THUMBNAIL

NATIONAL INCOME
 There are four sectors in an economy:

(i) Household sector (Consumers)

(ii) Firms (Producers)
(iii) Govt. sector (Government)
(iv) External sector (Rest of the world or abroad)
 Circular flow of income in Two sector Economy
Circular flow of income: It refers to circular
flow of income in the production process.
Income is generated by household from
firms and also they spend their income in
form of consumption expenditure to firms.
 Nature of controlling
Phases of circular flow of income

Generation Phase

Distribution Phase

Disposition Phase
 REAL FLOW VS. MONEY FLOW

(i) Real flow: Real flow refers to flow of factor services from
household to firms and flow of goods services from firms to
Real flow household.
• It measures the production volume.
• It also determines the growth process in economy.
• It is also called physical flow.

(ii) Money flow : Money flow refers to flow of money from firms to
households and household to firms, like flow of factor payments
Money flow from firms to household and flow of consumption expenditure
from household to firms.
• It measures the flow of money supply in the economy.
• It is also called nominal flow
 Difference between Stock & Flow
Basis Stock Flow
1. Meaning It refers to that variable which is It refers to that variable which is measured at a
measured at a particular point of particular period of time.
time.
2. Time Stock is not time dimensional as it Flow is time dimensional as measured only for a
Dimension is measured at a particular point of particular period of time.
time.
3. Nature It is a static concept. It is a dynamic concept.
4.Examples eg. wealth, distance of Delhi to e.g. pocket allowances, speed of a car travelling
noida, stock of water in a tank, Delhi to Noida, flow of water from tank,
bank deposits, capital, population demand, supply, consumption exp., savings,
on a particular date etc. profit or loss, national income, production, GDP,
Investment etc
 Types of Goods in the Economy

Final goods

Intermediate Goods

Consumption/Consumer Goods

Capital Goods
 FINAL GOODS
These are those goods. Which is finally produced and ready for
use by their final users. Final users may be (i) consumer and (ii) producers.
(i) Consumers are the final user of clothes, shoes, food, etc.
(ii) Producers are the final user of plant and machinery.
# Expenditure on final consumer goods by the household is called
Final consumption expenditure
# Expenditure on final goods by the producer is called Investment
expenditure

Expenditure on final goods = Consumption Expenditure + Investment Expenditure

 INTERMEDIATE GOODS

These are those goods which is not yet ready for use by
their final user. These goods are purchased by one firm from the other.
eg. Wood purchased by a carpenter for making chairs is an intermediate good.
Because it is a raw material for carpenter.
Shirt purchased by firm A from firm B for resale.
Note: Value of intermediate goods ultimately (Already) included in the value
of final goods.
Hence these goods are not included in National income.
Same Goods may be Final Goods and Intermediate goods
 CONSUMER GOODS
Consumption/Consumer Goods: These are those goods which are directly
used for the satisfaction of human wants. These are not used for the production
of other goods and services. Final user of consumption goods are (i) Consumer
or household. (ii) Government (iii) NGO (Non-Govt. Organisation).
These goods are also divided into
DURABLE GOODS
SEMI DURABLE GOODS
NON DURABLE GOODS
SERVICES
 CAPITAL GOODS

Capital goods are those goods which are used in the process
of production for several years and which are of high value. These goods are
fixed assets of the producers. E.g. Plant and Machinery.
But all machines are not capital goods.
Note: All capital goods are producer goods. But all producer goods are not capital goods
 Difference between final goods & Intermediate goods

Basis Final Goods Intermediate Goods

1.Meaning These are those goods which are ready These are those goods which are not ready to
to use by their final user. use by their final user.
2. Purpose Purpose of these goods are for These are used in the process of production as a
consumption and investment. raw material and for resale purpose
3. Nature These are included both domestic and These are not included in both domestic and
national income. national income.
4. Value There is no value addition in final goods Some value has to be added in intermediate
addition as they are ready for use. goods as they are not ready for use.
5. Production They have crossed the production They are still with in the production boundary.
boundary boundary.
6. Example Milk purchase by household for Milk purchased by a biscuit company is a raw
consumption, machinery purchased as material, milk purchased by a dairy shop is for
an investment. resale.
Q.1) Giving reasons classify the following into intermediate products and final products:

(i) Furniture purchased by a school.

(ii) Chalks, duster, etc. purchased by a school.
(iii) Computers installed in an office.
(iv) Mobile sets purchased by a mobile dealer.
(v) Paper purchased by a publisher.
(vi) Printer purchased by a lawyer.
(vii) Coal used by household.
(viii) Unsold coal at the Trader at year end
(ix) Seeds purchased by a farmer.
(x) Electricity consumption in a business.
(xi) Sewing machine purchased by a housewife.
(xii) Soft drink purchased by School Canteen.
(xiii) Coal used by manufacturing firms.
(xiv) Fertilizers used by a farmers.
(xv) Refrigerator installed by a firm
METHODS OF ESTIMATION OF NATIONAL INCOME
 Precautions regarding production method
(i) Value of the sale and purchase of second-hand goods is not included in value added because, value of
these goods is already accounted for during the year they were first time produced.
(ii) Commission earned on account of the sale and purchase of second-hand goods is included in the
estimation of value added. Because, commission is a factor payment for service rendered this is a new
service.
(iii) Own account production of goods of the producing units is taken into account while estimating value
added. Because these goods are like those produced for the market. They are simply not sold owing to
their need by the producers themselves. If we do not include, this cause under estimation of national
income.
(iv) Value of intermediate goods is not included in the estimation of value added. Because, value of
intermediate goods is reflected in the value of final goods. If we include this cause overestimation of
national income.
(v) Change in stock (increase in stock) will be included because it is a part of capital formation.
(vi) Services for self-consumption is not considered while estimating value added. Simply because, it is
difficult to estimate their market value, like services of housewives.
 Problem of Double Counting
Problem of double counting is the problem of estimating the value of goods and services more than once. In
production method we take the value of final goods and services only if we mistakenly taken the value of
intermediate goods this leads to double counting or overestimation of national income because value of
intermediate goods is already included in value of final goods.
e.g. A farmer produces one ton of wheat and sells if for ₹400 in the market to a flour mill. As the farmer is
concerned the sale is final sale. The flour mill have wheat as an intermediate goods he converts it into flour and
sells it for ₹600 to a Baker. The flour mill treats the sale is final sale but the Baker uses it as an intermediate
good and manufacture bread. The Baker sells the bread to shopkeeper for ₹800. For the Baker it is a final sale.
But for the shopkeeper it is an intermediate good. The shopkeeper sells the entire stock of bread to consumer
₹900. So, you may take the value of output = 400 + 600 + 800 + 900 = ₹2700 (but this is wrong estimation
because all intermediates are included) i.e. double counting occurs.
So, to avoid the problem of double counting
(i) Take value added instead of total output.
(ii) Take the value of final products only
 Precautions Regarding Income Method

1. Transfer earnings like old age pensions, unemployment allowances, scholarship, pocket money etc.
should not be included in national income, because corresponding to transfer payment there is no value
addition in the economy. Similarly, indirect taxes are not included.
2. Income from illegal activities like smuggling, theft, gambling etc. should not be included in national
income. Black money is not to be counted in national income. Lottery also not included because it is a
windfall gain. There is no productive activity connected with them.
3. Income from sale of second hand goods not included but commissions received on the sale of
secondhand goods are to be included in national income because these are new factor income for
rendering factor services.
4. Do not include income arising from the sale of financial assets. These are share, bonds, debentures, govt.
Securities, etc. Buying and selling of these are not an activity related to production of goods and services.
(However any Commission or brokerage charged by the intermediaries is a payment for the services
rendered by them and is a factor income).
5. Imputed rent of owner occupied houses is to be treated along with rent as a component of factor
incomes. Corresponding to production for self-consumption must be included
 Precautions Regarding Expenditure Method
1. Do not include expenditure on intermediate goods and services: Intermediate expenditure is already a
part of final expenditure. So, including intermediate expenditure will mean double counting of
expenditure.
2. Include imputed expenditure on self-consumed or own account produced: Output used for consumption
and investment. eg. self consumed output by farmers, self consumed services of owner-occupied houses
are included.
3. Do not include expenditure on transfer payments: A transfer payment is one against which no goods or
services is provided is return. eg. gift, donations, charity, scholarship, old age pension, unemployment
allowances etc.
4. Do not include expenditure on financial assets: It means expenditure on buying shares, debentures,
bonds, govt. securities etc. But if any brokerage or services charge is paid in buying financial assets it is
treated as expenditure on buying services. Hence brokerage, commission are included.
5. Do not include expenditure on second hand goods: Expenditure on these goods was accounted when they
were purchased new. Including expenditure on second hand goods would mean counting of the same
expenditure twice. No fresh production takes place in such a case. However, if any commission or
brokerage is paid to an intermediary in such transaction it should be treated as final expenditure because
it is a fresh payment for the services purchased.
National income: It is the sum total of income of only the normal residents of a country

Domestic territory (Economic territory) of a country refers to that area of economic activity which
generates domestic income.
 Domestic Territory does include:

Ships and aircrafts

Fishing vessels and oil rigs

Embassies
 Domestic Territory does not include:
1. Embassies and military establishments of a foreign country in India. e.g. Chinese embassy in India is a part
of domestic territory of China.
2. International Organizations like UNO, WHO, WTO, etc. located within the geographical boundaries of a
country
GDP and Welfare
 But there are some exception of GDP welfare:
1. Distribution of GDP
2. Composition of GDP
3. Barter system exchange
4. Externalities
 Difference between Real GDP & Nominal GDP
Real GDP Nominal GDP
When GDP is measured at the base or constant When GDP is measured at the current year prices
year prices it is called Real GDP. it is called Nominal GDP.
Real GDP is the inflation-adjusted GDP of a Nominal GDP is the Gross Domestic Product
country. without any effect of inflation.
It is true indicator of economic growth and It is not a true indicator of economic growth and
welfare. welfare

Real GDP is better than Nominal GDP

 GDP DEFLATOR/ PRICE INDEX

GDP deflator measures the change in the average level of prices of all the
goods and services that make up GDP.
GDP deflator is used to eliminate the effect of price changes and to
determine the real change in physical output.

Real and Nominal GDP Formula

Price index or GDP Deflator = ( Nominal GDP/ Real GDP ) x 100
Components of NFIA:
(i) Net compensation to employees.
(ii) Net income from property and entrepreneurship: likes rental income,
interest income and profits.
(iii) Net retained earnings: Part of profit after tax and dividend.
 Difference between Depreciation and Capital Loss

Basis Depreciation Capital Loss

1. Meaning It refers to fall in the value of fixed It refers to loss in value of the fixed
assets due to normal wear and tear, assets due to unforeseen
passage of time or expected obsolescence, natural calamities,
obsolescence thefts, accidents, etc.
2. Provision for loss Provision is made for replacement of No such provisions is made in case of
assets as it is an expected loss. capital loss as it is an unexpected loss.
3. Production It does not hamper the production It hampers the production process.
process process.
ALL FORMULAE REVISION
ALL NUMERICALS
Q.1) Calculate Net value added at factor cost from following data:

Particulars Amount in crores

Purchase of machinery to be used in the production unit 100
Sales 200
Intermediate costs 90
Indirect taxes 12

Change in stock/ Inventory Investment 10

Goods and service tax 6
Stock of raw material 5
Q.2) Calculate Sales from the following data:

Particulars Amount
Subsidies 400
Opening stock 100
Closing stock 600
Intermediate cost 3,200
Consumption of fixed capital 700
Profit 750
Net value added at factor cost 4,000
Q.3) Calculate the Operating Surplus

Particulars Amount
Sales 4,000
Compensation of employees 800
Intermediate consumption 600
Rent 400
Interest 300
Net indirect taxes 500
Consumption of fixed capital 200
Mixed income 400
Q.4) Calculate Gross Domestic Product of Factor Cost from the following data

Particulars Amount
Private final consumption expenditure 800
Net domestic capital formation 150
Change in stock 30
Net factor income from abroad -20
Net indirect tax 120
Government final consumption expenditure 450
Net exports -30
Consumption of fixed capital 50
Q.5) Calculate Gross fixed Capital Formation from the following data

Particulars Amount
Private final consumption expenditure 1,000
Government final consumption expenditure 500
Net exports -50
Net factor income from abroad 20
Gross domestic product at market price 2,500
Opening stock 300
Closing stock 200
Q.6) Calculate GNP at MP by income Method and Expenditure Method
Particulars Amount in crores
Net exports 15
Private final consumption expenditure 600
Consumption of fixed capital 30
Operating surplus 190

Net indirect taxes 105

Net factor income from abroad -5
Wages and salaries 520
Rent 60
Employers’ contribution to social security schemes 100
Government final consumption expenditure 200
Net capital formation 100
Q.7) Calculate Gross domestic product at factor cost and factor income to abroad
Particulars Amount in crores
Compensation of employees 800
Profits 200
Dividend 50
Gross national product at market price 1400
Rent 150
Interest 100
Gross domestic capital formation 300
Net fixed capital formation 200
Change in stock 50
Factor income from abroad 60
Net indirect tax 120
Q.8) On the basis of the following hypothetical data:
(all figures in ₹ crore)
Year Nominal GDP Nominal GDP adjusted to base year prices
2020 3,000 4,000
2023 4,000 4,500
Calculate the percentage change in Real Gross Domestic Product in the year 2023 using 2020 as the base
year.
MONEY & BANKING
MONEY
BARTER SYSTEM
 Money act as a Medium of exchange.
i.e. Money is commonly accepted as a medium of exchange
 Functions of money

Primary Secondary

Medium of Standard of
Exchange Deferred Payment

Common measure
of value Store of Value
Primary functions:- Primary function include the most important function of money which it must perform in every
country these are:

i) Medium of exchange:- Money as a medium of exchange means that it can be used to make payments for all
transaction of goods and services. It is the most essential function of money. Money has the quality of general
acceptability. So all exchange take place in term of money.

ii) Measure of value (Common unit of value) :- Money as a measure of value means that money works as a
common denomination in which values of all goods and service are expressed.

Secondary functions:- These refer to functions of money which are supplementary to the primary functions these
function are derived from primary functions and therefore they are also known as Derivative functions

i) Standard of Deferred payments:- Money as a standard of deferred payments means that money act as a
standard for payments which are to be made in future. Every day millions of transaction take place in which
payments are not made immediately. Money encourage such transactions and helps in capital formation and
economic development of the economy.
ii) Store of value (Assets function of money) :- Money as a store value means that money can be used to transfer
purchasing power from present to future. It provides security to individuals to meet contingencies,
unpredictable emergencies and to pay future debts. Under barter system it was difficult to use goods as a store
of wealth due to perishable nature of some goods and high cost of storage.
 MONEY SUPPLY
Supply of money is a stock concept.
Money supply does not include
(i) Stock of money held by the government
(ii) Stock of money held by the Banking System of a country.
They are considered suppliers of money. Money supply includes
(i) Individuals
(ii) Business firms
 Components or measurement money supply

M1 = CC + DD + OD with RBI
It does not include
(a) deposits of the Indian government of the country with RBI.
(b) deposits of the Commercial Bank of India with RBI.
M1 is also known as Transaction money
It is Most Liquid.
M1 = CC + DD + OD with RBI
Note: (i) CC : Currency in cash i.e. Paper notes & coins.
(ii) DD : Demand deposits i.e. deposits of public with Commercial Banks which can be withdrawn by issuing
a cheque. It must be noted that here we only include net demand deposits. It means inter bank deposits
are excluded. Interbank deposits are those deposits held by one bank of behalf of other bank.

(iii) OD: Other deposits with RBI. It includes:

(a) Deposits held by RBI on behalf of Foreign Banks and Foreign government.
(b) Demand deposits of international financial institutions like international monetary fund (IMF) and
World Bank.
(c) Demand deposit of financial institutions like NABARD (National Bank for Agriculture and Rural
Development)
NABARD established on 12 July 1982
 BANKING
A bank is an organization which keeps money safely for its customers; You can take money out, save,
borrow or exchange money at a bank

BANKS ARE OF TWO TYPES

1.) COMMERCIAL BANK
2.) CENTRAL BANK
 Meaning of Commercial Bank
A commercial bank is a kind of financial institution that carries all the operations related to deposit
and withdrawal of money for the general public, providing loans for Consumption, investment, and
other such activities.
These banks are profit-making institutions and do business only to make a profit.
E.g. HDFC Bank. , SBI, ICICI etc.
LRR: Legal Reserve Ratios
 Credit Creation by Commercial Bank
Commercial bank is an important source of money supply in the economy, which contribute to money supply
by creating credit in terms of demand deposit. Suppose a new deposit of ₹1000 is made by a depositor into
bank and Bank Legal Reserve Ratio is 10%
Bank will keep legal Reserve Ratio of ₹100 (10% of ₹1000) and lend the balance money of ₹900 to the
borrower by crediting as chequeable deposits (I round of credit creation).
The borrower will use the amount to pay its creditors which ultimately will be deposited in another bank and
bank keeps ₹90 (10% of ₹900) as legal Reserve Ratio and lends the balance ₹810 to borrower. (II Round of
Credit Creation). This process will continue till amount become zero and make the money 10 times the initial
deposits i.e. ₹10,000.

Deposit multiplier (or) Money multiplier Credit Creation Deposits Loans LRR
= 1/LRR = 1/10 % = 10 times
Initial Deposit 1000 900 100
As seen in the table, banks are able to
create total deposits of ₹10,000 with the Round I 900 810 90
nitial deposits of just ₹1000. It means total
deposits become 10 times of the initial Round II 810 729 81
deposit. This 10 times is value of
Money Multiplier. All Other Round -- -- --

Total 10000 9000 1000

 Central bank

It is an apex bank that controls the entire banking system of a country.

It is the sole agency of note issuing in a country. In India it is Reserve Bank, in England; Bank of
England, in America; Federal Reserve System.
RBI was established in April 1, 1935 under RBI Act passed in 1934
 Functions of central Bank

Issuing Authority of Currency Notes

Banker of the Government

“Bankers Bank” & “Supervisory Bank”

Lender of the Last Resort

Custodian of Foreign Exchange Reserve

Clearing house function

Control of Credit
(i) Issuing Authority of Currency Notes: Central Bank of a country has the exclusive right of issuing notes. In
20th century, the Central Bank was known as Bank of Issue. Central Bank is the sole agency of issuing
currency notes which is legal tender. However one rupee coin and notes are issued by Ministry of Finance.

(ii) Banker of the Government: Central Bank is a banker, agent and financial advisor to the government As a
banker to the government it manages accounts of the government As an agent to the government, it buys
and sells securities on the behalf of the government It helps the government in framing policies to regulate
the Money Market. As a financial advisor, the Central Bank advises the government from time to time on
economic financial and monetary matters. RBI also offers loans to the government against some securities.
In situation of deficit government budget, the government often seeks loans from the Central Bank. This is
called Deficit financing

(iii) “Bankers Bank” & “Supervisory Bank”: The Central Bank the banker’s bank and also plays a supervisory
role. As a Banker’s Bank, it has almost the same relation with other banks in the country as a Commercial
banks has with it’s customers. It accepts deposits from the Commercial Banks and offered them loans. The
rate at which Central Bank offers loans to the Commercial Bank is called ‘Repo rate’. The rate at which
commercial banks are allowed to park their surplus fund with RBI is called “Reverse Repo Rate”. As a
Supervisor, Central Bank Regulate and Controls the Commercial Banks. RBI continuously exercised
inspection on Commercial Banks. RBI gives license to Commercial Banks. Central Bank ensure that
Commercial Banks maintains Cash Reserve Ratio & Statutory Liquidity Ratio in proper way. Otherwise RBI
charge interest and penalty
(iv) Lender of the Last Resort: As we know, commercial bank create liabilities (demand deposits) many times
more than their cash reserves. However, there may be occasions when a bank suffers crises of finance. In
such a situation the Central Bank acts as a lender of last resort. Central Bank helps Commercial Banks in
critical situation.

(v) Custodian of Foreign Exchange Reserve: Central Bank is the custodian of nation’s foreign exchange
reserve. The Central Bank not only maintain foreign exchange reserve but also exercises managed floating
to ensure stability of exchange rate in the international money market. Managed floating refers to the sales
and purchase of foreign exchange with a view to achieving stability of exchange rate for the domestic
currency.

(vi) Clearing house function: Central Bank acts as a clearing house for transfer and settlement of mutual
claims of Commercial Banks. Since the Central Bank hold reserves of Commercial Banks. It transfer funds
from one Bank to other banks to facilitate clearing of cheques.

(vii) Control of Credit: The most important function of the Central Bank is to control supply of money in the
economy. It implies increase or decrease in the supply of money by regulating the ‘Creating of Credit’ by
the Commercial Banks. The Central Bank needs to control the supply of money to cope with the situation of
inflation and deflation. During inflation, supply of money is restricted and during deflation, supply of money
is liberalised
Credit Control By Central Bank/ RBI
MONETARY POLICY
 B. Monetary Policy by RBI
1. Quantitative Measures.
2. Qualitative Measures

INSTRUMEMTS OF QUANTITATIVE & QUALITATIVE MEASURES

Quantitative Measures Instruments Qualitative Measures Instruments

Banks Rate and Repo Rate Marginal Requirement
CRR + SLR = LRR
Open market operations.
Reverse Repo Rate
DETERMINATION OF INCOME &
EMPLOYMENT (AD-AS)
MEANING
COMPONENTS OF AD
 Components of Aggregate Demand (AD)
1. Private Final Consumption Expenditure (C)
It is also called household expenditure.
It depends on the level of disposable income of household.
Higher the level of Disposable income, higher will be private final consumption expenditure and vice versa.
2. Private Investment Expenditure (I)
It refers to expenditure by private investors on the purchase of such goods which add to their stock of capital i.e.
investment
 Two Types of investment
(ii) Autonomous investment: It refers to the investment,
(i) Induced investment: It refers to the which is made irrespective of level of income. It is
investment, which is made with the motive generally done by government with the motive of social
of earning profit. It is generally done in welfare. Autonomous investment curve remains parallel
private sector. It depends upon level of to X-axis. It is constant irrespective the level of income
income Induced investment curve moves
upwards from left to right Marginal efficiency of investment (MEI): It refers to the
expected rate of return on additional investment.
 G: Government Expenditure

3. Government final consumption expenditure (G):

It refers to the expenditure incurred by government on consumer goods
to meet public needs like law and order, education, health, transport,
defense, etc.

4. Government investment expenditure (G):

It refers to the expenditure incurred by the government on Capital
goods. These expenditure are need to develop the economy. Like
construction of highways, roads, hospital building, school, power plant,
etc.
5. Net Export (X – M) : Expenditure by the foreigners on our goods is added to total expenditure (AD) while
expenditure on imports is subtracted.
So difference between export and imports is considered as a component of Aggregate Demand.

So AD = C + I + G + (X – M)
But in two sector economy.
AD = C + I
C = Desired consumption, I = Desired Investment
 Schedule
Y C I AD= C + I
0 20 10 30 = 20 + 10
20 25 10 35 = 25 + 10
40 30 10 40 = 30 + 10
60 35 10 45 = 35 + 10
80 40 10 50 = 40 + 10
Important Points
(i) Consumption expenditure (c) can never be zero. At level of income there should be a minimum
consumption. It is essential even when income does not permit it. It is also called autonomous
consumption expenditure past savings and borrowings may be the source of such expenditure.
(ii) Investment is assumed to be constant irrespective the level of income. i.e. Autonomous investment.
(iii) Consumption can never be zero. Hence AD also can never be zero because AD is the sum of
consumption and investment.
MEANING
 AGGREGATE SUPPLY (AS)

(i) Consumption: It is the part of income which is spent on consumption (c).

(ii) Savings: It is the part of income which is not consumed i.e. saved. (S).
(iii) Initially saving is negative but after a stage it is positive.
AS= C + S (Y = C + S)
AS is 45-degree line
AS (Output) = Y (National income)

Y C S AS = C + S
100 70 30 100
200 140 60 200
300 200 100 300
 Why AS is 45 Degree line ?

Significance of 45° degree line (why AS is 45° line)

Aggregate supply refers to money value of final goods and services that all producers are willing to supply in
an economy during a fiscal year.
Before giving reason why AS is 45° line we must know that Y = C + S
Y = National income C = Consumption expenditure
S = Savings AS = C + S
Aggregate Supply is obtained by Adding Consumption and Savings
so, we can say AS=Y
Each point on AS line is equidistant from both axis AS line Bisect
the 90° angle.
X axis shows level of income &
Y axis shows consumption + Saving
Under Keynesian Economic Analysis
Y=C+S
Hence AS is 45° line
 Break even point
It is a point where income is equal to consumption.
savings are equal to Zero
 Equilibrium level of Output/ Income
I. AD-AS Approach:
In this approach, equilibrium level output (GDP) is
achieved when aggregate demand is equal to aggregate
supply. i.e. [AD = AS]
Schedule

Y C I AD S AS
100 150 50 200 -50 100
200 200 50 250 0 200
300 250 50 300 50 300
400 300 50 350 100 400
500 350 50 400 150 500
What happens if AD > AS ? What happens if AD < AS ?
• When AD is greater than AS, flow of goods and • When AS is more than AD, flow of goods
services in the economy tends to be less than and services in the economy tends to exceed
their demand. their demand.
• Producers need to produce more goods and • As a result, some of the goods would
services in the economy. remain unsold.
• To clear unwanted stock, the producer
• Whole existing stock sold out producers would
would plan a cut in production.
suffer the loss of unfulfilled demand.
Consequently, AS would reduce to become
equal to AD.
 II. S-I Approach:
In saving investment approach equilibrium level
of output (GDP) is achieved when planned
saving is equal to planned investment. i.e. [S = I]

Schedule
Y S I
0 -10 10
100 0 10
200 10 10
300 20 10

Point “e” is equilibrium point where

(S = I) at full employment level of income ₹200.
 What happens if S > I ? What happens if S < I ?
It implies that when planned savings (S) is greater It implies that planned savings (S) is less than
than the planned investments (I) is to the circular planned investments (I) into the circular flow of
flow of income. Accordingly, overall expenditure in income. Accordingly, overall expenditure in the
the economy would remain lower than what is economy would turn out to be greater than what is
require to buy the planned output. required to buy the planned output. Here the
Some output would remain unsold and producers producers would suffer the losses of unfulfilled
will have undesired stock. To clear their stocks, the demand. To manage the situation, the producer
producer would now plan lesser output. The process would now plan higher production.
would continue till S = I. The process would continue till S = I
A. Excess Demand
It refers to the situation when aggregate
demand (AD) is in excess of aggregate supply
(AS) corresponding to full employment level of
output in the economy.
AD > AS
Inflationary gap is
⇒ AD1 – AD
Causes of Excess Demand and Inflationary Gap
(i) increase in private final consumption expenditure.
(ii) increase in private investment expenditure.
(iii) increase in govt. final consumption expenditure.
(iv) increase in govt. investment expenditure.
(v) Increase in exports, owing to lower domestic prices in relation to international prices.
(vi) Decrease in imports, owing to higher international prices as compared to domestic prices.
(vii) A cut in tax rates leads to higher disposable income of people.
B. Deficient Demand
It refers to the situation when aggregate demand
(AD) is less than aggregate supply (AS)
corresponding to full employment in the economy.
AD < AS
Deflationary gap is
⇒ AD – AD1
 Causes of Deficient Demand and Deflationary Gap
(i) Decrease in private final consumption expenditure.
(ii) Decrease in private investment expenditure.
(iii) Decrease in government expenditure.
(iv) Decrease in exports and increase in imports.
(v) Increase in tax rate leads to decrease in disposable income of people.
 Full employment and involuntary unemployment

(i) Full employment: It refers to a situation when all those who are able to work and are willing to work
(at the existing wage rate) are getting work. It is a situation when, corresponding to a given wage
rate, demand for Labour force is equal to supply of Labour force and the Labour market is in
equilibrium. However, full employment does not mean that there is no unemployment in the
economy. Some people may voluntarily choose to remain unemployed they are not be willing to
work at all or not willing to work at the existing wage rate. This is a situation of voluntary
unemployment.
i.e. in full employment situation unemployment can be occurs like
(a) Structural unemployment: It refers to the situation of unemployment where poor people remains
unemployed due to modernization or structural changes in the economy like due to computerization
many unskilled peoples are unemployed.
(b) Frictional unemployment: When a person leave one job and find other job then the time period at which
he is unemployed for some days. That is called frictional unemployment.
(c) Voluntary unemployment occurs when some people are not Willig to work at all or are not willing to work
at an existing wage rate.
(d) Involuntary unemployment occurs when some people are not getting work, even when they are willing to
work at an existing wage rate. Here economy fails to create enough jobs because planned output is lower
than the potential output.
Measures to correct Excess demand & deficient demand
A. Fiscal measures (By the government)
B. Monetary policy (By RBI)
A. Fiscal Policy (Fiscal Measures) It refers to budgetary policy of the government to correct the situation of
excess demand and deficient demand.
Common instruments are
a) government spendings
b) Taxation policy
Components of Fiscal Policy (instruments)
(i) Government spending: It refers to the expenditure of govt. on public welfare works such as construction of
roads, dams, bridges, expenditure on education, defence, maintenance of laws, etc.
To correct situation of excess demand govt. reduces their all expenditures. So that less income generation in
the economy and consequently AD will be less as require to correct excess demand.
To correct situation of deficient demand govt. increases their all expenditure. So that more income
generation in the economy. And consequently AD will be more as required to correct deficient demand

(ii) Taxation policy: Taxes are a compulsory payment made to the

government under any law. By increasing tax burden on the
households and the producers govt. reduces the purchasing power
in the economy on the other hand by lowering the tax burden, the
government increases the purchasing power and excess demand
and deficit demand are corrected
 B. Monetary measures:
1. Quantitative Measures.
2. Qualitative Measures

1. Quantitative Measures Quantitative instruments are traditional tools related to the Quantity or
Volume of the money. These are also called general tools. It comprises of the following instruments

INSTRUMEMTS OF QUANTITATIVE MEASURES

Quantitative Measures Instruments Qualitative Measures Instruments
Banks Rate and Repo Rate Marginal Requirement
CRR + SLR = LRR
Open market operations.
Reverse Repo Rate
 PROPENSITY TO CONSUME & PROPENSITY TO SAVE

APC (Average Propensity to Consume) It is the part of income which is consumed. (or) It shows the
relationship between consumption and income.
APS (Average Propensity to Save): It is the part of income which is saved. It shows the relationship
between savings and income.
MPC (Marginal propensity to consume): It shows change in consumption due to change in income. MPC is
always more than zero less than one.

MUST REMEMBER

# MPC of Poor is More than MPC of Rich.

# MPC falls with successive increase in income.
MPS (Marginal propensity to save) It shows change in savings due to change in income.
 Consumption Function
The functional relationship between C and Y is called consumption function.
 Saving Function
It is the functional relationship between S and Y (income)
S = – a + (1 – b)Y
Here S = Saving
Note:
• MPC is slope of consumption function.
• MPC is constant at each level.
• MPS is slope of saving function
• MPS is constant for a straight line S-function

1. S-line must start from the point which indicate that the value of S (the value of S when Y = 0)
corresponds to the value of C (the value of C when Y = 0).
Here S-line starts from –20 where C line starts from +20 because C = 20, Y = 0 and S = –20.
2. S-line must cross the X-axis when (Y = C) so that S = 0. Thus S-line crosses X-axis when Y = C = 100 and
therefore S = 0.
3. The slope of S-line must be equal to (1 – slope of C-line) while slope of C line is 0.8 = MPC and slope of S
line is (1 – MPC) i.e. 0.2 i.e. MPS.
 INVESTMENT MULTIPLIER
It measures change in income due to change in investment in the economy. We have noted that increase
in income is many times more than the increase in investment. The number of times by which the increase
in income exceeds the increase in investment is called investment multiplier or output multiplier. It is
denoted by “K”
Conclusion
There is inverse relationship between MPC & MPS as value of MPC increases then value of MPS decreases as
shown in above schedule.
* There is inverse relationship between multiplier and MPS. Higher the value of MPS, lower the value of
multiplier & vice versa.
* There is a direct relationship between multiplier and MPC. Higher the value of MPC, higher the value of
multiplier and vice versa as shown in above schedule.
Working of investment multiplier with a numerical example.
 Investment Multiplier Process Assume MPC = 0.8 i.e. 80%
Round Increase in Increase in income Increase in
Investment consumption
1 100 100 80
2 - 80 64
3 - 64 51.20
All other Round - 256 204.80
Total 100 500 400
The above table clearly shows that initial increase in investment of `100 crores has resulted in an
increase of additional income of `500 crores. i.e. the resultant increase in income is 5 times the initial
investment.

• Ex – ante saving: It refers to planned saving in an economy in a year.

• Ex – ante investment: It refers to planned investment in an economy in a year.
• Ex – post investment: It refers to the actual amount of investment in an economy during a year. *
Ex-post saving : It refers to actual savings in an economy in a year
ALL FORMULAE
Q.1) Find consumption expenditure from the following:
Autonomous consumption = ₹200
MPC = 0.75
National income = ₹1,500
Q.2) Calculate MPC from the following:
(i) Investment ₹350
(ii) Consumption expenditure at zero level income ₹20
(iii) National Income 1000.
Q.3) An economy is in equilibrium. The economy’s consumption function is
C = 100 + 0.5Y
where C is consumption expenditure and Y is national income. National income is 1000.
Find out investment expenditure,
MPS and
Investment Multiplier.
Q.4) Given consumption function C = 100 + 0.75Y and investment expenditure ₹1000.
Calculate
(a) equilibrium level of national income
(b) consumption expenditure at that level.
Q.5) The saving function of an economy is given as: S = -10 + 0.20 Y.
if the ex-ante investment are ₹240 crores, calculate the following:
(i) Equilibrium level of income in the economy
(ii) Additional investments which will be needed to double the present level of equilibrium income
Q.6) The function of Saving (s) is given to be: S = -40+0.25Y.
If planned investments are ₹100 crores, determine:
a) Equilibrium level of income
b) Level of consumption at equilibrium
c) Savings at equilibrium
Q.7) In an economy, S = –100 + 0.6Y is the saving function.
Where S is saving and Y is national income if investment expenditure is ₹1100. Calculate:
(i) equilibrium level of national income.
(ii) Consumption expenditure at that level of income
Q.8) In an economy 75% of increased in income is spend on consumption. Investment is increased by ₹1000
crore. Calculate ∆Y (increase in income) and ∆C (total increase in C).
Q.9) In an economy, an increase in investment leads to increase in national income which is three times more
than the increase investment.
Calculate marginal propensity to consume.
Q.10) Complete the following tables.

Income Consumption Marginal propensity to Average propensity to

expenditure save save
0 80
100 140 0.4 _
200 _ _ 0
_ 240 _ 0.20
_ 260 0.8 0.35
GOVERNMENT BUDGET
 GOVERNMENT BUDGET

Government Budget is a statement of expected receipts

and expected expenditures of the government for a
fiscal year.
Every government prepares budget whether it is local,
state and central government.

First day of the month of February is well known in India

as a day the Finance Minister present annual budget of
the government called
Union Budget of India
 OBJECTIVES OF GOVERNMENT BUDGET
Budget is not only a statement but it is a reflection of Government policies and set of objectives
that the government seeks to achieve over time

Managing Public Sector Enterprise

Economic stability

Redistribution of income and wealth

Allocation of Resources
 OBJECTIVES OF GOVERNMENT BUDGET

Managing Public Sector Enterprise:

There are large number of public sector enterprises
which are established and managed for social welfare
of the public. Budget is prepared with the objective
of making various provisions for managing such
enterprise and providing them financial help.
However in case public sector enterprises are showing
inefficiency and losses. The govt may plan their
privatization.
Economic stability:
Main objective of budget is to bring stability in
economy.
It control fluctuations in general price level through
taxes, subsidies and government expenditure.
for e.g. when there is inflation (continuous rise in
prices) Government can increase taxes and reduce its
expenditure.
When there is deflation (continuous fall in prices).
Government can reduce taxes and grant subsidies to
encourage spending by people.
Redistribution of income and wealth:
It means reduce the inequalities between income and
wealth. Through the policy Government seeks to
promote “equity”. To increase the disposable income
of poor, Government provide them subsidies.
To decrease the disposable income of rich section, tax
system is made progressive. Putting greater burden on
richer sections of the society. These are reflected in
the government budget by way of tax revenue and
welfare expenditure.
Allocation of Resources: Through the budgetary
policy, government aims to reallocate resources in
accordance with profit maximization and social
welfare. Government can influence allocation of
resources through taxation and subsidies policy.
To encourage investment for welfare, Government
can give tax concessions and subsidies to the
producers. Government also discourage the
production of harmful consumption goods like,
liquor, bidi, cigarettes, tobacco etc. through heavy
taxation and encourages the use of “Khadi product”
by way of subsidies.
Classification of Government Budget
 Government Budget has Two Broad components:

Budgetary Receipts Budgetary Expenditure

(i) Budgetary Receipt

Budgetary receipts refer to total estimated money receipts of the Government from all sources
during a fiscal year.

Budgetary receipt are classified as

Revenue Receipts Capital Receipts

(A) Revenue Receipts:- These are those receipts of the government which do not leads to reduction
in any assets of the government nor creation of any liabilities of the government.

Revenue receipts are of two types

Tax Receipt Non-Tax Receipt

 1. Tax receipt: These are those receipt of the Government which are received from the tax component (Tax
source). ‘Tax’ is a compulsory payment to the government under any law. The taxpayer cannot expect any
service or benefit from the Government in Return. If a person fails to pay tax, he is liable to penal action. It is to
be treated as revenue receipt because it neither create any liability nor reduce any asset of the government

Tax are of two types

Direct Tax Indirect Tax

Direct tax are those tax, the person who bears the Indirect tax are those tax, the person who bears
burden of tax does himself deposit it with the burden of tax does not himself deposit it
government . with Government .
Burden of these taxes are not shiftable i.e. the Burden of these taxes are shiftable i.e. the
amount of tax can’t be recovered from any other.
amount of tax can be recovered from customer.
These taxes are progressive in nature.
e.g. Income tax, Corporation tax, gift tax, wealth These taxes are regressive in nature.
tax, etc. e.g. Goods and services tax, custom duty, etc.
2. Non-Tax Receipts: Non-tax receipts are those receipts which are received from sources other than taxes.
These are the following:
(i) Fines: Fines are those payments which are made by the law breakers to the Government by way of
economic punishment. The aim is not to earn revenue, but to make people respectful towards the
laws.
(ii) Fees: A fees is a payment to the Government for the services that it renders to the people. e.g. Land
registration fees, birth registration fees, passport fees, court fees, license fees, etc. It is to be noted
that fee is not a payment for commercial service. It is a payment for administrative and judicial
services provided to the people.
(iii) Escheat: It refers to income of the state which arises out of the property left by the people without a
legal heir.
(iv) Grants/ Donations: Grants received by the Government are also a source in revenue. In the event of
some natural calamities like floods, famine, earthquake, or during wars. It also includes donations
received from citizens and non residents and rest of the world.
(v) Income from public enterprises: Several enterprises are owned by the Government e.g. Indian
Railways, Indian Oil, Bhilai Steel Plant, LIC, BHEL, etc.
(vi) Interest: Interest received by the government on loans are considered as a revenue receipts.
 (B) Capital Receipts
These receipts are those receipts of the Government which leads to creation of any liabilities the
government or reduction in any assets of the government.

Components of Capital Receipts are

Borrowing and other

Recovery of loan Disinvestment (PSU)
liabilities

(i) Recovery of loan: Loan offered to others are assets of the Government Accordingly recovery of
loan cause reduction in assets.
(ii) Disinvestment (PSU): Disinvestment occurs due to the privatization. It means sale of share of
public sector undertaking to private corporate sector. It reduces the assets of Government
(iii) Borrowings & other liability: Government borrow money from general public by issuing share /
securities, from RBI, from Rest of the world, it create liabilities of the Government. Borrowings
are debt creating capital receipts.
 Difference between Revenue Receipts & Capital Receipts
Basis Revenue Receipts Capital Receipts

Meaning These are those receipts of the These are those receipts of the
government which don’t leads to government which leads to reduction in
reduction in any assets nor creation of any assets or creation of any liabilities
any liabilities
Nature These are recurring in nature. These are non recurring in nature.
Debt Creation Revenue receipts are not debt creating Some capital receipts like borrowing are
debt creating
Examples Tax receipts, fees, fines, interest, Recovery of loans, disinvestments (PSU) &
penalties, etc. borrowings.

Formula: Total Receipts = Revenue Receipts + Capital Receipts

Q.1) Classify the following into Revenue Receipts & Capital Receipts, give reason.
(i) Loan from world bank
(ii) Corporation tax
(iii) Sale of shares held by Government of a PSU.
(iv) Dividend Received by Government from a company.
(v) Profit of LIC, a public enterprise.
(vi) Amount borrow from Japan for bullet train.
(vii) Goods & Service Tax collection
(viii) Recover amount of loan from Bhutan.
Q.2) Classify the following into debt creating and non-debt creating capital receipt. Give reasons.
(i) Sale of public sector undertakings.
(ii) Borrowings from public
(iii) Recovery of loans
Formulae:
Total receipts = Revenue receipts + Capital receipts
Revenue receipts = Tax revenue + Non tax revenue
Tax revenue = Direct tax + Indirect tax
Capital receipts = Recovery of loans + Disinvestment + Borrowings
(ii) Budgetary Expenditure It refers to the total estimated expenditure of the government over a fiscal
year

Budgetary expenditure is classified into

Revenue Expenditure Capital Expenditure

(A) Revenue Expenditure: These are those expenditure of the government which do not create any asset nor
reduction in liability of the government.
Examples: Old age pension, subsidy, scholarship, salaries to Government employees, interest payment, gifts,
grants, donation any type, expense on defense service, wage bill of the government, expenditure on collection
of taxes, etc. These all are revenue expenditure because they do not create any assets nor reduction in any
liabilities of the government.
(B) Capital Expenditure: These are those expenditure of the government which leads to reduction in liabilities
of the government or creation of any Assets of the government
Examples: Repayment of loan, equity shares of the domestic or multinational, corporations purchased by the
Government Expenditure on land and Building, Machinery, equipment, construction of school, flyover,
hospitals, college, etc.
 Difference between Revenue Expenditure & Capital Expenditure

Basis Revenue Expenditure Capital Expenditure

Meaning These are those expenditure of the These are those expenditures of the
government which don’t leads to government which leads to creation of any
creation of any assets nor reduction of assets or reduction of any liabilities.
any liabilities.
Nature These are recurring in nature. These are non recurring in nature.
Purpose These are incurred on normal These are incurred on acquisition of assets
functioning of the government. and granting loans
Examples Interest, subsidies, expense on Acquisition of machinery, construction of
collection of taxes, donation, pensions, school, hospital, building, repaid loans, etc.
etc

Formula: Total expenditure = Revenue expenditure + Capital expenditure

Q.1) Giving reasons categories the following into revenue and capital expenditure:
(i) Grants given to state government
(ii) Repayment of loans.
(iii) Expenditure on construction of roads.
(iv) Interest payment on past loans.
(v) Payment of salaries to Government employees.
(vi) Taking over a private firm by the Government
(vii) Expenditure on subsidies.
(viii) Purchase of shares by the Government
Situation in Government Budget

(i) Balanced budget / Equilibrium Budget: It is a situation when budgetary expenditure is equal to budgetary
receipts.
TR = TE
(ii) Surplus Budget: It is a situation when budgetary receipts are greater than budgetary expenditure. In
situation of inflation, surplus budget is prepared by the government.
TR > TE
(iii) Deficit Budget: It is a situation when budgetary expenditures are greater than budgetary receipt. In
situation of deflation, deficit budget is prepared by the government.
TE > TR
 Budgetary Deficit = Total expenditure – Total receipts

Budgetary Deficit are Three types

Revenue Deficit Fiscal Deficit Primary Deficit

(i) Revenue Deficit: It is the excess of revenue expenditures over revenue receipts.
RD = RE – RR, Here (RE > RR)
IMPLICATIONS OF REVENUE DEFICIT
Since revenue receipts and revenue expenditures are related largely to recurring expenses of the
Government (as on administration & maintenance) High revenue deficit gives a warning signal to the
government either to cut its expenditure or increase its tax/non tax receipts. In less developed countries
like India, it is difficult to force the poor people to pay high tax. In such situation, the Government is
compelled to cope with high revenue deficit through borrowings or disinvestment. Borrowings creates
liability of the Government whereas disinvestment cause reduction in assets of the Government

(ii) Fiscal Deficit: It is the excess of Total expenditure over Total receipts other than borrowings.
i.e. Fiscal deficit is equal to borrowings of the Government Fiscal deficit =
TE – TR (excluding borrowings)
⇒ Fiscal deficit = Total expenditure – Revenue Receipts – Capital receipts excluding Borrowings
⇒ Fiscal deficit = (RE + CE) – RR – Recovery of loan – Disinvestment
⇒ Fiscal deficit = Budgetary deficit + Borrowing & Other liabilities
IMPLICATIONS OF FISCAL DEFICIT
Greater fiscal deficit implies greater borrowings by the Government.
(a) It causes Inflation: Government borrowings includes borrowing from RBI.
It increases circulation of money in economy and cause inflation.
(b) Increase foreign dependence: Government also borrows from rest of the world. It increases our dependence
on other countries.
(c) It accumulates financial burden for future generation to repay the loan with interest.
(d) Increase in fiscal deficit implies increase in borrowings i.e. ultimately leads to increase in interest
expenditure i.e. increase in revenue deficit also. It is also called Debt Trap.

(iii) Primary Deficit: It is the difference between fiscal deficit and interest payment
Primary Deficit = Fiscal deficit – Interest payment
While fiscal deficit shows borrowings requirement of the Government including of interest payment on the
accumulated national debt. Primary deficit shows borrowing requirement of the Government exclusive of
interest payment.
Q.1) How can the deficit in budget be financed?
(i) Deficit financing: This refers to borrowing by Government from RBI against Treasury Bills. RBI purchase the Bill
in Return of Cash, which the Government uses to fund the deficit.
(ii) Borrowing from public.
(iii) Disinvestment
(iv) Government should reduces its expenditure and increase tax & non tax revenue
Q.2) From the following data, Calculate (a) Revenue Deficit; (b) Fiscal Deficit

Particulars Amount
Tax revenue 1,000
Revenue expenditure 3,821
Non-tax revenue 2,000
Recovery of loans 135
Capital expenditure 574
Disinvestment 100
Interest payments 1,013
Q.3) Calculate (i) Revenue deficit (ii) Fiscal deficit (iii) Primary deficit.

Particular ₹ In crore
Capital Receipt net of borrowings (excluding borrowings) 95
Revenue expenditure 100
Interest payment 10
Revenue Receipts 80
Capital expenditure 110
FOREIGN EXCHANGE RATE
 Meaning

Foreign exchange rate refers to

the rate at which one unit of
foreign currency can be
exchanged for number of units
in domestic currency.
OR
It is the price paid in domestic
currency in order to get one
unit of foreign currency.

Example: $1 = ₹83 or ₹1 = $ 1/83

 Types of Exchange rate

1 Fixed exchange rate system

2 Flexible (or) floating exchange rate system

3 Managed Floating Rate system

1. Fixed exchange rate system
Fixed exchange rate system is a rate of exchange which is fixed by the government. Historically, it has two
important variables:

Gold standard system of exchange: Bretton woods system of exchange

According to this system before 1920’s gold was According to this system US $ was taken as
taken as common unit of exchange between the common unit of exchange between the
currencies of different countries. Each country currency of different countries. Different
was to define value of its currency in terms of currencies are related to one currency i.e. US
gold. Accordingly value of one currency in terms $ (dollar). Each country was to define value
of the other currency was fixed considering gold of its currency in terms of US Dollar.
value of each currency. e.g. 1 UK £ = 4 gm gold, 1
US $ = 2 gm gold then 1 UK £ = 2 US $ (exchange It is also called Adjustable peg system of
ratio between UK and US) exchange.
This system is also known as mint par value of
exchange or mint parity.

SUNIL PANDA COMMERCE CLASSES

 Merits and Demerits of fixed exchange rate system
Merits Demerits
a) Stability in the exchange rate a) Huge Gold reserves are required
b) Promotes international Trade and investment b) Difficulty in fixing the exchange rate
c) Prevent speculative activities c) Problem of undervaluation and
d) Control inflation overvaluation of Currency
2. Flexible (or) floating exchange rate system

It is the rate which is determined by the demand for and supply of different currencies in the foreign exchange
market. In other words, flexible exchange rate is determined by the market forces. The exchange rate at which
demand for foreign currency is equal to supply of foreign currency is called equilibrium rate or normal rate or
par rate of exchange. It is a flexible rate because it tends to change in accordance with changes in the demand
and supply for different currencies in the foreign exchange market

Merits and Demerits of flexible exchange rate system

Merits Demerits
a) Equilibrium level is determined a) Instability in the exchange rate
b) No need of huge Gold reserves b) Speculative activities
c) Free Market, No Unwanted Control of c) Creates inflationary situation
Government d) Risk of Foreign Trade and Foreign investment
d) No problem of undervaluation & Overvaluation
of currency
3. Managed floating rate system
It is a system in which exchange rate is determined by the market forces of demand and supply in
international money market, but when domestic currency is heavily depreciating then Reserve Bank of
India Intervenes to place some influence on the exchange rate so that it remains with in the desired
limits. It is also known as ‘Dirty floating’. Here RBI sells foreign exchange in international money market.
So that supply of foreign exchange increases. Managed floating is a Hybrid of a fixed exchange rate and
a flexible exchange rate system.
DEMAND FOR FOREIGN EXCHANGE
(OR)
Why foreign exchange is Demanded
(OR)
What are the sources of demand for foreign exchange?
1. To purchase goods and services from other countries.
2. To purchase assets (like land, shares, bond, etc.) in other
countries.
3. Payment of international loans.
4. Gift and grants sent to rest of the world.
5. Foreign exchange is needed to undertake foreign tours.

There is an inverse relationship between Demand for foreign

exchange and foreign exchange rate.

Increase in foreign exchange rate

leads to decrease in demand for
foreign exchange and vice-versa
 SUPPLY FOR FOREIGN EXCHANGE
(OR)
Why foreign exchange is Supplied?
(OR)
What are the sources of supply of foreign exchange?

1. Export of the country to rest of the world.

2. Foreign direct investment (FDI).
3. Gift / donation / Remittance received from foreign
countries.
4. Supply of foreign exchange also comes when foreign
tourists come in to Home Country

There is a Direct relationship between supply of foreign

exchange and foreign exchange rate.

Increase in foreign exchange rate leads to increase in supply

of foreign exchange and vice-versa
 Equilibrium Rate of Exchange
It is the rate at which demand for foreign exchange and
supply of foreign exchange are equal. In the given
diagram, X axis represents demand and supply of
foreign exchange and Y axis represents foreign
exchange rate. ‘DD’ shows Demand Curve of foreign
exchange and curve ‘SS’ shows Supply of foreign
exchange. Point ‘e’ stands for equilibrium point where
Demand ‘DD’ is equal to supply SS. OR is the
equilibrium rate of exchange and OQ is the equilibrium
quantity

SUNIL PANDA COMMERCE CLASSES

 Depreciation of Domestic Currency
(Or) Appreciation of Foreign Currency
It refers to decrease in the value of domestic currency in terms of foreign currency. Here Domestic
Currency is less valuable. e.g. $1 = ₹70 (Old stage) $1 = ₹80 (New stage) In the above example Indian rupee
is less valuable. In old stage ₹70 is required to buy one US dollar and in new stage to buy one US dollar we
have to pay ₹80. This shows that domestic currency is less valuable.

SUNIL PANDA COMMERCE CLASSES

 There are two reasons behind depreciation of domestic currency.
(i) Increase in demand for foreign currency. (ii) Decrease in supply of foreign currency.
An increase in demand for foreign exchange A decrease in supply of foreign exchange leads
leads to raise in foreign exchange rate. In the to raise in foreign exchange rate. In the given
given diagram as Demand increases from DD to diagram as supply decreases from SS to S′S′
D′D′ then exchange rate increases from OR to then exchange rate increases from OR to OR′.
OR′.
 Effects of Depreciation of Domestic Effects of Depreciation of Domestic
Currency on Exports/ National income Currency on Imports

Depreciation of domestic currency means a fall in Depreciation of domestic currency means fall in
the price of domestic currency (say rupee) in the price of domestic currency (say rupee) in
terms of a foreign currency (say US dollar). It terms of a foreign currency (say US dollar). It
means one dollar can be exchanged for more means one dollar can be exchange for more
rupee. So with the same amount of dollar more rupee so with the same amount of rupee less
goods can be purchased from India. It means goods can be purchased from USA. It means
export to USA becomes cheaper. This may result import from USA is expensive. This may results
an increase of Indian export to USA decrease in imports from USA
 Appreciation of Domestic Currency
(OR) Depreciation of Foreign Currency
It refers to increase in the value of domestic currency in terms of foreign currency. e.g. $ 1 = ₹80 (old stage)
$ 1 = ₹70 (new stage) In the above example, Indian rupee is more valuable in old stage ₹80 is required to buy
one US dollar and in new stage to buy one US dollar we have to pay only ₹70. This shows that domestic
currency is more valuable.

SUNIL PANDA COMMERCE CLASSES

 There are two reasons behind appreciation of domestic currency.
(i) Increase in Supply of foreign currency. (ii) Decrease in Demand for foreign currency
An increase in supply of foreign exchange leads A decrease in demand of foreign exchange leads
to fall in foreign exchange rate. In the given to fall in foreign exchange rate. In the given
diagram as supply increases from SS to S′S′ then diagram as Demand decrease from DD to D′D′
exchange rate decreases from OR to OR′ then exchange rate decreases from OR to OR′.
 Effects of Appreciation of Domestic Effects of Appreciation of Domestic
Currency on Exports / National income Currency on Imports

Appreciation of domestic currency means a Appreciation of domestic currency means a fall

fall in price of foreign currency (Say US dollar) in price of foreign currency (say US dollar) in
in terms of domestic currency (say rupee). It terms of domestic currency (say rupee). It
means foreigners have to spend more for means Indians have to spend less for purchase
purchase goods from India. So with the same goods from abroad. So with the same amount
amount of dollar less goods can be purchased of rupee more goods can be purchased from
from India. It means export to USA becomes abroad. It means import from USA becomes
expensive. This may result a decrease of cheaper. This may result an increase in Indian
Indian export to USA. imports from USA

SUNIL PANDA COMMERCE CLASSES

 Difference between Devaluation and Depreciation of domestic currency.

Basis Devaluation Depreciation

Meaning It refers to fall in price of domestic It refers to fall in price of domestic
currency under fixed exchange rate currency under flexible exchange rate
system system.
Control It is under the control of It is under the control of market forces
Government. of demand and supply
Exchange rate It was in fixed exchange rate system. It is in flexible exchange rate system
system

REVALUATION OF DOMESTIC CURRENCY

Revaluation refers to rise in price of domestic currency in terms of all foreign currencies under
fixed exchange rate regime
 FOREIGN EXCHANGE MARKET

It is a market for foreign currencies i.e. here foreign currencies are purchases and sold.
Functions of foreign exchange market.
(i) International transfer of foreign currency: Foreign exchange market helps in transferring foreign
currency from one country to another where it is needed.
(ii) Provide credit for foreign trade: Foreign exchange market provides credit for foreign trade.
(iii) Hedging foreign exchange risk: Hedging means covering exchange risk. It is done by foreign
exchange rate in forward transactions through banks. Foreign exchange market makes a contract to buy
or sell foreign exchange in advance to pay in future date at predetermined price
 Types of Foreign exchange market

Spot market Forward

market
(i) Spot Market (Current market): (ii) Forward Market:
It is that market which handles only It is that market which handles such
spot/current transactions. It operates daily transactions of foreign exchange
nature transactions. The rate of exchange which are meant for future delivery.
which is determined in the spot market is It does not deal in spot transactions.
known as spot rate of exchange It determines a rate of exchange for
future called forward exchange rate.
BALANCE OF PAYMENTS
 BALANCE OF TRADE

Balance of Trade:
It is the difference between the value of goods
exported and value of goods imported.
BOT = Export value – Import value
[Only Tangible/ Visible goods]
It is a Narrow concept as Compared to Balance of
payments.
 It is also
It is also
Called TRADE
Called TRADE
DEFICIT
SURPLUS
BALANCE OF PAYMENTS

It is a statement that records all economic

transactions of a country with the rest of
the world.
 Balance of payments includes the following

Visible items

Invisible items

Capital transfers

Unilateral transfers
 Visible items: It includes all types of physical goods exported & imported. These are seen crossing the
01
borders. e.g. Machines and many other tangible goods.

Invisible items: Which include all types of services. These are invisible like Banking Services, shipping
02 services, insurance services, etc.

Unilateral transfers: These are one-way transfers of money, goods or services from one country to
03
another. These are transfer for free e.g. gifts, grants, donations, aid to flood victims, etc.

Capital transfers: Which are connected with capital receipts and capital payments. These involves
04 transfer of capital Assets

SUNIL PANDA COMMERCE CLASSES

 Balance of Payment have two Accounts

Current Account Capital Account

in BOP in BOP
 Current Account in Balance of payment

It is that account in BOP which records export and import of goods, services and unilateral transfers.
 Components of Current account in a BOP

Export and import of goods

It records export and import of tangible goods like
Machineries etc. (visible items). All export of goods
are recorded as credit item or (+) items as these
results inflow of foreign exchange in to our country.
While all import of goods are recorded as debit item
or (–) items as these results outflow of foreign
exchange from our country
 Components of Current account in a BOP

Export and Import of Service

It records export and import of services i.e.
invisible items. Which is not seen as crossing the
borders. Services are split into two components (i)
factor services
(ii) non factor services.
Factor services involve payments in terms of
income like compensation of employees. Non-
factor services like shipping, insurance, banking,
involve payments in terms of revenue. So all
export of services are recorded as credit item or
(+) items as these results inflow of foreign
exchange where as all import of services are
recorded as debit item or (–) item because it
results outflow of foreign exchange
 Components of Current account in a BOP

Unilateral transfers
It also records current transfers. It refers to
“transfer for free” these are unilateral transfers by
way of gift, grant, donations etc. So receipt of
unilateral transfers are recorded as credit item or
(+) items because it results inflow of foreign
exchange in to our country. Whereas payment of
unilateral transfers are recorded as debit item or
(–) items because it results outflow of foreign
exchange from our country.
 Net value of these 3 items (i) visible (ii) invisible (iii) unilateral transfers
are recorded current account in BOP

•Current account surplus

•A country has a current account surplus when it exports more than it imports, bringing in more money from
abroad than it spends. This indicates that the country is a net creditor to the rest of the world.
•Current account deficit

•A country has a current account deficit when it imports more than it exports, spending more on imports and
foreign investments than it earns from exports. This indicates that the country is a net debtor to the rest of the
world.
 Capital Account in Balance of payment
It is that account of BOP which records all such transactions between resident of a country and rest of the
world which cause a change in Assets or liabilities of the Resident of a country or its government.
 Components of Capital Account in BOP

Foreign Investments

Borrowings / Loans

Change in foreign exchange reserves

(i) Foreign Investment
Foreign Investment has Two sub component:
(a) Foreign direct investment (FDI): It refers to the purchase of assets in the rest of the world which allows
control over that assets. e.g. Purchase of a firm by TATA in rest of the world. After purchase TATA has full
control over that firm.
(b) Portfolio investment (foreign institutional investment): It refers to purchase of an asset in rest of the
world, without having any control over that asset. e.g. Purchase of some shares of a foreign company by
TATA, FDI and Portfolio investment are non-debt creating capital transactions. FDI or portfolio
investment by the non-residents in our country is recorded as credit item or (+) items because it results
inflow of foreign exchange in to our country whereas, FDI or Portfolio investment by resident in rest of
the world is recorded as debit item or (–) items because it results outflow of foreign exchange from our
country
(ii) Borrowings / Loans
It has two sub components.
(a) Commercial Borrowings: It refers to borrowings by a country (including government & private sector) from
international money market.
(b) Borrowing from international monetary fund (IMF): It refers to borrowing by a country with consideration.
It involves lower rate of interest as compared to market rate. All the borrowings are debt creating capital
transactions loan from rest of the world are recorded as credit side, (+) items because this leads to inflow
of foreign exchange in our country. Whereas loan to rest of the world is recorded as debit side, (–) items
because outflow of foreign exchange from our country.
(iii) Change in foreign exchange reserves/ Official reserves: Foreign exchange reserves are the financial assets
held as reserve by a Central Bank in foreign currencies. A change in foreign exchange reserve affects the
balance of payments. Any withdrawn from the reserve are considered as a credit item or (+) item and any
addition to these reserves are considered as a debit item or (–) item. Net value of these items (foreign
investment and borrowings) is recorded as balance in capital account.
Equilibrium in BOP: Current account balance + Capital account balance = 0
There is no movement of official reserves of the Central Bank.
i.e. inflow of foreign exchange = outflow of foreign exchange.
Disequilibrium in BOP: When current account Balance + Capital account Balance is not equal to zero. (It
may be Positive and Negative).
(i) Surplus BOP: Here autonomous receipts are more than the autonomous payments.
(ii) Deficit BOP: Here autonomous receipts are less than the autonomous payments.
BOP is always balances, in case there is imbalance, it is corrected through accommodating transactions.
POINTS TO BE REMEMBER
A Negative Balance in Current Account of the Balance of payment is usually compensated by a surplus in
the Capital Account in Balance of payment.
A Negative Balance in Capital Account of the Balance of payment is usually compensated by a surplus in
the Current Account in Balance of payment.
A Negative Balance in Balance of Trade is usually compensated by a surplus in the Current Account in
Balance of payment.
But a Negative balance in Balance of Payment Account is not compensated by the balance of Trade
Account
 Difference between Autonomous and Accommodating Transactions

Autonomous Transaction Accommodating Transactions

Autonomous items refers to those international Accommodating items refer to those transaction
which occur due to some economics motive such which take place to cover deficit or surplus in
as profit maximization e.g. Import of machinery autonomous transactions. e.g. withdrawal from
from Japan, FDI, etc. foreign exchange reserve, loan from IMF, etc. to
maintain BOP
These items are independent in nature These items are dependent in nature
These item take place on both current and capital These item take place only on capital account
account
These items are also known as above the line These items are also known as below the line
items as they are recorded as first item before items, as they are recorded as secondary item
calculating deficit or surplus in BOP after calculating deficit or surplus in BOP
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