1. What do you mean by National income?

State main features of national

income.
Ans :- National Income – The money value of all the final goods and services
produced by normal residents of a country during a financial year is called national
income.

Features of National Income –

• National Income always takes the monetary value which can be obtained by
multiplying quantity of commodity by their respective prices.
• It includes only the value of final good. The value of intermediate goods is
not taken into consideration.
• It includes only factor income, transfer income is not included in it.
• It is a flow variable as it is measured during a period of one year.
• It is always measured during a financial year i.e. from 1 April to 31 March.

2. What do you mean by consumption and capital goods?

Ans :- Consumption Goods- The goods which are purchased by consumer to
satisfy their wants are called consumption goods. These goods satisfy human wants
directly such as pen, pencil, bread, butter etc.
These goods can be further divided into following categories-
Durable Goods: These are the goods which can be used again and again in
consumption over a long period of time. Such as T.V., Computer, Fan etc. Semi-
durable Goods: The goods which can be use for limited period of time are
known as Semi durable Goods. These goods have a life span of around one year.
Such as clothes, crockery, shoes etc.
Non-durable Goods: The goods which are used up in a single act of
consumption are called non durable Goods or perishable good.
Services –Services are produced and consumed simultaneously; it means there is
no time gap between their production and consumption. These are rendered for
direct consumption. Such as services of doctor, teacher etc.
Capital goods - The goods which help in production of other goods and services
and added in the capital stock of a country at the end of an accounting year are
called capital goods. It includes durable goods like car, fridge, road etc. Stock of
semi finished, finished goods and raw material are also part of it.

3. What do you mean by stock and flow variable?

Ans: - Stock -The economic variables that are measured at a particular point of
time are called stock variables. Stock is static concept. It has no time dimensions.
E.g. bank balance as on 1st Oct 2011 is ₹5000.
Flow-The economic variables that are measured during a period of time are called
flow variables. Flow is a dynamic concept. It has time dimensions. E.g. Interest
earned on bank deposits for 1 year, i.e. from 1st April 2011 to 31st March 2012.

4. Distinguish between Intermediate Goods and Final Goods.

Ans :- Difference between Intermediate Goods and final
goods

Sl. Intermediate Goods Final Goods

No.
i The goods which are purchased The goods which are meant for final
for resale or further production are consumption and investment are called
called Intermediate goods. final goods.
ii These goods lie within the These goods lie out of the production
production boundary so further boundary so further value cannot be
value can be added in these good. added in these goods.
iii These goods are not included in These goods are included in estimation
estimation of national income. of national income.

5. Distinguish between Factor income and transfer income.

Ans: - Factor income and transfer income
Sl.
No. Factor Income Transfer Income
i The amount of money that a factor of The amount of money that an
production earns by rendering its individual receive without providing
factor service in production process any service in return is called factor
is called factor income. income.
ii It’s an earned concept. It’s a receipt concept.
iii It’s a bilateral concept. It’s a unilateral concept.
iv It is included in national income It is not included in national income
and domestic income. and domestic income.
v E.g. Rent, interest, wages and profit E.g. Scholarship, old age pension,
unemployment allowance etc.
6. What do you mean by investment or capital formation? Name its various
concepts.
Ans: - Investment or Capital Formation- The addition in the capital stock of a
country is called investment or capital formation. E.g. - Construction of building,
purchase of machinery, addition to the inventories of goods etc.
Investment can be of two types-
1- Gross Investment: The total addition made to the capital stock of economy in a
given period is termed as gross investment. It consists fixed assets and unsold stock.
2-Net Investment: The actual addition made to the capital stock of economy in
a given period of time is called net investment. It can be obtained by subtracting
depreciation or consumption of fixed capital from gross investment.
Net Investment = Gross Investment – Depreciation
7. What do you mean by circular flow of income? Briefly explain its various
types.
Ans: - Circular flow of income- The flow of income among different sectors of
the economy is called circular flow of income.
Circular flow is of two types: money flow and real flow
Money flow – It refers to the flow of money in the form of factor payment
and consumption expenditure.
In other words money flow refers to the flow of factor payments from firms to
household for their factor services and corresponding flow of consumption
expenditure from household to firm for purchase of goods and services produced
by the firms. It is also called nominal flow.

Payment for factor services

Household Firms

Payment for goods & services

Real flow- It refers to the flow of factor services from household to firms and the
corresponding flow of goods and services from firms to households. It is also
known as product flow.
Goods & services

Household Firms

Factor services
8. Briefly explain the production method of measuring national income.
Ans: - Production Method: This method measures the national income by taking
the value of final goods and services produced by the different industrial sectors of
the economy.
Steps of Measurement:
i) Classify all the production units- It means grouping production units into
different sectors in the domestic (or economic) territory. The production units
are classified into primary, secondary and tertiary sectors.
ii) Estimate NVAFC of each industrial sector by taking the following sub-steps-
(A) Estimate gross value of output: Gross value of output (GVO) is the total
worth of goods produced .It can be estimated in two ways:
(a) As sum of sales and net addition to stocks
Value of output = Sales + change in stock
Where, Change in stock = Closing stock – Opening stock
(b) Quantity of output multiplied by price.
Value of output = Price × Quantity
(B) Estimate value of intermediate consumption and deduct the same from
gross value of output (GVO) to arrive at GVAMP.
Gross value added (GVAMP) = GVO - Intermediate consumption
(C) Estimate consumption of fixed capital (depreciation) and deduct it
from GVAMP to arrive at NVAMP.
NVAMP = GVAMP - consumption of fixed capital (depreciation)
(D) Find out net indirect tax by subtracting subsidies from indirect taxes (NIT=
indirect tax – Subsidies) and deduct it from NVAMP to arrive at NVAFC of an
industrial sector.
NVA FC = NVAMP – Net Indirect Tax (NIT)
iii) Take the sum of NVA FC of all the production units of all the industrial
sectors of the economy to get NDPFC.
NDPFC =Σ NVA FC
iv) Estimate net factor income from abroad and add the same to NDPFC to get
the NNP FC or national income.
NNP FC (N.I) = NDP FC + Net factor income from abroad (NFIFA)

Precautions : While estimating national income by the production method /

value added method the following precautions must be taken:
i) Avoid double counting of output.
ii) Value of own-account production should be included in total output.
iii) The value of intermediate goods should not be included.
iv) Do not include sale of second hand goods.

9. Briefly explain the income method of measuring national income.

Ans: -Income Method:-This method is also called income distribution method,
because in this method we measure the factor incomes paid out (i.e., distributed) to
the owners of factors of production by the various industrial sectors of the economy.
Steps in Measurement
i) Classify all the production units - It means grouping production units into
different sectors in the domestic (or economic) territory. The production units are
classified into primary, secondary and tertiary sectors.
ii) Estimate domestic factor income by each industrial sector: -There are three
components of domestic factor income— compensation of employees, operating
surplus and mixed income of the self-employed.
a) Compensation of employees refers to all payments by producers to their
employees in the form of wages and salaries both in cash and kind. It also
includes social security contributions such as pension, provident fund, gratuity
etc.
b) Operating Surplus is the sum of income from property (interest and rent) and
income from entrepreneurship (profits = dividend, corporate tax, and
undistributed profits). Thus, it is the sum of interest, rent and profits.
Operating Surplus = Rent + Interest + Profits
c) Mixed income of the self-employed is the income earned by self-employed
people like doctors, lawyers, chartered accountants, cobblers, barbers,
shopkeepers, farmers etc. A part of their income is wage income and another
part is property income. Thus it is called mixed income.
NVAFC = COE +OS+MI
iii) Estimation of NDPFC: Take the sum of NVAFC i.e., the factor incomes of all
the industrial sectors to arrive at NDPFC
NDPFC=∑ NVAFC
iv) Estimation of NNPFC - Add net factor income from abroad (NFIA) to NDPFC
to get NNPFC or National Income.
NNPFC (National Income) = NDPFC + NFIA
Precautions-The following precautions are required to be taken while
estimating national income by the expenditure method:
i) The imputed value of factor services rendered by the owners of production units
should be included in NI.
ii) Do not include any transfer incomes.
iii) Do not include income from sale of second hand goods.
iv) Do not include income arising from the sale of financial assets.
v) Do not include income from illegal sources.

10. Briefly explain Expenditure Method of measuring national income.

Ans:-Expenditure Method- In expenditure method we measure the expenditures
incurred on final goods and services produced by production units located within the
domestic (economic) territory of a country during a given year.
Steps of Measurement -
i) Identify and classify production units: Classify all the production units into
primary, secondary and tertiary sectors.
ii) Estimate final expenditure on goods and services produced by these
industrial sectors. These final expenditures are categorized as follows:
a) Private final consumption expenditure (PFCE) - It is the expenditure of
household and non-profit making institutions serving households for durable
goods (T.V., Fan etc.), semi-durable goods (clothes, shoes etc.) and non-
durable goods (vegetable, bread etc.).
b) Government’s final consumption expenditure (GFCE) - It is the
expenditure incurred by government on the purchase of goods and services
which are needed to provide facilities to the general public, such as,
expenditure on road, school, bridge, hospital etc.
c) Gross domestic capital formation (GDCF) - It refers to the expenditure
incurred on the purchase of capital goods, such as plant, equipments,
buildings, machine etc. It has two parts- Gross Domestic Fixed Capital
Formation (GDFCF) and Inventory Investment or Change in Stock.
d) Net exports (X-M) - It is the difference between exports of goods & services
and imports of goods & services during the given period of time. It refers to the
demand of foreigners for our goods & services over domestic demand
for foreign countries’ goods & services.
iii) Estimation of GDPMP - The sum of these final expenditures is GDPMP
GDPMP =PFCE + GFCE + GDCF + Net Exports
iv) Estimation of NDPFC - Estimate the consumption of fixed capital (Depreciation)
and net indirect taxes and deduct these from GDPMPto get NDPFC
NDPFC=GDPMP – Consumption of fixed capital (CFC) – Net indirect tax (NIT)
 v) Estimation of NNPFC- Add net factor income from abroad (NFIA) to NDPFC
to get NNPFC or National Income.
NNPFC (National Income) =NDPFC + NFIA

Precautions:-The following precautions are required to be taken while

estimating national income by the expenditure method:
i) Do not include expenditure on intermediate goods and services.
ii) Include imputed expenditure on self-consumed or own account produced
output used for consumption and investment.
iii) Do not include expenditure on transfer payments.
iv) Do not include expenditure on financial assets such as share, bond,
debenture etc.
v) Do not include expenditure on purchase of second hand goods.
11. Explain the following concepts-
a) Sectors of economy
b) Injection
c) Withdrawal
d) Double Counting
e) Depreciation
Ans: -
a) Different sectors of economy - There are three sectors of the economy-
i) Primary sector- It includes all those production units which exploit natural
resources for production. Such as Agriculture, mining, quarrying etc.
ii) Secondary sector- It includes all those production units which
transform one good in to another. Such as Industries, construction etc.
iii) Tertiary sector- It includes all those production units which provide
services. Such as banking, insurance, transport, communication etc.
b) Injection: The amount of money which is added in the circular flow of income is
called injection. Injections increase the speed of flow of income. Some examples
of injections are investment (I), government expenditure (G) and export (X).
c) Withdrawal: The amount of money which is taken out from the circular flow of
income is called withdrawal. Withdrawals decrease the speed of flow of income.
Some examples of withdrawals are savings (S), taxes (T) and import (M).
d) Double Counting – If the value of an item is estimated more than one time in
estimation of national income is called double counting. It leads to over
estimation of national income.
 It can be avoided by two ways-
i) By taking the value added by each enterprise
ii) By taking the value of final product
e) Depreciation: The reduction in the value of capital assets due to normal wear
and tear is called depreciation. These are the foreseen losses so cannot be
insured. It is also called consumption of fixed capital.
Whenever we subtract net value from the gross value we get depreciation.
Depreciation = Gross – Net

12. Distinguish between domestic product and national product.

Ans: - Difference between domestic product and national product
Sl.
No. Domestic Product National Product
I Domestic product is the money value National product is the money value of
of all the final goods and services all the final goods and services
produced within domestic territory produced by the normal residents of a
of a country during a country during a financial year.
financial year.
ii It includes the income of all the It includes the income of only normal
residents of the country. residents of the country.
iii Net factor income from abroad Net factor income from abroad
(NFIFA) is not included in it. (NFIFA) is included in it.

13. Distinguish between Nominal GDP and Real GDP. Ans: -

Difference between domestic product and national product
Sl.
No. Nominal GDP Real GDP
i The money value of all the final The money value of all the final goods
goods and services produced within and services produced within domestic
domestic territory of a country during territory of a country during a financial
a financial year at current year at base year prices is
year prices is called Nominal GDP. called Real GDP.
ii It is also known as GDP at current It is also known as GDP at constant
prices. prices.
iii Nominal GDP is affected by change Real GDP is affected by change in
in both output and prices. output only. It is not affected by change
in prices.
iv It is not a good indicator of It is a good indicator of measuring
measuring growth of an economy. growth of an economy.
14. Answer the following-
a) When will the domestic income be greater than the national
income? Ans: - If net factor income from abroad (NFIFA) is negative.
b) Why are net exports (X-M) a part of domestic income, and not a part of
NFIFA?
Ans: - Exports are goods produced within the domestic territory so treated as a
part of domestic income.

15. Will the following factor incomes be included in domestic factor income of
India? Give reasons for your answer.
(i) Compensation of employees to the residents of Japan working in Indian
embassy in Japan.
(ii) Profits earned by a branch of foreign bank in India.
(iii) Rent received by an Indian resident from Russian embassy in India.
(iv) Profits earned by a branch of State Bank of India in England.

Ans : - (i) Yes, It will be included in domestic factor income of India because
the Indian embassy in Japan is a part of domestic territory of India.
(ii) Yes, It will be included in domestic factor income of India because the
foreign bank is located in the domestic territory of India.
(iii) No, It will not be included in domestic factor income of India because
Russian embassy in India is not a part of domestic territory of India.
(iv) No, It will not be included in domestic factor income of India because branch of
State Bank of India which is earning profit is in England which is not a part of
domestic territory of India.
16. What is meant by gross domestic product? Explain any three limitations
of gross domestic product as a measure of economic welfare.
Ans :- Gross domestic product (GDP) refers to the money value of all the final
goods and services produced with in domestic territory of a country during a
financial year inclusive of consumption of fixed capital or depreciation.
Welfare means sense of material well being among the people. This depends upon
greater availability of goods and services. So it may be concluded that higher level
of GDP is an index of greater well being of people. But this generalisation is not
correct due to some limitations.
Limitations of GDP as a measure of economic welfare-
i) Distribution of GDP- If with increase in GDP inequality of income increase,
poor become poorer while rich become richer. This may lead to decline in
welfare even though GDP has increased.
 ii) Non-monetary transactions- GDP remains underestimated as non-monetary
transactions like services of housewife, barter exchanges, enjoyment from
hobbies like gardening, painting etc. are not included in GDP. Although they
increase economic welfare.
iii) Composition of GDP- If GDP increases due to more production of war goods
like weapons, tanks etc. it will not increase economic welfare.
iv) Externalities- Externalities refer to the benefits (or harms) a firm or an individual
causes to another for which they are not paid (or penalized). Externalities do not
have any market in which they can be bought and sold. Such as carrying out the
production of refinery may also be polluting the nearby river and create pollution.
This may cause harm to the people who use the water of the river. Such harmful
effects that the refinery is inflicting on others, for which it
does not have to bear any cost, are called externalities. Therefore, if we take
GDP as a measure of welfare of the economy we shall be overestimating the
actual welfare. This was an example of negative externality. There can be cases
of positive externalities as well. In such cases GDP will underestimate the
actual welfare of the economy.

17. What do you mean by barter system? What are its main difficulties?
How money overcome the problem of barter system? Explain
Ans: - Barter System implies direct exchange of goods against goods without the
use of money. It is also called C-C economy, i.e. Commodity-for-Commodity
exchange economy. E.g. When a weaver gives cloth to the farmer in return for
getting wheat from him, it is called barter exchange.

Main drawback of barter system are-

i) Lack of double coincidence of wants
ii) Lack of common measure
iii) Lack of divisibility
iv) Lack of storability
v) Problem of deferred payment

Money has solved the problem of barter exchange in the following ways:
a) Money as a medium of exchange solves the problem of lack of
double coincidence of wants.
b) In terms of money the value of other goods can be expressed.
c) Money is of a manageable size and shape, unlike some barter standards,
such as cattle.
d) The value of money changes less where as bartered goods may lose their
value after some time.
e) In term of money future payments can be easily made as value of
money changes less.
18. What is money? State the four functions of money.
Ans: - Money is anything that is generally accepted by people of a country as
a medium of exchange and measure of value.
Functions of Money-
i) Medium of exchange- People can sale and purchase (exchange) goods
and services through money.
ii) Measure of Value (Unit of value)- The values of different goods and
services can be expressed in term of money
iii) Standard of deferred payments- Future transactions or payments can be
made in terms of money.
iv) Store of value - The money has a quality of storability. So value of goods
can be stored in term of it for long period of time.

19. Define money supply. State two components of money supply.

Ans:- Money supply is the stock of coin, currency and demand deposits held
with public at a particular point of time in an economy. The main components of
money supply are-
(i) Currency held with the public.
(ii) Demand deposits with commercial banks

20. What do you understand by double coincidence of wants and

demand deposits
Ans: - Double coincidence of wants is the situation in which both parties agree to sell
and buy commodities of each other. What a person desires to sell is exactly what the
other wishes to buy. This problem exists in case of the barter system of exchange.
Demand Deposits - The deposits that can be withdrawn any time by cheque or
otherwise are known as demand deposits.

21. What do you mean by money /credit creation? Explain the process of
Credit (deposit) creation by the commercial banks with the help of numerical
example. Also explain its Limitations.
Ans: - Money/Credit creation - The Process of multiplying the deposits
by commercial bank is called credit creation.
Money creation or deposit creation or credit creation by the bank is determine by –
(i) The amount of the initial fresh deposits and
(ii) The Legal Reserve Ratio (LRR) i.e. the minimum ratio of deposit
legally required to be kept as cash by banks.
It is assumed that all the money that goes out of bank is re-deposited in to
the banks.
Let the LRR be 20% and there is a fresh deposit of 10,000. As required, the banks
keep 20% i.e. 2,000 as cash. Suppose the bank lend the remaining 8000. Those who
borrow use this money for making payments. As assumed who receive payments put
the money back in to the bank. In this way bank receive fresh deposit of 8,000. The
bank again keeps the 20% i.e. 1,600 as cash and lends 6,400 which is also
80% of the last deposit. The money again comes back to the banks leading to a
fresh deposit of 6,400. The money goes on in multiplying in this way, and
ultimately total money creation is 50,000.
Given the amount of fresh deposit and the LRR, the total money creation formula
is:
1
Money creation = Initial deposit 
LRR
Money creation = 10000  ()
=   
= 50,000
Limitations to credit creation - There are following limitations to credit creation
by banks:
1. The total amount of cash reserves in the banking system. Larger the cash reserves
more will be the credit creation.
2. Cash reserve ratio fixed by the central bank. More is the ratio, less is the power to
create credit and vice versa.
3. Banking habits of the people of the country- It means banking transactions through
cheques, drafts, bills etc. Good banking habit results in keeping smaller amount of cash
with the banks and therefore, more can be lent. This will create large credit.

22. Define Central bank. What are the main functions of central Bank?
Explain. Ans: - Central bank: A central bank is an apex institution of a country
that controls and regulates the monetary and financial systems of a country.
In India Reserve Bank of India (RBI) is the central bank.
Main functions of a central bank are:
i) Issue of Currency - The central bank has monopoly of issuing currency in the
country. Currency issued by it, is its monetary liability so it has to keep a reserve in
the form of gold and foreign securities. It promotes efficiency in the financial
system. Firstly, because this leads to uniformity in the issue of currency. Secondly,
because it gives Central Bank a direct control over money supply.
ii) Bankers to Government- Central bank acts as the bank of central and state
governments. It carries out all banking business of the govt. The govt. keeps its cash
balances on current a/c with the central bank. It gives loans to central government for
short period and manages the public debt of the country. It also transfers government
funds and buys and sells securities, treasury bills etc. on behalf of the government.
iii) Bankers Bank & Supervisor- As the banker to banks the central bank holds a
part of cash reserve of banks, lends them short-term funds and provides them with
centralized clearing and remittance facilities.
The central bank supervises, regulates and controls the commercial banks. The
regulation of these banks may be related to their licensing, branch expansion,
liquidity of assets, management, merging of banks etc. The control is exercised by
periodic inspection of banks and the returns filed by them.
iv) Controller of Money Supply- The central bank of the country tries to control the
availability of credit in the market with its many tools like CRR, SLR, bank rate, open
market operation etc which are also called the instruments of Monetary policy. Central
bank regulates the money supply and credit in the best interest of the country.
v) Lender of Last Resort- It helps the commercial banks in times of financial
difficulties. Scheduled banks can take the loans by rediscounting first class bills or
short term approved securities, whenever they do not get funds from any other
sources.

23. What is credit control? How central bank control the credit? Explain.
Ans :- Credit Control :- The Central Bank controls the money supply and credit in
the best interests of the economy. The bank does this by taking recourse to various
instruments. These are:
i) Bank Rate Policy: The bank rate is the rate at which the central bank lends
funds to banks. The effect of a change in the bank rate is to change the cost of
securing funds from the central bank.
A rise in the bank rate will increase the cost of borrowing from the central bank then
causes the commercial banks to increase the interest rates at which they lend. This
will discourage businessmen and others from taking loans. Thus reduces the volume
of credit and vice versa.
ii) Open Market Operations: The act of buying and selling of government
securities by the Central Bank from / to the public and banks is called open market
operations.
When the Central Bank buys securities from the banks and public it adds to cash
balances in the economy. If cash balances are increased in the economy there will
be more deposits with the commercial banks which raise the banks’ ability to give
credit and thus increase the money supply.
When the Central Bank sells securities to the banks and public it withdraws cash
balances from the economy. If cash balances are decreased in the economy there
will be lesser deposits with the commercial banks which reduce the banks’ ability to
give credit and thus decrease the money supply.
iii) Legal Reserve Ratio (LRR) – LRR is the minimum ratio of deposits which
every bank legally is required to keep as liquefied reserve. There are two
components of LLR namely CRR and SLR.
Cash Reserve Ratio (CRR): The minimum percentage of their total deposits which
is to be kept by commercial banks with the Central Bank is called Cash Reserve
Ratio. A change in CRR affects the power of commercial bank to create the credit.
An increase in the CRR reduces the lending capacity of commercial banks to grant
loan. Then the commercial banks will increase the interest rates at which they lend.
This will then discourage businessmen and others from taking loans. Thus reduces
the volume of credit and vice versa.
Thus the CRR should be increased when credit is to be contracted and it (CRR)
should be decreased when credit is to be increased.

Statutory Liquidity Ratio (SLR): Commercial Banks are required to maintain a

specified percentage of their net total in the form of designated liquid assets or cash
with themselves. This specific percentage is called Statutory Liquidity Ratio (SLR).
An increase in the SLR reduces the lending capacity of commercial banks to grant
loan. Then the commercial banks will increase the interest rates at which they lend.
This will then discourage businessmen and others from taking loans. Thus reduces
the volume of credit and vice versa.
Thus the SLR should be increased when credit is to be contracted and it
(SLR) should be decreased when credit is to be increased.
iv) Repo Rate: When the commercial banks are in need of funds for a short period,
they can borrow from the Central Bank. The rate of interest charged by the Central
Bank on such lending is called Repo Rate.
Raising Repo Rate makes such borrowings by the commercial banks costly. As such
when Repo Rate is raised, banks are also forced to raise their lending rates. This has
a negative effect on demand for borrowings from the commercial banks and vice
versa.
v) Reverse Repo Rate: When the commercial banks have surplus funds they
can deposit the same with the central bank and earn interest. The rate of interest
paid by the Central Bank on such deposits is called Reverse Repo Rate.
When this rate is raised, it encourages the commercial banks to keep their funds
with the central bank. This has the negative effect on the lending capability of the
commercial banks and vice versa.
vi) Margin Requirements: A margin is the difference between the amount of the
loan and market value of the security offered by the borrower against the loan.
If the margin imposed by the Central Bank is 20%, then the bank is allowed to give
a loan only up to 80% of the value of the security. By altering the margin
requirements, the Central Bank can alter the amount of loans made against securities
by the banks. So higher margin requirements decreases the demand for credit and
vice versa.
24. What is Aggregate Demand? What are its main components?
Ans: - Aggregate Demand is the total demand for all the final goods & services by
all the consumers in the economy during a year. The main determinants of
Aggregate demand are
i) Private final consumption demand (C) - It is the demand of household and non-
profit making institutions serving households for durable goods (T.V., Fan etc.),
semi-durable goods (clothes, shoes etc.) and non-durable goods (vegetable, bread
etc.).
ii) Government final consumption demand (G)- It is the expenditure incurred by
government on the purchase of goods and services which are needed to provide
facilities to the general public, such as, expenditure on road, school, bridge, hospital
etc. The level of government expenditure is determined by the government policy.
iii) Private investment demand (I)- It refers to the expenditure incurred by the
private firm on the purchase of capital goods, such as plant , equipments, buildings,
machine etc. The investment is made in the economy in order to increase the
production capacity as well as to maintain the present level of production. The rate
of interest affects the investment demand inversely.
iv) Net exports (X-M) - It is the difference between exports of goods & services
and imports of goods & services during the given period of time. It refers to the
demand of foreigners for our goods & services over domestic demand for foreign
countries goods & services.

25. Define APC and APS. Derive the relationship between APC and APS.
Ans: - APC (Average Propensity to consume) is defined as the ratio of
C
total consumption to total income. Mathematically APC =
Y
Where, C= Consumption, Y= Income

APS (Average Propensity to Save) is defined as the ratio of total saving to

S
total income. Mathematically APS =
Y
Where, S= saving, Y= Income

Relationship between APC and APS

The sum of consumption and saving is equal to income.
So, C + S = Y
Dividing both sides by Y we get
C+S =Y
Y Y
C S
+ =1
Y Y
APC + APS = 1.
Thus, the sum of average propensity to consume and average propensity to save
is equal to one.

26. Explain the concept of MPC with the help of table and diagram. Why can
the value of MPC be not greater than 1?
Ans: - MPC (Marginal Propensity to consume) is defined as the ratio of change
ΔC
in consumption to change in income. Mathematically MPC = Where  C =
ΔY
change in consumption, Y= change in income.

For example, if income increases from 200 crores to 250 crores and consumption
increases from 20 crores to 40 crores, it implies that 0.4 is the MPC or 40%
increase in the income is being consumed.
This can further be explained with the help of a table and a diagram. If income
and consumption are:
Income (Y) Consumption Marginal propensity to consume
ΔC
Expenditure (C) MPC=
ΔY

200 20 ---
250 40 0.4
MPC can also be explained with the given diagram.

In the diagram, x-axis represents national income and y-axis represents

consumption level.
So, MPC = ΔC/ΔY
The value of MPC cannot be greater than 1 - It is because change in
consumption can never be greater than change in income.

27. What do you mean by Consumption Function? Briefly explain Linear

Consumption Function.
Ans: -
Consumption Function: - Consumption Function shows functional
relationship between total consumption and total income.
C = f (Y)
Where, C = Consumption; Y= Level of income
Linear consumption function: - If the consumption function is given on the
basis of constant marginal propensity to consume, is called linear consumption.
C = C + bY
Where, C = Consumption; C = Autonomous consumption / minimum level
of consumption; b = Marginal propensity to consume; Y= Level of income.

28. Define:-
a) Psychological law of consumption
b) Ex-ante Investment
c) Ex-post investment.
d) Involuntary unemployment
e) Full employment

Ans: -
a) Psychological law of consumption: It state that as income in an economy
increases consumption also increases but less than increase in income.
b) Ex-ante Investment:- Ex-ante Investment refers to the planned or intended
investment during a particular period of time. It is planned on the basis of
future expectations. So it is imaginary (intended), in which a firm assumes the
level of investment on its own.
c) Ex-post Investment:- Ex-post Investment refers to the actual level of
investment during a particular period of time. It signifies the existing
investment of a particular time.
d) Involuntary Unemployment refers to a situation in which people are ready to
work at prevailing wage rate, but do not find work.

e) Full Employment refers to a situation in which all the persons in the economy
those who wish to work at prevailing wage rate, are getting the work. It means
there is no involuntary unemployment
29. Explain the meaning of equilibrium level of income with the help of
a diagram.
Ans: - The level of income and output in an economy is determined at that
point where; aggregate demand is equal to aggregate supply.
AD= C+I
AS=C+S
AS=Y (refers to countries national
income) At equilibrium point AD=AS.

Equilibrium can be achieved at full employment and even at under

employment situation. It may not be always at full employment condition in an
economy. We can explain it with the help of following schedule and diagram-

Income Y) Consumption(C) Investment (I) AD=C+I AS=Y Remark

() () () () ()
0 50 100 150 0

100 100 100 200 100 AD>AS

200 150 100 250 200

300 200 100 300 300 AD=AS
400 250 100 350 400
AD<AS
500 300 100 400 500

The above schedule shows equilibrium level of income is 300 where AD=AS
300=300.
We can explain it with the help of diagram as follows-
In diagram OY is the equilibrium level of
income because at E aggregate demand is
equal to aggregate supply.
Before this equilibrium level of income and
output, when income falls to OY0, AD is
D0Y0 against AS is S0Y0. This AD > AS
indicates planned spending > planned output
then there will be more demand for goods and
services so the firms will increase the output
.Consequently, employment
,output and income will be increased till the
equilibrium level of income and output OY is
reached where AD = AS.
On the other hand, when AD < AS it means planned spending < planned output,
then there will be unsold stock of goods with the firm so the firm will reduce the
level of output to the equilibrium output. Consequently, output, income and
employment will be reduced till the equilibrium level of income and output OY is
reached where AD = AS.

30. How equilibrium level of income and output is determined by the investment
and saving in the economy. In an economy planned savings exceed planned
investment. How will the equality between the two be achieved? Explain.
Ans:- In an economy, equilibrium level of income and output will be determined at
that point where investment is equal to saving. At equilibrium I=S

Excess of planned savings over planned investment means that the expenditure in
the economy is less than what the producers had expected. This would result in
undesired or unplanned build up of unsold stock. To correct this situation producer
will produce less. This will reduce level of output and income. Fall in income will
result in fall in savings. These changes will continue till income falls to a level at
which savings equal investment.
Y
Investment &Saving

O Y

31. What do you mean by multiplier? Explain the working of

investment multiplier with the help of a numerical example?
Ans :- Multiplier is the ratio of change in income to change in investment.

K = ΔY/ΔI , Where ∆Y is change in income and ∆I is change in investment.

Working of the multiplier -The working of the multiplier is based on the fact that
one person's expenditure is other person's income. When investment increases, it
increases the income consequently consumption also increases. And increase in
consumption lead to increase in income.
Symbolically: ∆I→∆Y→∆C→∆Y

It can be explain with the help of an example as follows.

Suppose, in an economy investment increase by 1,000 and MPC is 0.5 or 50%.
How increase in investment affect income can be shown in the following table:
 Increase in Increase in Increase in
Rounds Investment (∆I) Income (∆Y) Consumption (∆C)
[] [] []
i 1,000 1,000 500 (= 0.5×1,000)
ii --- 500 250 (= 0.5 × 500)
iii --- 250 125 (= 0.5×250)
iv --- --- ---
v --- --- ---
-- --- --- 0
Total 1,000 2,000 1,000
In example ,the initial increase in investment is of 1,000 .The impact of this
new investment of 1,000 will be that the income of employees working in the
economy will increased by 1,000.The MPC is 0.5 or 50% so they will spend
500(50% ×1,000) on their new consumption goods. The producers of these goods
will have an extra income of 500 and this will increase their consumption
expenditure by 250 (50% × 500) .This process continues till the effect of all is
over or change in consumption is zero.
We can get it by calculation as follows-
1
Y =  I
1 −MPC
1
Y =  1,000
1 − 0.5
1
 1,000
= 0.5
= 2 ×1,000
= 2,000
By calculation, we see that the increase in investment of 1,000 has increase the
income by 2,000.Thus income is increasing twice of the increase in investment
which shows value of multiplier is two.

32. Explain how the multiplier is related with MPS and MPC.
Ans: - Relationship between multiplier and MPS
1
Since, K = so the value of multiplier varies inversely with the value of MPS.
MPS

Higher the value of MPS, the smaller will be the value of multiplier and lower
the value of MPS; the larger will be the value of multiplier.
Relationship between multiplier and MPC
1
Since, K = so the value of multiplier varies directly with the value of
1−MPC
MPC. Higher the value of MPC, the larger will be the value of multiplier and
lower the value of MPC, the smaller will be the value of multiplier.

33. Explain the meaning of inflationary gap with the help of diagram and
also write measures to correct it.
Ans: - Inflationary Gap- The excess of actual aggregate demand over
aggregate supply at full employment equilibrium point is called inflationary gap.
When AD > AS this lead to price rise or inflation so it’s called inflationary gap.
We can show it with the help of diagram as follows.

In diagram EF shows inflationary gap.

Impact on the Economy- As aggregate demand is greater than aggregate supply;
producers want to produce more output. But output cannot increase as there is non-
availability of resources due to full employment.
Income - Real income cannot increases because real output can’t increase
only money income will increase.
Price - Price will increase. It will lead to an increase in monetary
income. Measures to correct inflationary gap-
• Reduction in government expenditure -
• Increase in taxes
• Reduction in availability of credit - By increase in bank rate, increase in CRR &
SLR, sale of securities by central bank, increase in margin requirement etc.

34. Explain the meaning of deflationary gap (deficient demand) in an

economy with the help of diagram and also write measures to correct it.
Ans:- Deflationary Gap- The extent to which actual aggregate demand fall short to
aggregate supply, at full employment equilibrium point is called deflationary gap.
When AD < AS this lead to fall in price regularly or deflation so it’s
called deflationary gap.

In diagram EF shows deflationary gap.

Impacts on the Economy: - As AD < AS, producers wish to produce less. The
level of output and income will reduce.
Impacts on output - Output will reduce.
Employment - Level of employment will decrease.
Price - Price will fall
Measures to correct deflationary gap-
• Increase in government expenditure
• Decrease in taxes
• Increase in availability of credit - by decrease in bank rate, decrease in CRR &
SLR, purchase of securities by central bank, decrease in margin requirement etc.
35. Define a government budget. State any four of its main objectives.
Ans: - Government Budget - It is an annual financial statement of estimated
receipts and expenditure of the government for coming financial year.
Objectives of a Government Budget -
(i) Reallocation of resources - The Government has to reallocate resources from less
priority areas to more priority areas, to achieve its social and economic objectives.
(ii) Reduction of inequalities - Through the budget government can adopt
progressive taxation policy and spend more on requirement of the poor to reduce the
inequalities of income and wealth.
(iii) Economic growth- To promote rapid and balanced economic growth so as to
improve living standard of the people.
(iv) Economic stability- The Government tries to prevent business fluctuations and
maintain economic stability to maintain price stability and correct business cycles.
(v) Reduction of poverty and unemployment- To eradicate (reduce) mass
poverty and unemployment by creating employment opportunities and providing
maximum social benefits to the poor.
(vi) Management of public enterprises - Government undertakes commercial
activities that are of the nature of natural Monopolies, heavy manufacturing etc.,
through its public enterprises.

36.What do you mean by revenue receipts? Why is tax, profits of public sector
undertakings, corporation tax, fee of Government College, grant and aid
treated as revenue receipts?
Ans: - Revenue receipt is a receipt which neither reduces an asset nor creates any
liability.
Tax neither reduces assets nor creates a liability for the government. So treated
as a revenue receipt.
Corporation tax neither reduces assets nor creates any liability for the government.
So treated as a revenue receipt.
Fee of Government College neither reduces assets nor creates any liability for the
government. So treated as a revenue receipt.
Grant and aid neither reduces assets nor creates any liability for the government.
So treated as a revenue receipt.
Profits of public sector undertakings neither reduce assets nor create any
liability for the government. So treated as a revenue receipt.
37. Define tax. What is direct and indirect taxes give some examples of each.
Ans: - Tax – Tax is a legally compulsory payment imposed by the government.
Direct tax- A tax in which liability to pay tax and actual burden of the tax falls on
the same person. The burden of these taxes cannot be shifted to other person. These
taxes can be made progressive easily. Examples- income tax, corporation tax,
wealth tax, gift tax etc.
Indirect tax- A tax in which liability to pay tax is of one person but actual burden of
the tax falls on the some other person. The burden of these taxes can be shifted to some
other person. These taxes cannot be made progressive easily. These can be made
progressive by imposing more taxes on luxury items which are mainly used by the high
income group people. Examples- sales tax, excise duty, service tax, VAT etc.

38. What do you mean by capital receipts? Why are borrowings, recovery of
loans and disinvestment treated as capital receipts?
Ans: - Capital receipt is a receipt which either reduces an asset or creates
any liability.
Borrowings treated as capital receipts because borrowings create a liability.
Recovery of loans treated as capital receipts because recovery of loans reduces an
asset.
Disinvestment treated as capital receipts because disinvestment reduces an asset.

39. What do you mean by revenue expenditure? Why is payment of interest

and subsidies revenue expenditure?
Ans: - Revenue expenditure is an expenditure which neither creates an asset nor
reduces any liability.
Payment of interest neither creates an asset nor reduces any liability. So treated as
revenue expenditure.
Subsidies neither create an asset nor reduce any liability. So treated as revenue
expenditure.
40. What do you mean by Capital expenditure? Why is repayment of loan,
purchase of railway coach from Japan, construction of a bridge and purchase
of share in a company a capital expenditure?
Ans: - Capital expenditure is an expenditure which either creates an asset
or reduces any liability
Repayment of loan reduces the liability of government. So treated as
capital expenditure.
Purchase of railway coach from Japan creates an asset. So treated as capital
expenditure.
Construction of a bridge creates an asset. So treated as capital
expenditure. Purchase of share in a company creates an asset. So treated
as capital expenditure.
41. What is the basis of classify government expenditure into revenue
expenditure and capital expenditure? Give an example of each.
Ans: - There are two basis of classifying the expenditure-
i) Creation of an asset
ii) Reduction of any liability.
Any expenditure that neither creates an asset nor reduces any liability is called
revenue expenditure. Example- Payment of salaries, subsidies, interest payment
etc. Any expenditure that either creates an asset or reduces any liability is called
capital expenditure. Example- Construction of factory, repayment of loan,
purchase of share etc

42. What are the various types of deficits in government budget? Also
write their implications.
Ans: - There are 3 types of deficits: -
Revenue Deficit- The excess of government revenue expenditure over
revenue receipts is called revenue deficit.
Revenue Deficit = Revenue Expenditure - Revenue Receipts

Implications
• It implies dissavings of government.
• It indicates the inability of the government to meet its regular and
recurring expenditure.
• A high revenue deficit gives a warning signal to the government to either
curtail its expenditure or increase its revenue.
• Revenue deficit is financed through capital receipts like borrowings and used to
meet the consumption expenditure of the government. It leads to inflationary
pressure in the economy.
Fiscal Deficit- The excess of total expenditure of the government over its
total receipts excluding borrowing is called fiscal deficit.

Fiscal Deficit = Total Expenditure - Total Receipts excluding borrowing

Implications-
• It indicates total borrowing requirements of the government. Borrowing create
problem of not only payment of interest but also repayment of loans.If it
continuously increases it means government takes more loans to repay the
previous loans. As a result country is caught in debt trap.
• If government borrows from central bank, central bank issue new currency notes. It
increases money supply and generates inflationary pressure in the economy.
• When government borrows from rest of the world, it raises the country’s
dependence on other countries.
Primary Deficit- the excess of fiscal deficit over interest payments is
called primary deficit.

Primary Deficit = Fiscal Deficit - Interest Payments

Implications:
• It indicates how much of the government borrowing are going to meet
expenses other than interest payments.
• If it is zero, it indicates that government is only borrowing to repay the interest of
previous loans.

43. Distinguish between Balance of Trade and Balance of Payments.

Ans :- Difference Balance of Trade and Balance of Payments
Sl. Balance of Trade (BOT) Balance of Payments (BOP)
No.
i Balance of trade is the difference BOP is a systematic record of all the
between the money value of exports economic transactions of residents of a
and imports of goods country with rest of world during a
during a given period of time. given period of time.
ii It includes only visible items. It includes both visible and invisible
items.
iii It’s a narrow concept as it is a part It’s a wider concept as it includes
of balance of payment. balance of trade in it.
iv It can be favourable, un- favourable It is always balanced.
or balance.
v It is not a true indicator of It represents a better picture of a
economic condition of a country. country’s economic condition than the
balance of trade.
44. What is meant by visible and invisible items in the Balance of
payments account? Give some examples of each.
Ans: - Visible items refer to items relating to trade of material goods with
other countries.
Examples - tea, clothes, machinery etc.

Invisible items refer to items relating to trade of services with other countries and
unilateral transfers.
Examples- Transport services, Insurance and banking services etc.
45. Differentiate between Current Account and Capital Account of BOP.
Ans:- Difference between current account and capital account of BOP-
Sl.
No. Current Account Capital Account
i It is the account which records It records capital transactions such as
exports and imports of goods, loan and investment between a country
services and unilateral transfers. and rest of the world.
ii Items of current account do not cause Items of capital account cause change in
change in the assets and liability the assets and liability status of the
status of the residents of a country & residents of a country & its government.
its government.
iii The main components of current The main components of capital
account are export and import of account are private capital transaction,
goods, services and unilateral official capital transaction and baking
transfers. capital transaction etc.

46. Differentiate b/w autonomous and accommodating items of

BOP. Ans:- Autonomous and Accommodating items of BOP

Sl. Autonomous items Accommodating items

No.
i These refer to those international These refer to those transactions that
economic transactions that take place occur due to other activities of BOP.
due to some economic motive such as
profit maximisation.
ii These items are independent of the These items are meant to maintain
state of BOP account. the balance in BOP account.
iii These transactions occur in both These transactions occur only in
current account and capital account. capital account.
 iv These items are also called above the These items are also called below
line items because they are recorded as the line items because they are
first items before calculating surplus or recorded after calculating surplus or
deficit in BOP. deficit in BOP.

47. What is meant by foreign exchange rate? How it can be determined in a

free market? Explain.
Ans: - Foreign Exchange Rate – It is a rate at which the currency of one country
is exchanged with the currency of other country e.g., $1 = ₹48 or one Indian rupee
1/48 th $.
Determination of the FER – The rate is determined in the foreign exchange market
by the interaction of the demand for and supply of foreign exchange.

Demand for Foreign exchange comes from - Domestic residents purchase goods
and services from other countries (imports), for sending gifts to foreigners, by the
domestic residents to purchase financial assets in other country, speculative purpose
and tourists going abroad etc. There is inverse relationship between foreign
exchange rate and demand for foreign exchange. So demand curve for foreign
exchange is downward sloping.

Supply of Foreign exchange comes from - The foreigner’s purchasing goods and
services (exports), the foreigners who invest in home country through joint ventures,
remittances from abroad, foreign tourists come to visit a country. There is direct
relationship between foreign exchange rate and supply of foreign exchange. So
supply curve of foreign exchange is upward sloping.
Y
Df
Sf In diagram, Df Df is demand and Sf Sf
FER
is supply curve of foreign exchange
E
R .They are equal at point E, so E is
equilibrium point. At this point OR is
Sf Df
determined as equilibrium foreign
X exchange rate.
O M
Foreign Exchange

48. When exchange rate of foreign currency rise its supply rises? Explain.
Ans: - A rise in foreign exchange rate makes home country’s goods cheaper to
foreigners so they will purchase more goods and services, as a result demand for
country’s goods increases in foreign market which leads to increase in country’s
exports. At the same time foreigners who want to invest in home country will invest
more, more foreign tourists will come to visit home country. This brings a greater
supply of foreign exchange. Hence supply of foreign currency rises.

49. Explain the following terms.

a) Foreign Exchange Market
b) Spot Market
c) Forward Market
d) Managed Floating
e) Dirty floating
f) Deficit of balance of payment
g) Devaluation of a currency
h) Depreciation of a currency
Ans: -
a) Foreign Exchange Market: The foreign exchange market is the market
where the national currencies of various countries are converted, exchanged
or traded for one another.
b) Spot Market: The exchange rate that prevails in the spot market for foreign
exchange is called Spot Rate.
c) Forward Market: A market in which foreign exchange is bought and sold for
future delivery is known as forward market. Exchange rate that prevails in a
forward contract for purchase or sale.
d) Managed Floating: This is the combination of fixed and flexible exchange
rate. Under this, country manipulates the exchange rate to adjust the deficit
in the balance of payment by following certain guidelines issued by I.M.F.
e) Dirty floating: If the countries manipulate the exchange rate without
following the guidelines issued is called dirty floating:
f) Deficit in BOP- If in current account of balance of payment (BOP),
autonomous receipts are less than autonomous payments, then balance of
payment (BOP) is said to be in deficit. It reflects disequilibrium in BOP.
g) Devaluation of a currency means reduction in the external value of a
country’s currency as a conscious policy measure adopted by the Government
of a country. In other words, we make our currency cheaper in terms of
foreign currency. This makes our goods cheaper to foreign buyers and foreign
goods costlier to our buyers. Hence exports increase, imports fall and the gap
in trade balance becomes smaller. When a country suffers from continued
deficit in its balance of payments, it may resort to devaluation of its currency
with a view to encouraging exports and restricting imports and thus narrowing
down or covering its trade gap and balance of payments deficit. It takes place
in Fixed Exchange Rate System.
h) Depreciation of a currency means fall in value of domestic currency in
terms of foreign currency. Example: if value of rupee in terms of US dollars
falls, say from Rs. 45 to Rs. 50 per dollar, it will be a case of depreciation of
 Indian rupee because more rupees are required now to buy one US dollar.
It occurs in Flexible Exchange Rate System

50. Differentiate between fixed exchange rate and flexible exchange rate
system.
Ans: - Difference between fixed exchange rate and flexible exchange rate system
Sl.
Fixed Exchange Rate System Flexible Exchange Rate System
No.
i The system in which exchange rate is The system in which exchange rates are
officially declared by government or determined by the demand and supply
central bank of a country and only a forces of foreign exchange in the market
very small deviation from this fixed is called Flexible Exchange Rate
value is possible is called Fixed System.
Exchange Rate System.
ii Advantages (Merits) Advantages (Merits)
1- It ensures stability, in the exchange 1- This system does not require huge
rate which encourages international reserves of gold and international
trade. currencies.
2- It prevents speculations in foreign 2- This system does not require the huge
exchange market. back-up of international reserves so
3- It helps co-ordination of encourage the movement of capital
macroeconomics policies across across different parts of the world.
different countries of the world. 3- Deficit and surplus in BOP is
4- It implies low risk and low automatically corrected.
uncertainty of future payments so.
iii Disadvantages (Demerits) Disadvantages (Demerits)
1-This system requires huge reserves 1- It encourages speculation leading to
of gold and international currencies. fluctuations in exchange rate.
2-In this system the benefits of free 2- It discourages investment and
markets are deprived. international trade.