:
C=C̅ + cY
Where, C = the consumption expenditure by households.
C̅ = Autonomous consumption.
cY= Induced Consumption

Types of Consumption:
There are two types of consumption they are:
1. Autonomous consumption (C̅).
2. Induced Consumption (cY).

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1. Autonomous Consumption (C̅): Minimum level of consumption, which is needed for
survival, i.e., consumption of zero level of national income is called autonomous
consumption. Autonomous consumption is denoted by C̅.
2. Induced Consumption (cY): The level of consumption is dependent on income this is
called induced consumption. The induced component of consumption, cY shows the
dependents of consumption of income.
Marginal Propensity Consume (MPC):
The change in consumption per unit change in Income is called marginal propensity
consume. It is denoted by ‘c’.
Therefore,
𝚫𝐂
MPC = =c
𝚫𝐘
Where, Δ𝐂 = Change in Consumption, 𝚫𝐘 = Change in Income
Generally, MPC lies between 0 and 1. This means that as income increases either the
consumers does not increase consumption at all (MPC = 0) or use entire change in income on
consumption (MPC = 1) or use part of the change in income for changing consumption (0<
MPC<1).

Average Propensity to Consume (APC):

Average propensity to consume is the consumption per unit of Income.
𝐂
APC =
𝐘
Where, C= Consumption, Y= Income.

Savings:
Savings is that part of income that is not consumed
In other words, S= Y-C
Where, S= Savings, Y = Income and C= Consumption.

Marginal Propensity to Save (MPS):

Marginal propensity to save is the change in savings per unit change in income. It is
denoted by ‘s’.
∆𝐒
MPS = =s
∆𝐘
Or MPS = s = 1-c

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Average propensity to save (APS):
It is the savings per unit of income.
𝐒
APS =
𝐘

Consumption function – Graphical representation:

The functional relationship between consumption and income is called consumption
function.
We can describe this function as,
C=C̅ + cY
Where, C̅ = Intercept of the consumption function, cY= Induced Consumption, c=slope
of consumption function = tan 𝛼.

Investment function:
Investment is defined as addition to the stock of physical capital (such as machines,
buildings, and roads etc., i.e. anything that adds to the future productive capacity of the
economy) and changes in the inventory (or the stock of finished goods) of a producer.
The functional relationship between investment and autonomous investment is
called autonomous investment.
I = I̅
Where, I = investment, I̅ = is a positive constant which represents the autonomous
(given or exogenous) investment in the economy in a given year.
Graphically, this is shown as the horizontal line at a height = I̅ above the horizontal axis.

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 In this model I is autonomous which means, it is the same no matter whatever is the
level of income.

Aggregate demand function:

The Aggregate Demand function shows the total demand (made up of consumption +
investment) at each level of income.
Aggregate Demand = C̅ + I̅ + cY
The total value of final goods and services which all the sectors of an economy are
planning to buy at a given level of income during a period of one accounting year is called
aggregate demand.
The factors causing change in aggregate demand:
There are two factors which cause change in aggregate demand, they are:
1) Consumption
2) Investment
Aggregate demand function can be obtain by vertically adding the consumption and
investment function.

In the graph, OM = C̅, OJ = I̅ , OL = C̅ + I̅ .

The aggregate demand function is parallel to the consumption function i.e., they have
the same slope c. It may be noted that this function shows ex ante demand.
The equation of aggregate demand for final goods written as AD= C̅+ I̅ + cY

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Fiscal variables influencing aggregate demand:
The two fiscal variables which influence aggregate demand are:
1. Tax.
2. Government expenditure.
Supply side of Macroeconomic equilibrium:
In the first stage of macroeconomic theory we are taking the price level of fixed. Here,
aggregate supply or the GDP is assumed to smoothly move up or down since they are unused
resources of all types available.
Whatever is the level of GDP that much will be supplied and price level has no rule to
play. This can be explained with the help of following diagram.

In the above diagram supply situation is shown by 45‹ line. Now, the 45‹ line has feature that
every point on it has the same horizontal and vertical co-ordinates.
In the diagram, GDP is Rs. 1000 at point A. The supply is Rs.1000 worth of goods
corresponding to point A is at point B which is obtained at intersection of 45° line and the
vertical line at A.

Equilibrium:
The point where ex-ante aggregate demand is equal to ex-ante aggregate supply will be
the equilibrium.
Ex-ante aggregate demand = ex-ante aggregate supply

Effect of an autonomous change in aggregate demand on income and output:

The equilibrium level of income depends on aggregate demand. Thus, if aggregate
demand changes, the equilibrium level of income changes. This can be happen in any one or
combination of following situation.
Change in consumption: This can happen due to (i) change in C̅ (ii) Change in c (c=MPC)

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Change in Investment: There are number of variables other than income which can effect
investment, they are:
i. Availability of credit: Easy availability of credit encourages investment.
ii. Interest rate: Interest rate is the cost of investable funds, and at higher interest rates,
firms tend to lower investment.
Let us now concentrate on change in investment with the help of the following example.
Y = C + I + cY
Let C = 40+ 0.8Y+10,
Where, C=40, I =10 and c = 0.8.
Therefore, Y = 50 + 0.8Y
50
Y= = 250
1−0.8
In this case, the equilibrium income (obtained by equation Y to AD) comes out to be
250. Now, let investment rise to 20. It can be seen that the new equilibrium will be 300. This
can be seen by looking at the graph. This increase in income is due to rise in investment, which
is a component of autonomous expenditure here. This can be explained with the help of
following diagram.

In the above diagram OX axis represents income OY axis represents aggregate demand.
 When autonomous investment increases, the AD1 line shifts paralleled upwards and
assumes the position AD2.
 The value of aggregate demand at output Y*1 is Y*1 F, which is greater than value of output
OY*1= Y*1 E1 by an amount of E1 F. E1 F measures the amount of excess demand that
emerges in the economy as a result of the increase in autonomous expenditure. Thus E1 no
longer represents the equilibrium.
 To find the equilibrium in the final goods market we must look for the point where the new
aggregate demand line, AD2, intersects 45° line. That occurs at point E2, which is, therefore,

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 the new equilibrium point. The new equilibrium values of output and aggregate demand
are Y*2 and AD*2.
 In the new equilibrium, output and aggregate demand have increase by an amount
E1G=E2G, which is greater than the initial increment in autonomous expenditure
𝛥I̅ =E1F=E2J. Thus an initial increment in the autonomous expenditure seems to have a
multiplier on the equilibrium values of demand and output.

The multiplier mechanism:

The ratio of the total change in income to the initial change in investment is known as
multiplier.
The concept of multiplier was first originated by Lord R F Khan. Keynes has
successfully implemented it in his employment theory.
∆𝐘
K=
∆𝐈
Where, ∆Y= Increase in Income, ∆I = Increase in Investment and K = Multiplier

Multiplier and marginal propensity to consume (MPC):

The value of multiplier is determined by MPC if MPC is higher, Multiplier will also be
higher but the value of multiplier more than one. The multiplier can be calculated by the
following formula:
𝟏
K=
𝟏−𝐌𝐏𝐂
Where, K= Multiplier, and MPC = marginal propensity to consume.

Investment Multiplier:
The ratio of the total increment in equilibrium value of final goods output to the initial
increment in autonomous expenditure is called investment multiplier.
Formula:
∆𝐘 𝟏 𝟏
Investment multiplier = = =
∆𝐀 𝟏−𝐜 𝐒
Where, ∆Y = change in the value of final goods, ∆A = change in autonomous
expenditure and c = MPC.

Working of multiplier:
 A given new investment will create an additional income by the same amount. The process
however does not end there.

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 The increase in income will lead to an increase in consumption, the additional consumption
expenditure will become the basis of a new income.
 Therefore, the new income will lead to a new consumption expenditure and so on.
Example: Let us assume that new investment is Rs. 100 crores. This leads to an additional
income of Rs. 100 crores. The additional income is expected to be spend on consumption
expenditure.
Let us assume that marginal propensity to consume (MPC) is 50% or 0.5 in other words
out Rs. 100 crores of income, 50 core are spent for consumption and remaining amount of Rs.
50 crores is saved.
This amount of Rs. 50 crores investment will be income for other people out of this
income those people will spent Rs. 25 crores. This process will go on until the consumption
becomes 0 The total income so far created is 100 +50+25+12.5+6.25…….=200 crores.

Paradox of thrift:
If all the people of the economy increase the proportion of the income they save (i.e. if
the MPS of the economy increases), the total value of savings in the economy will not increase.
It will either decline or remain unchanged. This result is known as paradox of thrift.
Example: Suppose at the initial equilibrium of Y=250, there is an exogenous or autonomous
shift in people’s expenditure pattern, they suddenly become thriftier.
This may happen due to a new information regarding an imminent war or some other
impending disaster, which makes people more circumspect or a conservative about their
expenditure. This can be regarded as an autonomous reduction in consumption expenditure.
But as aggregate demand decreases by 75, there emerges an excess supply equal to 75
in the economy. Stocks are piling up in warehouses and producers decide to cut the value of
production by 75 in the next round to restore equilibrium in the market. But that would mean
the reduction in factor payments in the next round and hence a reduction in income by 75.
As income decreases people reduce consumption proportionately but, this time,
according to the new value of MPC which is 0.5. Consumption expenditure and hence
aggregate demand, decreases by 75, which creates again an excess supply in the market.
In the next round therefore producers reduce output further by 75. Income of the people
decrease accordingly and consumption expenditure and aggregate demand goes down again by
75. The process goes on. However, as can be inferred from the dwindling values of the
successive round effects. The process is convergent.
Paradox of thrift can be explained with the help of following diagram:

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 In the above diagram OX axis represents income, OY axis represents aggregate
demand. When changes the line shifts upwards or downwards in parallel. When c changes,
however, the line swings up or down. An increase in mps, or a decline in mpc, reduces the
slope of the AD line and it swings downwards.

Some more concept:

Full employment level of Income: The level of income where all the factors of production are
fully employed in the production is called full employment level of income.

Excess demand: The situation when aggregate demand is more than the aggregate supply
corresponding to full employment level of output in the economy is called excess demand.
It leads to rise in prices in the long run.

Deficient demand: The situation when aggregate demand is less than the aggregate supply
corresponding to the full employment level of output in the economy is called deficient
demand. It leads to decline in prices in the long run.

Points to remember:
 Consumption which is independent of income is called autonomous consumption.
 The point where ex-ante aggregate demand is equal to ex-ante aggregate supply will be
equilibrium.
 Easy availability of credit encourages investment.
 In the situation of excess demand, demand is more than the level of output.
 Investment is defined as addition to the stock of physical capital.
 Size of the multiplier depends on the value of marginal propensity to consume (c).
 I is a positive constant which represents the autonomous investment in the economy.
 Aggregate demand for final goods (AD) = C̅ + I̅ + cY.
 Excess demand leads to rise in the prices in the long run.

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 Chapter-5: Government Budget and the Economy

Government Budget Meaning and Its Components:

Budget is a statement of estimated receipts and expenditures of the government in
respect of every financial year which runs from 1 April to 31 March.
‘Annual Financial Statement’ constitutes the main budget document of the government.

Types of government budget accounts:

There are two types of accounts:
1. Revenue Account: The budget document relates to the receipts and expenditure of the
government for a particular financial year. It is also called revenue budget.
2. Capital Account: The budget documents that concern the assets and liabilities of the
government into the capital account. It is also called capital budget.

Objectives of the Government Budget:

The government plays a very important role in increasing the welfare of the people. So,
to do that the government intervenes in the economy in the following ways:
1. Allocation Function of Government Budget.
2. Redistribution Function of Government Budget.
3. Stabilisation Function of Government Budget.

Public goods:
Public goods are the goods and services provided by the Government and which cannot
be provided by the market mechanism. Government provides certain goods and services which
cannot be provided by the market mechanism i.e. by exchange between individual consumers
and producers. Example, Roads, national defence, etc.

Private Goods:
Goods such as clothes, cars, food items etc. are only restricted to one particular
consumer this is called private goods.

Free riders:
If some users do not pay and it is difficult and sometimes impossible to collect fees for
the public good, such non-paying users are known as free riders. They are called so because,

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consumers will not voluntarily pay for what they can get for free and for which there is no
exclusive title (ownership) to the property being enjoyed.

Why public goods must be provided by the Government?

 The benefits of public goods are available to all and are not restricted to one consumer.
 In case of private goods anyone who does not pay for the goods can be excluded from
enjoying its benefits. But, in pubic goods, there is no feasibility way of excluding anyone
from enjoying the benefits of the good.
 Hence, public goods must be provided by the Government.

Difference between Public production and Public Provisions:

Public Provision Public production
 A set of facilities financed by the  When the goods produced directly by
government through its budget. the Government, it is called public
production.
 These are used without any direct  These are used with direct payment.
payment. Example Free education, Example Electricity, water supply etc.
mid-day meals etc.

The Chart of the Government Budget:

Classification of Receipts:
Receipts of the government are classified into two types:
1. Revenue Receipts. 2. Capital Receipts.
1. Revenue Receipts: Revenue Receipts means the revenue earned by the government from
tax and non-tax sources. Revenue receipts are divided into two types:
A) Tax revenue B) Non-Tax Revenue

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A) Tax revenue: Tax revenues, an important component of revenue receipts. Tax revenues
include:
i) Direct Taxes: The tax in which the incidence and impact are borne by the same
person are called direct taxes. Direct taxes are levied on individuals and firms.
Examples of direct taxes are Personal income tax, Corporation tax, other taxes such as
wealth tax gift tax and excise duty. Thus have been referred to as paper taxes.

Progressive Income Taxation: The redistribution objective is sought to be

achieved through progressive income taxation, in which higher the income, higher
is the tax rate.
Firms are taxed on a proportional basis, where the tax rate is a particular
proportion of profits. With respect to excise taxes, necessities of life are exempted
or taxed at low rates, comforts and semi-luxuries are moderately taxed, and
luxuries, tobacco and petroleum products are taxed heavily.

ii) Indirect Taxes: The taxes in which the incidence and impact are borne by the
different individuals are called indirect taxes. The important indirect taxes are excise
duty, customs duty, goods and service tax (GST).

B) Non Tax Revenues:

The important Non tax Revenues are –
 Interest receipts on account of loans by the central government.
 Dividends and profits on investments made by the government.
 Fees, fines and penalties.
 Cash grants -in-aid from foreign countries and international organisations.

2) Capital receipts: Capital receipts are the receipts of the government which either create
liability for the government or reduces the financial assets of the government. The capital
receipts are:
 Sale of shares in the public sector undertakings (PSU disinvestment).
 Loans raised by the government.
 Recoveries of loans.
 PPF etc.

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Classification of Expenditure:
The public expenditure can be classified as follows:
1. Revenue Expenditure.
2. Capital Expenditure.
1. Revenue Expenditure:
It is the expenditure of the government spent on the purposes other than the creation of
physical or financial assets. It is incurred for the normal functioning of the government
departments and various services, interest payments, grants given to state governments and
other parties. The revenue expenditure consists of the following:
 Plan Revenue expenditure: The plan revenue expenditure is related to central plans
and central assistance for state and union territory plans.
 Non-plan Revenue expenditure: The non-plan revenue expenditure is the more
important component of revenue expenditure. It covers a vast range of general,
economic and social services of the government. The main items of non-plan
expenditure are interest payments, defence services, subsidies, salaries and pensions.
2. Capital Expenditure:
The capital expenditure of the government includes the expenditures which result in
creation of physical or financial assets or reduction in financial liabilities. This includes
expenditure on the acquisition of land, building, machinery, and equipment, investment in
shares, and loans and advances by the central government to state and union territory
governments, public sector undertakings (PSUs) and other parties.
The capital expenditure is categorized as follows:
 Plan capital expenditure: The plan capital expenditure is related to central plan and
central assistance for state and union territory plans.
 Non-plan capital expenditure: The non-plan capital expenditure covers various
general, social and economic services provided by the government.

Fiscal Responsibility and Budget Management Act, 2003 (FRBMA):

FRBMA - Along with the Budget, three policy statements are mandated by Fiscal
Responsibility and Budget Management Act -2013. The three policy statements are:
1. The Medium-term Fiscal Policy Statement sets a three year rolling target for
specific fiscal indicators and examines whether revenue expenditure can be
financed through revenue receipts on a sustainable basis and how productively
capital receipts including market borrowings are being utilised.

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 2. The Fiscal Policy Strategy Statement sets the priorities of the government in the
fiscal area, examining current policies and justifying any deviation in important
fiscal measures.
3. The Macroeconomic Framework Statement assesses the prospects of the economy
with respect to the GDP growth rate, fiscal balance of the central government and
external balance.

Types of Budget:
Budget can be classified into three types. They are:
a) Surplus Budget: When the tax collection exceeds the required expenditure, the budget
is called surplus (Revenue > Expenditure).
b) Deficit Budget: When the expenditure exceeds revenue, the budget is called deficit
(Expenditure > Revenue).
c) Balanced Budget: The government may spend an amount equal to the revenue it
collects. This is known as balanced budget (Revenue=Expenditure).

Budget Deficits:
The Excess of Budgetary expenditure over its Budget receipts is called Budget deficits.
The important types of Budget deficits are:
a) Revenue Deficit: Revenue deficit refers to the excess of government’s revenue
expenditure over revenue receipts.
It can be expresses as:
Revenue Deficit =Revenue expenditure - Revenue receipts.
It signifies that government’s own revenue is insufficient to meet the normal running
of the government. This creates shortage of stock and increase liability.
b) Fiscal Deficit: Fiscal deficit is the difference between the government’s total
expenditure and its total receipts excluding borrowings.
Gross fiscal deficit = Total Expenditure [Revenue receipts + Non debt creating
capital assets]
Here, non-debt receipts do not rise debt since they are the receipts which are not
borrowings. Therefore,
Gross fiscal deficit - Net borrowings at home + Borrowings from RBI + Borrowing
from abroad.

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 c) Primary Deficit: The Excess of fiscal deficit over interest payments is called primary
deficit. So,
Primary deficit = Gross fiscal deficit - Net interest payments.

Changes in taxes and change in aggregate demand:

When there is a change in the tax rate disposable income also change. If tax rate
increases, disposable income decreases. If tax rate decreases disposable income increases.
Therefore, there is an opposite relationship between tax rate and disposable income. We can
calculate the tax multiplier using the following formula:
−𝐜
Tax multiplier, ∆Y = (∆T)
𝟏−𝐜
∆𝐘 −𝐜
=
∆𝐓 𝟏−𝐜
We find that a cut in taxes increase disposable income (Y-T) at each level of income.
This shifts the aggregate expenditure schedule upwards by a fraction of “C” of decrease in
taxes. This can be shown in a diagram as follows:

 In the above diagram OX axis represent income and output OY axis represent Aggregate
demand.
 If there is a cut in the taxes at each levels, the disposable income increases. This shifts the
aggregate expenditure schedules upwards by a fraction of C decrease in taxes. Aggregate
demand increases from AD to AD1.
 The new equilibrium increases from E to E1. The new higher level of income is Y to Y1.

Proportional Income Tax Acts as Automatic Stabilizer:

 The proportional income tax, acts as an automatic stabilizer because, it makes disposable
income and consumer spending less sensitive to fluctuations in GDP.

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 When GDP rises, disposable income also rises but by less than the rise in GDP because a
part of it is siphoned off as taxes. This helps to limit the upward fluctuation in consumption
spending.
 During a recession when GDP falls, disposable income falls less sharply and consumption
does not drop as much as it otherwise would have fallen, had the tax liability been fixed.
 This reduces the fall in aggregate demand and stabilizes the economy.

Fiscal Deficit Gives Borrowing Requirements of the Government:

Fiscal Deficit Gives Borrowing Requirements of the Government can be explained as
follows:
Fiscal deficit means the difference between the government’s total expenditure and its total
receipts excluding the borrowings. The fiscal deficit gives borrowing requirements of the
government. Fiscal deficit arises when there is excess of government’s total expenditure over
its revenue. Fiscal deficit will have to be financed through borrowings and other liabilities of
the government. Fiscal deficit of a country judges the financial health of the public sector and
the stability of the nation. Fiscal deficit adversely affects the economy in different ways:
1. Inflation: The government mainly borrows from RBI to meet its fiscal deficit. RBI
prints new currency notes to meet the deficit requirements. It increases money supply
in the economy and creates inflationary situation.
2. Foreign dependence: Government also borrows from rest of the world which raises its
dependence on other countries.
3. Hampers the Future growth: Borrowings increase financial burden for the future
generations. It adversely affects the future growth and development of the country.
4. Debt Trap: Borrowings not only involve repayment of principal amount, but also
require payment of interest. Interest payment increase the revenue expenditure and
leads to revenue deficit. It creates a vicious circle of fiscal deficit and revenue deficit,
where the government takes more loans to repay the earlier loans. As a result, country
is caught in a debt trap.

Public Debt:
Public debt refers to the borrowings of the government from the public to meet the
budget deficit.
Public debt is used as an effective instrument to control inflation and deflation.

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Public Debt Impose a Burden To The Future Generation:
This statement is true. This can be explained as follows:
1. By borrowing the government transfers the burden of reduced consumption on future
generations.
2. Government borrowings from the people reduces the savings available to the private
sector.
3. Borrowings of today means higher taxes in the future.
4. When we borrow from other countries, purchasing power will transfer from our country
to another through debt payment and interest payments.
A Note on Ricardian Equivalence:
Traditionally, it has been agreed that, when the government cuts taxes, and runs Budget
deficit consumers respond to their after tax income by spending more. It is possible that these
people are spending more.
It is possible that these people are short sighted and do not understand the implications
of Budget deficits. They may not realise that at some point in the future the government will
have to raise taxes to pay off the debt and the accumulated interest. They may expect the future
taxes to fall not on them, but on future generations.
Famous economist of 19th century David Ricardo gave a counter agreement to this
which has popularity as “Ricardian Equivalence”
Ricardo says, the consumers are forward looking and will base their spending not only
on their current income but also on their expected future income. They will understand that
borrowing today means higher taxes in the future.
Consumers are concerned about future generations because, they are the children and
grandchildren of the present generation and the family which is the relevant decision making
unit continues living. They would increase saving now which will fully offset the increased
government dissaving so that national income do not change.

Discuss the Issue of Deficit Reduction:

When there is greater expenditure than receipts budgetary deficit occurs, which leads
to inflation, and it increases during recession period leading to social unrest. Reducing the
budget deficit is very essential to control inflation and deflation to stabilise the economy.
There are mainly three ways where the government reduces budgetary deficit. They are:
1. Increasing direct tax collection.

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 2. Reducing government expenditure through making government activities more
efficient through better planning of government programmes.
3. Better administration to achieve economic welfare.
4. To raise receipts through the sale of the share in the public sector undertaking (PSUs)
that is, disinvestment.
Larger deficit do not always signify a more expansionary fiscal policy. The
same fiscal measures can give rise to a large or small deficit depending on the state of
the economy.
For example, if an economy faces recession, its GDP falls, tax revenue falls,
firms and households pay lower taxes, when they earn less profit. This means deficit
increases during recession and falls during boom.
Assignment and Project Oriented Question:
Budget on monthly income and expenditure of a family:

Sources of Income Monthly Income Monthly Expenditure

1. Father’s salary Rs. 30,000 1. Food items Rs. 10,000
2. Income from Agriculture Rs. 15,000 2. Bank loan Rs. 15,000
3. Mother’s salary Rs. 5,000 3. Petrol Rs. 5,000
4. Telephone, Rs. 3,000
Electricity bills
5. RD-Savings Rs. 2,000
6. Education Rs. 10,000
7. Others Rs. 5,000
Total Income Rs. 50,000 Total Expenditure Rs. 50,000

Points to remember:
 The taxes on individual and firms are direct taxes.
 The tax which acts as an automatic stabilizer is proportional income tax.
 Duties levied on goods produced within the country is known as excise duties.
 Wealth Tax is an example for paper tax.
 When demand exceeds the available output under conditions of high level of employment,
this may give rise to inflation.
 Non-paying users of public goods are known as free riders.
 Taxes imposed on goods imported into and exported out of India are called customs duties.

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 Chapter-6: Open Economy Macro-Economics

Meaning of Open Economy:

An open economy is one which interacts with other countries through various channels.

Linkages of Open Economy:

The three linkages of open economy are:
1. Output Market Linkage: The consumers and producers can choose between domestic and
foreign goods.
2. Financial Market Linkage: An economy can buy financial assets from other countries.
3. Labour Market Linkage: Firms can choose where to locate production and workers can
choose where to work.

Balance of Payments (BOP):

Balance of payments is the record of trade in goods and services and assets between the
residents of a country with the rest of the world for a specified period of time, usually a year.
There are two main accounts in the Balance of payments they are:
1. Current Account:
Current Account is the record of trade in goods and services and transfer payments. The
components of current account are:
 Trade in goods includes exports and imports of goods.
 Trade in services includes factor income and non-factor income transactions.
 Transfer payments are the receipts which the residents of a country get for ‘free’,
without having to provide any goods or services in return. They consist of gifts,
remittances and grants. They could be given by the government or by private
citizens living abroad.
 Balance on Current Account: a Current Account is in balance when receipts on
current account are equal to the payments on the current account. Balance on
Current Account has two components:
a) Balance of Trade or Trade Balance (BOT).
b) Balance on Invisibles.
a) Balance of Trade or Trade Balance (BOT): Balance of Trade (BOT) is the
difference between the value of exports and value of imports of goods of a country
in a given period of time. Types of BOT:

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  Balanced balance of trade: BOT is said to be in balance when exports of
goods are equal to the imports of goods.
 Surplus BOT: Trade surplus will arise if country exports more goods than
what it imports.
 Deficit BOT: Deficit BOT or Trade deficit will arise if a country imports
more goods than what it exports.
a) Balance on Invisibles: Net Invisibles is the difference between the value of exports
and value of imports of invisibles of a country in a given period of time.
Invisibles include services, transfers and flows of income that take place
between different countries. Services trade includes both factor and non-factor
income.
Factor income includes net international earnings on factors of production (like
labour, land and capital). Non-factor income is net sale of service products like
shipping, banking, tourism, software services, etc.
2. Capital Account:
Capital Account records all international transactions of assets. An asset is any one of
the forms in which wealth can be held, for example: money, stocks, bonds, Government
debt, etc. Purchase of assets is a debit item on the capital account.
Capital account classifies the items which are a part of capital account transactions.
These items are:
 Foreign Direct Investments (FDIs).
 Foreign Institutional Investments (FIIs).
 External borrowings and assistance.
 Balance on Capital Account:
Capital account is in balance when capital inflows (like receipt of loans from
abroad, sale of assets or shares in foreign companies) are equal to capital outflows
(like repayment of loans, purchase of assets or shares in foreign countries).
Surplus in capital account arises when capital inflows are greater than
capital outflows, whereas deficit in capital account arises when capital inflows are
lesser than capital outflows.

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Components of Current Account:

Components of Capital Account:

The Foreign Exchange Market:

The market in which national currencies are traded for one another is known as the
foreign exchange market. The major participants in the foreign exchange market are
commercial banks, foreign exchange brokers and other authorised dealers and monetary
authorities. It is important to note that although participants themselves may have their own
trading centres, the market itself is world-wide.

Foreign Exchange Rate:

Foreign Exchange Rate (also called Forex Rate) is the price of one currency in terms of
another. It links the currencies of different countries and enables comparison of international

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costs and prices. For example, if we have to pay Rs. 50 for $1 then the exchange rate is Rs 50
per dollar.

Demand for Foreign Exchange:

People demand foreign exchange because:
 They want to purchase goods and services from other countries;
 They want to send gifts abroad;
 They want to purchase financial assets of a certain country.
Determination of the Exchange Rate:
The three methods of Determination of the exchange rate systems are:
1) Fixed Exchange Rate System.
2) Flexible (Floating) Exchange Rate System.
3) Managed Floating (Dirty Floating) Exchange Rate System (Mixture of Flexible and
Fixed Exchange rate System).
1) Fixed Exchange Rate System:
In this system, the exchange rate is officially fixed by the government or monetary
authority. Fixed exchange rate is also known as stable exchange rate.
 Merits of fixed exchange rate:
 It provides stability to the foreign exchange market.
 It creates conditions for smooth flow of foreign capital between Nations.
 It eliminates speculative activities in foreign exchange market.
 In this system, the government has the monopoly right to maintain the exchange
rate at the specified period of time.

 Demerits of Fixed Exchange Rate System:

 It is very difficult to determine the level at which the exchange rate should be fixed.
 Fixed exchange rates are not permanently fixed.
 In this system, if there is any deficit in BOP, the government must take measure to
fill the gap of BOP by using its official reserves.

2) Flexible (Floating) Exchange Rate System:

In this system the exchange rate is determined by the forces of supply and demand in
the foreign exchange market. It is also called floating exchange rate system.
If there is a deficit in the BoP, in a fixed exchange rate system, governments will have
to intervene to take care of the gap by use of its official reserves.
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  Merits of Flexible Exchange Rate System:
 Movements in the exchange rate automatically take care of the surpluses and
deficits in the BOP.
 Countries gain independence in conducting their monetary policies.
 The government do not interfere in the determination of exchange rate.
 There is no need for the government to hold large foreign exchange reserves.

 Demerits of flexible exchange rate:

 It encourages speculation.
 There can be wide fluctuations in exchange rate.
 Which may hamper foreign trade etc.
 It generates inflationary trends in the economy, when there is increase in the prices
of imports due to depreciation of the currency.

3) Managed Floating (Dirty Floating) Exchange Rate System:

Without any formal international agreement, the world has moved on to what can be
best described as a managed floating exchange rate system. It is a mixture of a flexible
exchange rate system (the float part) and a fixed rate system (the managed part).
Under this system, also called dirty floating, central banks intervene to buy and sell
foreign currencies in an attempt to moderate exchange rate movements whenever they feel
that such actions are appropriate. Official reserve transactions are, therefore, not equal to
zero.

Meaning of Official Reserve Sale:

When the Reserve Bank of India sells foreign exchange when there is deficit balance
of payments, it is called official reserve sale.

Diagram showing foreign exchange market with fixed exchange rates:

Stable exchange rate: Fixed exchange rate is a system in which the exchange rate is officially
fixed by the government. It is also called stable exchange rate. The foreign exchange market
with fixed exchange rate can be explained with the help of a diagram.

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 In the above diagram, ox axis represents demand and supply of foreign exchange and
OY represents foreign exchange rate.
Let us suppose that for some reason the Indian government wants to encourage exports
for which it needs to make rupee cheaper for foreigners. It would do so by fixing a higher
exchange rate say Rs. 70 per dollar. Thus the new exchange rate set by the government is e1.
(Where e1>e) At the exchange rate, the supply of dollars exceeds the demand for dollars.
The RBI intervenes to purchase the dollars for rupees in the foreign exchange market
in order to absorb this excess supply which has been marked as AB in the diagram. Thus,
through intervention, the government can maintain any exchange rate in the economy.
On the other hand, if the government was to set an exchange rate at a level such as e2
there would be an excess demand for dollars, in the foreign exchange market. To meet this
excess demand for dollars, the government would have to withdraw dollars from its past
holdings of dollars.

Effect of an increase in demand for imports in the foreign exchange market:

An increase in demand for foreign goods and services result in a change in the exchange
rate. This can be explained in a graph as follows:

Suppose the demand for foreign goods and services increases (for example, due to

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Increased international travelling by Indians), the demand curve shifts upward and right to the
original demand curve. The increase in demand for foreign goods and services result in a
change in the exchange rate.
The initial exchange rate e* = 50, which means that we need to exchange Rs 50 for one
dollar. At the new equilibrium, the exchange rate becomes e1 = 70, which means that we need
to pay more rupees for a dollar now (i.e., Rs 70). It indicates that the value of rupees in terms
of dollars has fallen and value of dollar in terms of rupees has risen. Increase in exchange rate
implies that the price of foreign currency (dollar) in terms of domestic currency (rupees) has
increased. This is called Depreciation of domestic currency (rupees) in terms of foreign
currency (dollars).
Similarly, in a flexible exchange rate regime, when the price of domestic currency
(rupees) in terms of foreign currency (dollars) increases, it is called Appreciation of the
domestic currency (rupees) in terms of foreign currency (dollars). This means that the value
of rupees relative to dollar has risen and we need to pay fewer rupees in exchange for one
dollar.

The Gold Standard (The Gold Standard Exchange System):

The gold standard was prevailing as an exchange rate system from 1870 to 1914 all
over the world. Gold standard was a typical example of fixed exchange rate system.
In this system, all currencies were defined in terms of gold. Under gold standard each
country states that its currency is equivalent to particular quantity of gold and each country
agrees to convert its currency in to gold at a fixed price.
For example, if one unit of say currency A was worth one gram of gold. One unit of
currency B was worth two grams of gold. Currency B would be worth twice as much as
currency A. Economic agents could directly convert one unit of currency B into two units of
currency A without having to first buy gold and then sell it.
The rates would fluctuate between an upper limit and lower limit. These limits being
set by the costs of melting shipping and re-coining between two countries.

The Bretton Woods System:

The Bretton Woods Conference held in 1944 set up the International Monetary Fund
(IMF) and the World Bank and re-established a system of fixed exchange rates. This was
different from the international gold standard in the choice of the asset in which national
currencies would be convertible.

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 A two-tier system of convertibility was established at the centre of which was the dollar.
The US monetary authorities guaranteed the convertibility of the dollar into gold at the fixed
price of $35 per ounce of gold.
The second-tier of the system was the commitment of monetary authority of each IMF
member participating in the system to convert their currency into dollars at a fixed price. The
latter was called the official exchange rate.

Special Drawing Rights (SDRs) or Paper gold:

Triffin suggested that the IMF should be turned into a ‘deposit bank’ for central banks
and a new ‘reserve asset’ be created under the control of the IMF. In 1967, gold was displaced
by creating the Special Drawing Rights (SDRs), also known as ‘paper gold’, in the IMF with
the intention of increasing the stock of international reserves.
Originally defined in terms of gold, with 35 SDRs being equal to one ounce of gold
(the dollar-gold rate of the Bretton Woods system), it has been redefined several times since
1974. At present, it is calculated daily as the weighted sum of the values in dollars of four
currencies (euro, dollar, Japanese yen, and pound sterling) of the five countries (France,
Germany, Japan, the UK and the US).
It derives its strength from IMF members being willing to use it as a reserve currency
and use it as a means of payment between central banks to exchange for national currencies.

Foreign Currencies:
 Dollar - USA  Renminbi (Yan) - China
 Pound Sterling - UK  Peso - Argentina
 Euro - Germany  Dirham - UAE
 Yen - Japan  Taka - Bangladesh
 Ruble - Russia

Points to Remember:
 Current Account is the record of trade in goods and services and transfer payments.
 Capital account records all international transactions of assets.
 The price of foreign currency in terms of domestic currency has increased and this is called
depreciation of domestic currency.
 Managed floating exchange rate is a mixture of a flexible and fixed exchange rate system.
 The Bretton Woods conference held in the year 1944.

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