1

Chapter – 1
Theory of income and employment
The Keynesian theory of income determination was developed by 1936 by
the British economist J.M. Keynes. The cornerstone of the Keynesian model is
that income and output in an economy in the short-run depends in the aggregate
spending or aggregate demand.
Assumptions of the theory
1. Focus on Aggregate Spending: While understanding this theory, our focus
is on aggregate spending rather than its composition.
2. Short-Run: In macro-economics, the short-run is taken as the period
during which the full employment or potential level of output is given. However,
the actual level of national output can be more or less than the potential output
depending up on the aggregate spending.
3. Fixed Price Level: We assume that the prices do not change at all, and the
firms are willing to sell any amount of output at eh given level of prices.
4. Excess Capacity: It is assumed that the economy has excess capacity in
terms of the stock of capital and availability of labour. Thus, it is possible to
increase output in short-run by using the available capital stock and other
resources like labour.
5. Closed Economy: We develop a simple model of income determination by
assuming the absence of imports and exports of goods and services. Thus,
domestic spending and domestic output are same.
6. Two-Sector Model: We are considering an economy in which there are only
two entities namely households and firms and we have assumed away the role
of the government.
The concept of aggregate demand
Aggregate demand is the total amount of goods demanded in the
economy. It refers to the desired, intended or planned ex ante demand or
spending by the people i.e, the total amount of goods and services they would
like to purchase. These buyers can be classified into four groups:
Households - Desired Consumption Expenditure
Firms - Desired Investment Expenditure
Government - Desired Government Expenditure
Foreign sector - Desired Net Exports
Thus, desired aggregate demand is also be referred to as the desired aggregate
expenditure and is expressed as:

AE = C + I + G + (X-M)
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Effective demand is the total amount of goods and services that people
actually buy in the economy. It is ex post concept or the actual aggregate
demand. Desired aggregate demand in the economy can either be greater than
or less the actual aggregate demand. However, at equilibrium, actual spending
is equal to planned spending.
While discussing the simple Keynesian theory, we are taking a model of
closed economy, i.e. an economy with no exports and imports. We are not taking
into account the expenditure and other activities of the government. Therefore,
in a two sector closed economy:
AE = C + I
The concept of aggregate supply

Aggregate supply is the total amount (money value) of all final goods and
services that is produced in the economy during a particular year. In a closed
economy, we do not consider the output produced by Indian firms situated
abroad. Thus aggregate supply, in a closed economy, is same as the Gross
domestic product (GDP) of the economy.
GDP of a country is the value of all final goods and services produced within
the domestic territory of the country during a particular year. GDP, on the other
hand is same as the domestic factor income of the country and income is either
consumed or saved. Thus aggregate supply is same as the total income of the
economy.
AS = GDP = Y = C + S

Income AS
10 10
20 20
30 30
40 40

Y AS
Aggregate Supply

450
O Income X

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Consumption function – propensity to consume

The Keynesian theory of consumption function shows the functional
relationship between the desired consumption expenditure and the factors that
determine it. The amount that the people desire to spend on consumption
depends on a numerous factors such as income, wealth, interest rates, liquidity
preferences, etc. However, income is the major determinant of propensity to
consume.
Therefore, consumption function shows the functional relationship
between consumption and income. Thus, consumption is a function of income.
C = f (Y)
We use two technical concepts to understand consumption function:
1. Average Propensity to Consume (APC): It is that portion of total income
which is devoted to consumption. It is defined as the ratio of total consumption
to total income.
APC = C
Y
For Example: When total income is Rs 1000 out of which Rs 900 is spent
on consumption, then APC = Rs 900/ Rs 1000 i.e. 0.9
Y
C
Consumption

APC = 0.9

O Income X
2. Marginal Propensity to Consume (MPC): It refers to the ratio of change in
consumption to change in income.
MPC = ΔC
ΔY

For example: In the above example, when income rises from Rs 1000 to
Rs 1100 due to which consumption increases from Rs 900 to Rs 980, then MPC
is found out in the following way:
MPC = ΔC = Rs (980 - 900) = 80 = 0.8
ΔY Rs (1100 - 1000) 100

Y MPC = 0.8
Consumption

ΔC

ΔY

O Income X
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Properties of consumption function

1. Consumption expenditure in an economy is directly proportional to
income. The level of consumption increases with increase with income and vice-
versa. Countries with higher incomes typically have higher level of consumption.
Thus, consumption is a function of income.
C = f (Y)
2. Though consumption increases with increase with income but only by a
somewhat smaller amount. TO the extent consumption expenditure increases
with increase in income, c>0 and to the extent consumption increases by a
smaller amount than increase in income, c<1. Therefore, MPC lies in between 0
and 1
0<c<1
3. The proportion of income consumed declines as income increases. Thus,
APC decreases with increase in income.

Using the concepts of average and marginal propensities to consume and

the C curve, we can explain the properties of consumption function with the help
of the following diagram:
Y AS (Y)

C
Consumption

450
O Y Income X

1. The consumption line C is upward sloping indicating that a higher income

leads to higher consumption expenditure. When consumption is zero, a typical
household will still have some minimum consumption which is either financed by
borrowing or by drawing from past savings. Thus, an economy will have some
minimum consumption at zero income which is known as autonomous
consumption. It is shown as “a” on Y – Intercept.
2. The slope of the C line is marginal propensity to consume. IT is clear that
C line is positive sloping but it is less than 1 at the same time. (450 line has slope
of 1). This indicates that MPC is greater than zero but less than one.
3. The consumption line C cutting the income line Y from its left indicates that
consumption is greater than income initially but later on income exceeds
consumption. When C>Y, APC must be greater than one. (Since APC =C/Y).
Similarly, when C<Y, APC must be less than one. At break-even level of income
E, C=Y and therefore APC is equal to one. Therefore, it is clear that as income
increases, APC goes on decreasing.
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It must be kept in mind that we are taking only linear consumption function
into consideration which is generally expressed as:
C=a+cY
Where; C = Aggregate consumption expenditure
Y = Income.
a = Positive constant showing autonomous consumption
c = Slope, marginal propensity to consume.

Saving function – propensity to save

Saving function is the counterpart of consumption function. It states the
relationship between the level of saving and the level of income. In a simplified
two sector economy, the part of the income that is not spent on consumption is
saved.
S=Y–C

Like consumption function, saving is an increasing function of the level of

income. The amount of saving increases with an increase in the level of income.
There are two concepts of saving function which are exactly analogous to
the consumption function:
1. Average Propensity to Save (APS): It is that proportion of the total
income that households want to save. It is the ratio of total saving to total
income.
APS = S
Y
For example: When the level of income is Rs1000 while saving is Rs 100,
then, APS will be 0.1 i.e. 100/1000.

S
Saving

APS = 0.1

Income X

2. Marginal Propensity to Save (MPS): It refers to the ratio of change in

saving to change in income.
MPS = ΔS
ΔY
For example: In the above example, when income rises from Rs 1000 to
Rs 1100 due to which saving increases from Rs 100 to Rs 120, then MPS is found
out in the following way:
 6

APS = ΔS = Rs (120 - 100) = 20 = .20

ΔY Rs (1100 - 1000) 100
Y
S
MPS = .20

Saving
ΔS

ΔY
O Income X

Relationship between consumption function and

saving function
In a simplified two-sector economy, the part of income that is not spend
on consumption is saved. Since income is either spent or saved, there is Siamese
twin relationship between consumption and saving. It follows that once we know
the relationship between consumption and income, we can automatically know
the relationship between saving and income.
There is a simple relationship between consumption function and saving
function. In an economy, the sum of APC and APS must add to unity and so must
the sum total of MPC and MPS.
Since income is either consumed or saved, this follows:
Y=C+S
Dividing by Y on both sides
Y = C+ S
Y Y
Y=C+S
Y Y+Y
1 = APC + APS

Since an additional income is used either in additional consumption or in

additional saving, this follows that:
ΔY = ΔC + ΔS
Dividing by ΔY on both sided
ΔY = ΔC + ΔS
ΔY ΔY
1 = ΔC + ΔS
ΔY + ΔY
1 = MPC + MPS
 7

The relationship between consumption function and saving function can be

shown diagrammatically in the following way:

Y AS (Y)

Consumption
C

G
a

O Y1 Y0 Y2 Income X
Y
Savings

O Y1 Y0 Y2 Income X
-a
We have taken consumption function in the upper panel and the desired
saving function has been derived from the consumption function. The difference
between 450 income line (Y) and consumption line (C) represents saving (S).
When income is zero, consumption is equal to intercept “a”. Hence, negative
saving corresponding to zero level of income is “-a”. The relationship between
consumption and saving are as follows:
(i) When income level is smaller than OY0, (say OY1), consumption
expenditure exceeds the income level and therefore saving is negative.
(ii) Beyond OY0 level of income, (say OY2), consumption expenditure is smaller
than income and therefore saving is positive.
(iii) Corresponding to OY0 level of income, the consumption line intersects the
450 income line. At this level of income, the consumption expenditure is
exactly equal to income. Therefore, saving at this level of income is zero.

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Properties of saving function

Y AS (Y)

Consumption
C

a
O X
Y Y1 Y0 Y2 Income
Saving

Y1 Y0 Y2 Income X
-a

As the consumption function is linear, the saving function is also linear.

Hence saving line is shown by S line. The slope of the S line indicates a constant
marginal propensity to save. It is important to note the following three properties
of saving function:
(i) The saving line S slopes upward indicating that the higher income level
leads to higher amount of saving. At lower levels of income saving is
negative and at higher levels of income saving is positive. However, at
break-even level of income G, saving is zero (since C=Y).
(ii) The slope of S line indicates marginal propensity to save. It is clear from
saving line S that its slope is positive but less than 1. (450 line has a slope
of 1). This means that MPS is greater than zero but less than one at all
levels of income.
0 <MPS <1
(iii) The third property of the saving function is that the proportion of income
saved, i.e. APS increases with increase in income. This is so because,
consumption increases at a smaller rate than increase in income.

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 9

Investment function
In the modern macro-economic analysis, investment is taken in the sense
of real investment. In this sense, investment refers to that part of the aggregate
output which takes the form of new plant, new capital equipment and machinery,
new structures such as factories and office building and addition to business
inventories. Investment is measured by the amount of total expenditure incurred
on these items.
Private and Public investment
Private investment refers to the expenditure incurred by the private
entrepreneurs on the purchase of capital goods like plants, machineries,
buildings, inventories etc. The sole movie of such investment is profit earning.
Public investment, on the other hand, is the investment undertaken by the
government. It may be in the form of projects like roads, dams, schools, water
supply, housing etc. Such investment is largely motivated by public welfare.
Autonomous and induced investment
Autonomous investment is that type of investment which is not affected
by the change in the level of income or output. It is, therefore, income-inelastic.
However, it may change due to factors other than income like innovation of new
techniques of production, increase in public expenditure etc.
Y
Investment

O Y1 Y2 Income X
Induced investment, on the other hand, is that type of investment which
is undertaken as a result of change in the level of income. An increase in level
of income leads to increase in demand for consumer goods. This, in turn, lead
to increase in investment so as to increase in the production of consumer goods.
Hence, induced investment is income-elastic.
Y
I
Investment

O Y1 Y2 Income X
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Determination of Equilibrium Income and output

As stated early, to simplify our analysis, we assume a simple two-sector
economy consisting of the household sector and the business sector. All the
decisions concerning consumption expenditure are taken by the household
sector while the business firms take decisions regarding investment. There are
two approaches to determine the equilibrium level of income:
1. Aggregate Demand – Aggregate Supply Approach
2. Saving – Investment Approach.

Aggregate Demand – Aggregate Supply Approach

The equilibrium level of income and output in the economy is one where
the aggregate demand for goods and services is equal to the aggregate supply.
The aggregate demand curve is represented by (C + I) curve. It is derived by
taking the vertical summation of C-line and the I-line. Aggregate supply is shown
as the 450 line which is equal to the value of national income.
AS (Y)
Y AD
AD (C + I)

E C

O Y1 Y0 Y2 Y/O/E X
The equilibrium level of income is at point E corresponding to the point of
intersection of AD curve and AS curve. Let us see what happens if the economy
is at some other level of income:
For instance, if we suppose that the economy is operating at OY 1. At this
output, aggregate demand is greater than aggregate supply. Thus, the planned
expenditure is greater than production. Therefore, firms will have to draw down
their inventories in order to meet higher level of sales. As a result of increase in
production, income level rises. This rise in income continues until it reaches OY0.
Similarly, if we suppose that the economy is operating at OY2. At this level,
the planned expenditure is less than aggregate supply. This means that the firms
are able to sell a lesser amount than they are producing. This unplanned rise in
inventories induces firms to reduce production and thereby income. The fall in
income continues till the equilibrium level OY0.
 11

Saving – investment approach

An alternative approach to income and output determination is saving and
investment approach. In an economy, the level of income where AD=AS is same
as the level of income where S=I.
AD = AS
C+I=C+S
S=I
This relationship can also be seen from the following schedule

Income Planned Planned Planned AD AS

Consumption Savings Investment

200 250 -50 50 300 200

300 300 0 50 350 300
400 350 50 50 400 400
500 400 100 50 450 500
600 450 150 50 500 600
Y AS (Y)
AE (C+I)
E
AD & AS

a I

O Y1 Y0 Y2 Y/O/E X
Y
S&I

E I

Y1 Y0 Y2 X
-a Y/O/E
The economy is in equilibrium at point E corresponding to OY0 level of
income where AD=AS which is shown in the upper panel. The lower panel shows
that at the same level of income saving is equal to investment.
 12

Let us now see what happens if the economy functions at a level of income
other than OY0.
If we suppose that the economy is operating at OY1 level of income. At this
level of income, saving is less than the planned investment. Lower saving
denotes a higher consumption expenditure. Thus, consumption expenditure
exceeds planned investment which means that AD exceeds AS. Therefore, firms
will like to expand production and hire more workers to build up their inventories.
Thus, level of output will rise. This process will continue until output increases
to OY0 where saving equals planned investment.
On the other hand, if we suppose that the economy is operating at OY 2
level of income, it is clear that saving exceeds planned investment. Higher saving
denotes lower consumption expenditure which, in turn, means that planes
investment is in excess of consumption expenditure, i.e. AS exceeds AD. There
will be excess production due to which stocks will pile up with the producers.
The firms will cut down production and lay off workers. AS a result, level of
income and output will decrease. The process will continue till the income
decreases to the equilibrium level OY0.
INVESTMENT MULTIPLIER
The investment multiplier is defined as the amount by which income
increases as a result of increase in investment expenditure. The multiplier is the
ratio of the change in income to the change in investment.
K = ΔY
ΔI
For instance, if an increase in investment by Rs 100 crore lead increase in
income by Rs 500 crore, the multiplier is 5 [500/100].

Relationship between multiplier, mpc and mps

In an economy, multiplier is directly proportional to MPC and it is inversely
proportional to MPS. Mathematically, Multiplier K = 1 OR 1
1-MPC MPS
K = ΔY ……… (I)
ΔI
Y=C+S
At equilibrium; S=I
Y=C+I
ΔY = ΔC + ΔI
ΔI= ΔY – ΔC……… (II)

Substituting the value of ΔI in equation (I)

K = ΔY
ΔY – ΔC
Dividing numerator and denominator by ΔY
K= ΔY/ ΔY
ΔY- ΔC/ ΔY MPC + MPS = 1
K= 1 = 1 K= 1
ΔY – ΔC 1 - MPC MPS
ΔY ΔY
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Working mechanism (process)

Investment multiplier measures the ratio of change in income to change
in investment. A small change in investment in the economy brings about a
comparatively larger change in income. Let us illustrate the working mechanism
of multiplier with a numerical example:
Let us suppose that a company, say Reliance Industries Limited
undertakes an investment of Rs 100 crore. This will create demand for factor
services such as machinery, materials, labour etc. This will generate income for
all those people who are associated with setting up of this plant. Therefore, in
the first round, national income will increase by an amount equal to the amount
of investment i.e. Rs 100 crore.
People who receive this new income directly from setting up of new plant
will spend some part of the income on consumer goods such as food, clothing,
medicine etc. The exact amount of consumption expenditure, however, depends
upon MPC. Suppose MPC is 0.8. Therefore, consumption expenditure in the
second round would rise by 0.8 × 100 = Rs 80 crore. (ΔC = MPC × ΔY).
The expenditure of the people in the second round will become new income
for those people or firms who are fulfilling the demand of the people of the
second round. Thus, income generated in the third round is equal to the
expenditure incurred by the people in the second round i.e. Rs 80 crore. This
increased income of 80 crore will further be spent on consumption which will
amount to Rs 64 crore i.e. (0.8 × 80 crore).
This will generate income of the amount equal to the consumption
expenditure of the third round and this process will continue to be repeated in
the subsequent rounds. Ultimately, a point will be reached when income rises
by an amount which is some definite multiple of initial increase in investment.
In our example, income will rise by Rs 500 crore. The reason behind this rise in
explained below:
Round of Increase in Increase in Increase in
spending Investment Consumption Income
(ΔI) (ΔC) (ΔY)
1 100 - 100
2 0.8 × 100 = 80 80
3 0.8 × 80 = 64 64
4 0.8 × 64 = 51.2 51.2

100 400 crore 500 crore

K= 1 = 1 = 1 =5
1 – MPC 1 – 0.8 0.2
K = ΔY ΔY = ΔI × K = 100 × 5 = Rs 500 crore.
ΔI
ΔC = ΔY × MPC = 500 × 0.8 = Rs 400 crore.
 14

Graphical representation of multiplier

Investment multiplier can also be explained with the help of a diagram. In
the following diagram, income is shown along x – axis while desired aggregate
expenditure is shown along Y – axis. The initial equilibrium is E0, where AE0 cuts
the 450 Y line. The equilibrium level of income corresponding to this point is OY 0.
Y
AS (Y)
AE1
AD E1 AE0
&
E0 M
AS ΔI N

O Y0 Y1 Income X
An increase in autonomous expenditure shifts the desired spending
function from AE0 to AE1.This means that the desired spending is more than
before. Therefore, income will increase. The new equilibrium shifts to E 1, where
the AE1 curve intersects the 450 line corresponding to the new income level OY1.
Thus, as a result of an increase in investment by ΔI i.e. by E1M, the level
of income rises from OY0 to OY1. It is clear from points E0 and E1 that income
rises from E0Y0 to E1Y1, i.e, by E1N. Therefore, Y0Y1 is same as E1N. As increase
in income is greater than increase in investment, the multiplier is greater than
unity.
Thus; K =
ΔY = E1N
>1
ΔI E1M
This shows that a given autonomous change in investment will lead to a
change in income which exceeds the change in investment.

The concept of full employment

Full employment may be defined as the situation when all those persons
who are willing to work at the prevailing wage are getting work and are in fact
employed.
Full employment does not mean that everyone is employed. People who
are voluntarily unemployed, such as idle rich are not employed because they are
not will to work. They are not treated as unemployed.
Secondly, at any given time, there might be some amount of frictional
employment owing to technological improvements, decrease in demand or some
persons changing jobs. Therefore, they may remain temporarily unemployed.
Experience of developed economies indicate that 3 to 4 % of labour force is
frictionally employed.
 15

Therefore, full employment is said to exist in an economy even if there

prevails frictional unemployment provided only 3 to 4% of labour force are
unemployed at a given time. However, if the number exceeds this mark, full
employment does not prevail.
Voluntary Unemployment
Voluntary unemployment refers to those persons who are unemployed by
their choice. They may not work due to laziness or otherwise they are not
interested in any gainful job.
In this category, we may include both the idle rich and idle poor. Similarly,
there may be some anti-social people like thieves or pickpockets who may be
voluntary unemployed.
Involuntary Unemployment
Involuntary unemployment refers to a situation when people are willing to
work at a prevailing wage rate but are unable to find work. It refers to all those
able-bodied persons who have the ability to work at the prevailing wage rate but
are not able to find work which may yield them some regular income.
THE PROBLEM OF EXCESS DEMAND
The difference between aggregate demand and aggregate supply at full
employment level of income is known as excess demand.
Let us suppose that the economy is in equilibrium at E corresponding to
the full employment level of income where initial aggregate expenditure AE0 is
equal to aggregate supply AS.
Y AS (Y)
AE1
A AE0
AE & AS

450
O Yf Income X
Now, suppose that aggregate demand curve shifts upward to AE1, due to,
say, increase in government expenditure. The output will not rise since the
economy is at full employment level of output and there will emerge excess
demand in the economy. This excess demand will push up price level and cause
inflation. Therefore, the gap between the desired aggregate demand and the
actual aggregate demand i.e. AE is also termed as inflationary gap.

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 16

THE PROBLEM OF DEFICIENT DEMAND

Deficient demand is defined as the amount by which aggregate
expenditure falls short of the aggregate supply at full employment level. This
can be explained with the help of the diagram:
Y AS (Y)
AE0

AE & AS E AE1
A
E1

O Y1 Yf Income X
The aggregate expenditure curve AE0 intersects the 450 line at E, which
gives us the equilibrium income OYf. This is the full employment level of income.
Now, suppose that the government expenditure falls, as a result of which the
new aggregate expenditure curve becomes AE1. The deficient demand at the
level of full employment is EA. This situation of deficient demand will lead to a
fall in income to OY1 causing unemployment in the economy. This will lead to a
decrease in the general price level causing deflation. Therefore, the gap between
the desired aggregate demand and the actual aggregate demand i.e. AE is also
termed as deflationary gap.
Measures to correct excess demand and
Deficient demand
The government can use the instruments of fiscal and monetary policies
to correct the situation of excess demand. The fiscal policy includes the
instruments of public expenditure, taxation and public borrowing. The monetary
policy, on the other hand, consists of various quantitative methods which can
control the situation of instability in the economy. These measures are discussed
below:
Fiscal measures
1. Public Expenditure:
During inflation, the government must reduce public spending. This will
reduce the creation of new income in the economy which, in turn, will reduce
excess demand for goods and services.
On the other hand, during deflation, public spending must be increased
particularly in social and economic overheads. This will lead to the creation of
income in the economy as a result of which demand for goods and services in
the economy will rise.
2. Taxation: Increase in direct taxes or introduction of new tax rates may
prove to be anti-inflationary as it will reduce the disposable income of the tax-
payers, thereby reducing their demand.
 17

Similarly, tax rates must be liberalised or subsidies must be provided

during deflation so as to induce potential consumers and producers to consume
or invest more.
3. Public Borrowing: The government may increase the rate of public
borrowings to reduce the amount of purchasing power and thereby total demand
in the economy.
It may, however, decrease the rate of such borrowings or redeem its debts
so as to increase the purchasing power of the economy which will eventually
result in increase in demand.
Monetary measures
a) Bank Rate: The bank rate or the discount rate is the rate at which the
central bank rediscounts first class bills of exchange and government securities
held by commercial banks.
Increase in bank rate would lead to a corresponding increase in the rate
of interest charged by the commercial banks from their customers. This will lead
to contraction on credit which reduces pressure on the price rise.
It is, therefore, advisable to increase bank rate during inflation and
decrease it during deflation.
b) Cash Reserve Ratio: It refers to that percentage of total deposits of
commercial bank which it has to keep with the RBI in the form of cash reserves.
An increase in CRR means that commercial banks are required to keep
more cash with the central bank. Therefore, the commercial banks would be able
to create a smaller amount of credit.
Therefore, CRR must be raised to control the problem of inflation and it
must be reduced to tackle the problems of deflation.
c) Statutory Liquidity Ratio: It refers to that portion of total deposits of a
commercial bank which it keeps with itself in the form of cash reserves, gold and
government securities.
An increase in SLR means that commercial banks are required to keep
more cash with itself. Therefore, the commercial banks would be able to create
a smaller amount of credit.
Therefore, SLR must be raised to control the problem of inflation and it
must be reduced to tackle the problems of deflation.
d) Open Market Operations: Open market operations refer to the sale and
purchase of government and other approved securities by the central bank in
the money and capital markets.
During boom when the economy faces the inflationary pressure, the
central bank would like the commercial banks to reduce the amount of credit. In
this situation, the central bank sells the government and other approved
securities in the money and capital markets. Buyers of these securities pay
central bank by drawing on their cash deposits in the banks. This reduces the
power of commercial banks create credit.
Similarly, when the central bank aims at an expansion of credit during the period
of recession, it pursues the policy of purchase of securities from the commercial
banks and other components of money and capital markets.
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 18

“Test your brain”

1. What will be the value of APS if APC = 0.75?
2. If MPC is 1, how much will be MPS?
3. Complete the following table:
Income Saving MPC APS
0 -12 - -
20 -6 - -
40 0 - -
60 6 - -

4. Complete the following table:

Income Saving MPS APC
0 15 - -
50 50 - -
100 85 - -
150 120 - -

5. Given; National income = 1,000

Autonomous Consumption = 200
MPC = 0.5
Find the value of consumption.
6. Given; National income = 1,000
Autonomous Consumption = 200
MPS = 0.4
Find the value of saving.
7. Given C = 400 + 0.9 Y and I = 4000. Find equilibrium Y, S and C at
equilibrium.
8. In an economy, MPC = 0.75. What will be the effect on total income if
investment increases by Rs 300 crore?
9. If in an economy, MPC = 0.8, investment increases by 1000 crore,
calculate the total increase in income.
10. Find the value of MPC and MPS if an additional investment of Rs 100 crore
generated an additional income of Rs 500 crore.
11. Find the value of Multiplier when MPC = MPS.
12. In an economy, 75% of increase in income is spent on consumption. If
investment increases by 1000 crore, calculate the change in income.
13. Differentiate between MPC and MPS
14. Differentiate between APC and APS.

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 19

Chapter – 2
Money: meaning and functions
Meaning of money
According to Kent, “money is anything which is commonly used and
generally accepted as a medium of exchange or as a standard of value.”
According to Crowther, “anything that is generally acceptable as a means
of exchange i.e. as a means of settling debts and, at the same time, acts as a
measure and store of value.”
Kinds of money
1. Deposit Money: It refers to those currencies and coins which are deposited
by the individuals in the bank, payable on demand and on the basis of which
cheques can be drawn. These are also known as bank money.
2. Token Money: It is the money the face value of which is higher than its
intrinsic/metallic value. For example, coins of the value of Re 1, 5, 10 etc.
3. Convertible money: It refers to those bank notes or promissory notes
which could be exchanged for gold or silver coins on demand. This system was
practised before the evolution of money.
4. Inconvertible money: Inconvertible paper money is the final stage of
evolution of bank notes. These notes are inconvertible in the sense that there is
no compulsion from the central bank to exchange it for gold.
5. Fiat Money: Money is known as fiat money as it has been declared a legal
tender by the government. It acts as money because people have confidence in
it as it is issued on the order (fiat) of the government.
6. Legal Tender: Coins and currency notes are often termed as legal tender
because they have the backing of the government. They serve as money on the
order of the government. Being legal tender, an individual is bound to accept it
in exchange of goods and services, i.e. it cannot be refused in settlement of
payments of any kind.
7. Limited Legal Tender: It is the money which is accepted as legal tender
only up to a certain maximum amount. IT cannot be forced upon the people
beyond that limit. In India, coins of small denominations, such as 5, 10, 20 paise
coins are legal tender only upto Rs 25.
8. Unlimited Legal Tender: It is the money which a person has to accept
without any maximum limit. In India, currency notes of all denomination and
coins of 50 paise and higher denominations are unlimited legal tender.
9. Optional money: It is that form of money which is generally accepted but
legally, it cannot be forced upon anyone. For example, cheques, bank drafts,
bills of exchange, etc. do not have legal backing and their acceptance is totally
optional. It is, therefore, a non-legal tender.
 20

Functions of money
Money performs several important functions. Prof. Kinley has classified the
functions of money into three groups. They are discussed below:
1. Primary Functions: These are the fundamental and essential functions of
money. These functions must be performed by money in every economy under
all circumstances. These functions are as follows:
a) Medium of Exchange: Money commands general purchasing power to
purchase goods and services which people want. It is generally and widely
accepted as the medium through which most of the purchases and sales are
made. Thus, money has promoted efficiency in exchange and production of
goods and services.
b) Measure of Value: Just as we use kilogram in measuring weight of a
commodity, similarly for measuring the value of a commodity, we take money
as a unit of account. Since the values of all commodities are expressed in terms
of money, it becomes easy to determine the rate of exchange between them.
For example, if the price of a trouser is Rs 1000 and the price of a shirt is Rs
500, then the rate of exchange between a trouser and a shirt is one trouser is
equal to two shirts.
2. Secondary Functions: These functions of money are derived from the
primary functions of money. These are explained below:
a) Standard of Deferred Payments: Acting as s standard of deferred
payment means that a payment to be made in future can be stated in money
terms. For example, interest, rent, insurance premium etc. which involve future
payments are expressed in money terms. Money is used as a medium of
exchange but the payment is spread over a period of time.
b) Store of Value: Store of value means that people can keep their wealth
in the form of money. Money is a perfectly liquid asset and it is readily and
generally acceptable means of payment. Money allows us to store purchasing
power which can be used at any time in future to purchase goods and services
including other assets.
c) Transfer of Value: This function arises from the general acceptability
function of money as a medium of exchange. Money helps us to transfer value
from one person to another or one place to another. We can sell a house in Delhi
in exchange of money and can use the same money in buying a house in Kolkata.
3. Contingent Functions: It explain the role of money in assisting various
economic entities such as consumers, producers etc. in arriving at various
economic decisions. These functions are discussed below:
a) Maximisation of Utility: A rational consumer wants to maximise utility
while purchasing various goods and services. In order to purchase these goods
and services, a consumer must pay a price for them and prices of all commodities
are expressed in money terms.
b) Employment of Factor Inputs: A profit-maximising producer will be in
equilibrium when the marginal productivity of a factor is equal to the rate of
 21

remuneration paid for that factor. These rates are expressed in money terms
which helps a producer in arriving at decisions with regard to the units of a factor
of production to be employed.
c) Distribution of National Income: Production is the outcome of
combination and collective efforts of various factors of production. Contribution
of these factors of production to the production of goods and services is
rewarded not in terms of goods and services but in money terms.
d) Basis of Credit System: In the modern times, commercial and business
activities are highly dependent upon the credit system. It is money which
provides the basis of the entire credit system. Without the existence of money,
important credit instruments like cheques, bills of exchange, etc. cannot be
used.
Money is a matter of functions four –
A medium, a measure, a standard, a store.

Supply of money
Money supply refers to the stock of money at a point of time held by the
public as a means of payments and store of value. The term public refers here
to all economic units including private individuals, business firms and
institutions. It does not include the producers of money i.e. the central bank,
the government and the commercial banks. Money supply is a stock concept and
therefore is measured at a point of time such as money in circulation in India on
1st December, 2017. Total money supply in a country consists two important
components namely:
1. Currency: It includes both paper currency and coins issued by the
government and the central bank of the country.
2. Deposit Money: It refers to the demand deposits held by the public with
commercial banks on the basis of which cheques can be drawn.
Narrow money (M1)
The narrow definition of money supply is based upon the high liquidity of
money. It includes the most liquid assets in its definition of money supply. Thus,
narrow definition is made up of currency of the public and demand deposits with
commercial banks.
M1 = C + DD
Broad money (m3)
It includes in its definition, those forms of assets which are readily
available in the form of liquid assets. Therefore, it not only includes the narrow
definition but also considers time deposits (including saving deposits) in its
definition. Thus, broad money supply includes currency with the public, demand
deposits and time deposits with commercial banks.
M3 = C + DD + TD
 22

RBI measures of money supply

M1 = Currency with public + Demand deposits with the banking systems + Other
deposits with RBI.
M2 = M1 + Savings deposits of post office savings banks,
M3 = M1 + Time deposits with the banking system.
M4 = M3 + All deposits with post office savings banks (excluding national savings
certificates).
High powered money
The term high powered money or monetary base is a term related to the
money supply or the amount of money in the economy. It consists of coins,
paper money, (with both public and commercial banks) and reserves of
commercial banks with the Central bank.
M0 = Currency in circulation + Bankers deposits with RBI
+ Other deposits with RBI.

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 23

Chapter – 3: Commercial banks &

central bank
A Bank is an institution that accepts deposits of money from the public,
withdrawable by cheque or otherwise and uses the money so collected for
lending to the households, the firms and the government.
There are three features that a financial institution must fulfil to be termed
as bank. These features are as follows:
1. The essential function of a bank is that it accepts chequeable deposits from
the public. These deposits are repayable on demand and withdrawable by
cheques or otherwise.
2. The second essential function of a bank is that the bank uses these
deposits for lending to others and undertaking investment in securities.
3. Creation of money is a unique characteristic of commercial banks. Banks
have the power to create and destroy money through their lending activities.
Post office savings banks are not regarded as bank even though some of
them accept chequeable deposits from the public. This is because they do not
perform the other essential functions of a bank namely lending to others and
creating money. Similarly, LIC, UTI, mutual funds etc. are all financial
institutions but they are not banks because they do not have the power of
creating money.
Therefore, every bank is a financial institution but every financial
institution is not bank.
Functions of commercial banks
1. Acceptance of Deposits: The most important function of a
commercial bank is to accept deposits from the public. People who have surplus
funds would like to deposit these with commercial banks for their safe custody.
Banks accept deposits in the following ways:
(a) Current Account: It is an account which is maintained by businessmen
or traders. Deposits in current account are payable on demand due to which
they are also known as demand deposits. Money from these deposits can be
withdrawn by cheques without any restrictions on the amount or number of
withdrawals made. Banks provide various services to the current account holders
such as making payments through cheques, issuing drafts on behalf of the
customers, providing overdraft facility, etc. Banks do not allow any interest on
such accounts. In fact, bank impose service charges on the customers for
rendering these services.
(b) Savings Bank Account: These accounts are generally maintained by
households who have idle cash for a short period. These deposits are payable on
demand and money is withdrawable by cheques. However, there are certain
restrictions imposed on the depositors of this account with regard to the amount
and the number of withdrawals made due to which savings bank accounts do
not qualify as demand deposits. Banks provide a nominal rate of interest on
these accounts.
 24

(c) Fixed Deposits: It is a form of deposit in which money is deposited for a

fixed period of time, say 6 months, one year or five years etc. These deposits
are not payable on demand. They do not enjoy cheque facilities. They are also
known as time deposits since the money deposited in them cannot be withdrawn
before the maturity of the period for the deposit is made. In practice, however,
banks allow the depositors to withdraw funds before the maturity period after
charging a certain amount as compensation. Interests on these deposits are
higher than savings bank deposits.
(d) Recurring deposits: These are one type of fixed deposits. In this form,
the depositors are not required to deposit a lump-sum amount. Rather, the
depositors make regular deposits of a given sum for a specified period. Such
deposits are designed to motivate small saver to save a particular amount
regularly.
2. Advancing of loans: Lending is the most profitable business of
banks. Banks charge interest from the borrowers which is higher than the
interest which they pay to their depositors. They make profits out of these
transactions. Banks extend loans and advances to their customers in the
following ways:
(a) Outright Loans: Banks provide outright loans or term loans for a fixed
period. In this case, the entire amount of loan sanctioned is credited to the
current account of the borrower. The borrower pays interest on the entire
amount he has borrowed from the bank.
(b) Cash Credit: In this case, the entire sanctioned amount of loan by the
bank is not given to the borrower at a particular time. The bank opens an account
in the name of the borrower and allows him to withdraw the borrowed amount
as and when he requires the money. The bank charges interest on the amount
actually withdrawn and not on the amount of loan sanctioned.
(c) Overdraft facilities: When a customer gets an overdraft facility from the
bank, this means that he is allowed to draw cheques in excess of the balance
standing to his credit to the extent of the amount of overdraft. This facility is
available only to the current account holders. The bank charges interest only on
the amount overdrawn.
(d) Discounting Bill of Exchange: A bill of exchange is drawn by a creditor
on the debtor specifying the amount of debt and also the date when it becomes
payable (usually 90 days). If the creditor needs money before the expiry of this
90 days period, he can get it discounted from a commercial bank. When the bill
matures, the bank will get payment from the debtor. This makes a bill of
exchange one form of bank lending.
3. Facilitation of payments through cheques: Banks
have provided a very convenient system of payment in the form of cheques. The
cheque is the principal method of payment in business in recent times. It is
convenient, cheap and safe means of making payments.
4. Transfer of funds: Banks help in the remittance or transfer of
funds from one place to another through the use of various credit instruments
like cheques, drafts, mail transfers and telegraphic transfers.
 25

5. Agency functions: Banks provide various agency functions for

their customers. The banks charge commission or service charge for such
functions. The main agency functions are as follows:
(a) The commercial banks collect cheques, drafts, bills and other financial
instruments on behalf of their customers.
(b) They make and collect various types of payments such as insurance
premium, dividend, pension, interest etc. on behalf of their customers.
(c) They act as agents for their customers in the sale and purchase of
securities.
(d) They provide investment services to the companies by acting as
underwriters and bankers for new issue of securities to the public.
(e) They render agency services of various types such as buying and selling
foreign currency, national savings certificates and units of UTI on behalf of
their customers.
(f) Commercial banks act as trustees and executors by keeping the wills of
their customers and executing them after their death.
6. Miscellaneous services: Commercial banks provide various
miscellaneous services such as provision of locker facilities for safe custody of
jewellery and other valuables. They issue travellers cheques, gift cheques etc.
They also provide provision of tax assistance and investment advice etc.
7. Credit creation: A unique function of commercial banks is that
they have the power of credit creation. In the process of accepting deposits and
granting of loans, commercial banks are able to create credit. This means that
they are able to grant more loans than the amount of initial deposits made by
the customers.

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 26

Credit creation by commercial banks

Commercial banks perform a very unique function of credit creation. It is
the process wherein commercial banks are able to grant more loans than the
amount of initial or primary deposits by the customers. Banks can create money
by creating bank deposits and they can reduce money by reducing bank
deposits. There are two forms of deposits:
1. Primary Deposits: When customers deposit currency or cash with
commercial banks, such deposits are known as primary deposits. These deposits
transforms currency money into deposit money and there is no change in the
volume of money supply in the economy.
2. Derivative Deposits: It is the form of deposit created by commercial banks
when they grant loans, discount bills of exchange, provide overdraft facilities
and make investments through purchase of bonds and securities. These deposits
increase the volume of money supply in the economy.
Assumptions:
(i) We assume that CRR is 20% and SLR is nil for simple presentation.
(ii) One particular bank receives a primary deposits of Rs 1000.
(iii) We take a real world situation of multiple banking system
(iv) The amount of loan drawn by a customer of one bank is transferred in
full to the second bank and so on.
Explanation:
Suppose a customer makes a primary deposit of Rs 1000 in a particular
bank, say Bank A. The initial balance sheet of this bank would appear as follows:
Initial Balance Sheet (Bank A)
Liabilities Amount Assets Amount
Deposits 1000 Cash reserves 1000

Total 1000 Total 1000

The Bank is required to keep cash reserve of 20% and the balance issued
for advancing loans. Bank A keeps 20% i.e Rs 200 as reserves and advances a
loan of Rs 800 to X ltd. who uses this loan in purchasing goods from Y ltd. who
has an account with Bank B. The final balance sheet of Bank A will appear as
follows:
Final Balance Sheet (Bank A)
Liabilities Amount Assets Amount
Deposits 1000 Cash reserves 200
Loans 800
Total 1000 Total 1000
Now, Bank B gets a deposit of Rs 800. The initial balance sheet of Bank B
would appear in the following manner:
 27

Initial Balance Sheet (Bank B)

Liabilities Amount Assets Amount
Deposits 800 Cash reserves 800

Total 800 Total 800

Bank B is also obliged to keep a cash reserve of 20%, i.e. Rs 160 and the
balance of Rs 640 can be extended as loans. Suppose this amount is lent to Z
ltd. who uses this loan in making purchases from R ltd. by issuing cheque drawn
on Bank B. Suppose that R ltd. has an account with Bank C, Bank B will lose Rs
640 to Bank C. The final balance sheet of Bank C will appear as follows:
Final Balance Sheet (Bank B)

Liabilities Amount Assets Amount

Deposits 800 Cash reserves 160
Loans 640
Total 800 Total 800

In the same way, Bank C which has a deposit of Rs 640 can extend loans
amounting to Rs 512 after keeping aside a reserve of Rs 128 (20% of Rs 640).
Thus, an initial deposit of Rs 1000 has results in the creation of deposits by three
banks amounting to Rs 1000 + 800 + 640 + 512 = Rs 2952 and the process is
still going on. This process will come to an end when the deposit received by a
particular bank is too small to generate any fresh loan and all the banks have
used the excess cash reserves in extending loans.
The amount of credit creation by the banking system as a whole can be
worked out by the following formula:
Deposit Multiplier = 1 × ΔD
RR

i.e. 1 × 1000
20%
i.e. Rs 5000

Where;
RR = Reserve Ratio
ΔD = Initial Deposits

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 28

Limitations of credit creation

1. Total Amount of Cash Reserve: Larger the cash reserves available in the
economy, larger will be the credit created by commercial banks and vice-versa.
The total availability of cash in the economy will determine the amount of cash
with the public, which, in turn, determines the primary deposits made by the
public with commercial banks. The power of credit creation of the commercial
banks is limited by the primary deposits with them.
2. Ratio of Cash Reserves to Deposits: Bank`s power to create credit is
determined by the amount of cash reserves that the banks maintain. The smaller
is the amount of cash reserves, more will be the power of the banks to create
credit, and vice-versa.
3. Banking Habits of the People: If people are in the habits of using cheques,
drafts, bills, etc. in their business and other transactions, banks need to keep a
smaller amount of cash reserves and therefore, their power to create credit will
be more. However, if people use more of currency in making payments, the
banks will be required to keep large cash reserves which will reduce their power
to create credit.
4. Nature of Securities offered: Banks provide loans to its customers on the
basis of some kind of collateral security which may be in the form of shares,
stocks, building and other properties. Is proper securities are not available with
the public, banks cannot create credit. As, Crowther puts it, “the bank does not
create money out of thin air, it transmutes other forms of wealth into money.”
5. Business Conditions: During the periods of business prosperity,
investment climate is rosy and businessmen will like to undertake more
investment by taking more loans and advances from the banks. This will expand
credit. On the other hand, during depression, business activity is at low level
and investment is infavourable due to which the demand for loans and advances
falls leading to a fall in credit creation.
6. Monetay Policy of Central Bank: The central bank of a country has the
absolute power of controlling the volume of credit in the country. The central
bank can influence the amount of cash reserves with commercial banks by
employing various measures of credit control such as bank rate, open market
operations, statutory reserve ratio, etc.
Central bank
A Central Bank is the apex institution in the banking and financial structure
of the country. It plays a leading role in organising, running, supervising,
regulating and developing the banking and financial structure of the economy.
The Central Bank in India was established as the Reserve Bank of India on 1 st
April, 1935.
Central bank VS commercial banks
1. A central bank is not a profit-making institution like a commercial bank. It
acts in the public interest so as to control and regulate the banking and financial
system of the country.
2. A central bank does not perform ordinary commercial banking functions
such as accepting deposits from the general public of the country.
 29

3. A central bank is an organ of the government which is controlled by the

government or its officials. A commercial bank is generally owned by private
individuals as shareholders and in some cases, may be owned by the
government.
4. Every country has one central bank with a few offices. While, there are a
number of commercial banks in every country with a large number of branches
all over the country.
5. The central bank has a monopoly over issuing new currencies and coins.
Commercial banks have no such authority.
6. Central bank is the banker to the government and adviser to the
government while commercial banks is the banker and financial adviser to the
general public.

Functions of Central bank

1. Bank of Issue: As a bank of issue, central bank enjoys the monopoly of

note issue. Currency notes and coins issued by the central bank are the legal
tender. However, the central bank is required to keep a certain amount of gold
and foreign securities against the issue of notes.
Concentration of exclusive power of note issue with the central bank has
the following advantages:
(a) It brings uniformity in note issue as a result of which these notes are widely
accepted as a medium of exchange.
(b) It imparts a distinctive prestige to the notes due to which people develop
faith in the currency.
(c) It enables the central bank to have effective control on the bank money
created by the commercial banks.
(d) It allows the government to have supervision and control over the supply
of money in the economy.
2. Banker, Fiscal Agent and Adviser to the Government: As a banker to
the government, the central bank receives deposits of cash, cheques, drafts,
etc. from the government. It provides cash to the government for paying salaries
and other cash disbursements. It makes payment on behalf of the government.
It gives short-period loans to the government. It buys and sells foreign
currencies on behalf of the government.
As fiscal agent, it manages public debt. It issues new loan on behalf of the
government, receives subscriptions to these loans, pays interest on them and
finally repays these loans. It also acts as government’s agent in enforcing foreign
exchange control.
As adviser, the central bank advises the government on all financial and
monetary matters. It also advises in the formulation of the new economic
policies, such as those for the control of inflation or deflation, devaluation or
revaluation of currency, use of deficit financing, budgetary policy, etc.
 30

3. Banker to the Banks: The central bank has the same relationship with
the commercial banks as the commercial banks have with the general public. As
a banker to the banks, central bank performs the following functions:
(a) It acts the custodian of cash reserves of commercial and other banks.
(b) The central bank discounts bills of commercial banks.
(c) It provides them guidance and direction and regulates their activities.
(d) Commercial banks are under statutory obligation to keep a part of their
deposits as reserves with the central bank.
4. Custodian of Foreign Exchange Reserves: As the custodian of foreign
exchange reserves, the central bank performs several functions:
(a) The central bank controls both the receipts and payments of foreign
exchange as all foreign exchange transactions are routed through the
central bank.
(b) It tries to maintain stability in the exchange rate by buying or selling
foreign currency as the case may be.
(c) It enforces exchange control regulations prescribed by the government
from time to time.
5. Lender of the Last Resort: In its capacity as the lender of the last resort,
the central bank provides, directly or indirectly, all reasonable financial
assistance to commercial banks, discount houses, bill brokers and other financial
institutions. The central bank assists these institutions in times of financial crisis
through discounting of approved securities and collateral loans and advances.
6. Clearing House for Transfer and Settlement: Every day the customers
of different banks issue cheques drawn on their bank. This creates the needs of
settling claims of the commercial banks on each other. Since, the commercial
banks keep their cash reserves with the central bank, it is easier and convenient
to clear and settle claims on each other by making transfer entries in their
accounts maintained with the central bank. For transfer and settlement of
mutual claims, the central bank provides clearing house facility in big cities and
trade centres.
7. Controller of credit: In order to ensure the smooth functioning of the
economy, it is essential that the supply of money is regulated. For this purpose,
the central bank adopts quantitative and qualitative methods of credit control.
Quantitative methods aim at controlling the cost and availability of credit while
qualitative methods influence the use and direction of credit.
8. Promotional and Developmental Functions: The important
promotional and developmental functions performed by central bank are as
follows:
(a) It is entrusted with the responsibility of developing and promoting a strong
banking system. It provides liberal and cheap rediscounting facilities to
commercial banks and gives various types of concessions.
(b) Central bank performs various functions to promote economic
development of the country. It assists in the development of agriculture,
industry and other sectors of the economy. It also pursues appropriate
monetary policy to promote economic development.
 31

Credit control – regulatory role of the central bank

The central bank uses monetary policy for appropriate monetary
management. Monetary policy is the policy of the central bank to regulate the
availability, cost and use of money for achieving certain objectives of the
economic policy. Some of the objectives of monetary policy of the central bank
are price stability, attainment of full employment, balance of payments
equilibrium, growth with equity etc.
The central bank adopts two types of methods to control the credit creation
by commercial banks namely quantitative measures which are the traditional
methods of credit control and qualitative measures which are the selective
methods of credit control.

Quantitative methods
These methods aim at controlling the cost and quantity of credit by using
instruments such as bank rate, SLR, etc. These measures are discussed below:
1. Bank Rate: The bank rate or the discount rate is the rate at which the
central bank rediscounts first class bills of exchange and government securities
held by commercial banks.
Increase in bank rate would lead to a corresponding increase in the rate
of interest charged by the commercial banks from their customers. This will lead
to contraction on credit which reduces pressure on the price rise.
It is, therefore, advisable to increase bank rate during inflation and
decrease it during deflation.
2. Cash Reserve Ratio: It refers to that percentage of total deposits of
commercial bank which it has to keep with the RBI in the form of cash reserves.
An increase in CRR means that commercial banks are required to keep
more cash with the central bank. Therefore, the commercial banks would be able
to create a smaller amount of credit.
Therefore, CRR must be raised to control the problem of inflation and it
must be reduced to tackle the problems of deflation.
3. Statutory Liquidity Ratio: It refers to that portion of total deposits of a
commercial bank which it keeps with itself in the form of cash reserves, gold and
government securities.
An increase in SLR means that commercial banks are required to keep
more cash with itself. Therefore, the commercial banks would be able to create
a smaller amount of credit.
Therefore, SLR must be raised to control the problem of inflation and it
must be reduced to tackle the problems of deflation.
4. Open Market Operations: Open market operations refer to the sale and
purchase of government and other approved securities by the central bank in
the money and capital markets.
During boom when the economy faces the inflationary pressure, the
central bank would like the commercial banks to reduce the amount of credit. In
this situation, the central bank sells the government and other approved
securities in the money and capital markets. Buyers of these securities pay
central bank by drawing on their cash deposits in the banks. This reduces the
power of commercial banks create credit.
 32

Similarly, when the central bank aims at an expansion of credit during the
period of recession, it pursues the policy of purchase of securities from the
commercial banks and other components of money and capital markets.
5. Repo Rate and Reverse Repo Rate: In reality, the RBI has replaced
bank rate with repo rate as the monetary instrument to manage liquidity and
interest rate in the country. Repo rate is the rate of interest at which RBI lends
to banks for short periods against government bonds. This is done by RBI by
buying government bonds from banks with an agreement to sell them back at a
fixed rate. During inflation, repo rate will be increased by the RBI to contract
credit and vice-versa.
Reverse repo rate, on the other hand, is the rate of interest at which the
RBI borrows from different banks for short period. This is done by selling
government bonds to the banks.
Qualitative methods
These methods aim at regulating and controlling the allocation of credit among
various users rather than influencing the general availability of credit. Some of
these methods are discussed below:
1. Regulation of Consumer Credit: Hire-purchase finance is the method of
using bank credit by the consumers to buy expensive durable consumer goods
like motor cars, houses, computers, etc. A certain percentage of the price of the
durable goods is paid by the consumers as the cash-down payment and the
remaining portion is financed by the bank credit.
If the central bank wants that more of bank credit should be given to the
consumers (during recession), it may reduce the down payment and increase
the maximum period of repayment.
On the other hand, if the central bank desires to reduce the availability of
such credit, it raises the amount of down payment and reduces the maximum
period of repayment.
2. Regulation of marginal requirement: The difference between the value
of collateral security and the amount of loan granted is known as marginal
requirement. For example, if the central bank fixes a marginal requirement of
10% against the security of food-grains, the trader of food-grains can borrow Rs
9000 against the stock of food-grains worth Rs 10,000.
If the central bank wants to expand credit, it reduces the amount of
marginal requirement.
On the other hand, if it wants to curb the bank credit, it will raise the
marginal requirements.
3. Credit Rationing: The central bank may impose a limit on the commercial
banks in the following two ways:
(i) The central bank may fix the maximum amount of loans and advances for
every commercial bank
(ii) The central bank may fix the maximum ratio of loans and advances of a
commercial bank to its total assets.
Depending upon the exigencies, the central bank may increase or decrease
the ceiling of the bank credit through these two ways and thereby increase or
decrease the power of the commercial banks to create credit.
 33

4. Direct Action: It refers to various directives issued by the central bank

to commercial bank from time to time to regulate their lending and investment
activities. These direct actions may take the form of refusal of discounting
facilities, refusal of loans, charging of penal rate of interest etc.
5. Moral Suasion: It is the method of persuasion, request, informal
suggestion and advice to the commercial banks by the central bank. Central
bank convenes the meeting of the heads of the commercial banks and explains
to them the need for adoption of a particular monetary policy and appeals to
them follow this policy.
6. Publicity: The central bank expresses its views about various monetary
and banking policies by putting forward its views using facts and figures through
the media of publicity. This method is used to influence the public opinion in the
country.

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 34

Chapter – 4: balance of payments

& exchange rate
Definition
The balance of payments is a systematic record of all economic
transactions taking place between the residents of one country and the residents
of foreign countries during a given period of time. There are three important
things to note in this regard:
1. Balance of payments is a record of economic transactions only i.e. those
which involve a receipt or a payment such as flow of economic goods. Services
and the assets. However, there may be some economic flows without any
payment such as gifts from abroad.
2. Economic transactions reflected in the balance of payments are between
residents of one country and the residents of other countries.
3. Balance of payments is a flow concept. It always refers to a certain time
period, usually a calendar year.
Components of balance of payments
The items included in the balance of payments are called components of
balance of payments. Each transaction in the balance of payment is recorded on
the basis of receipts or payments that would arise from it. Any item that enables
a country to acquire foreign currency is recorded as a credit item and any item
that leads to the use or spending of foreign currency is recorded as a debit item
in the balance of payments.
The transactions in the balance of payments are generally categorised in
to the following two groups:
1. Current Account: The current account records transactions relating to
export and import of goods, services, unilateral transfers and international
incomes.
2. Capital Account: The capital account records all international economic
short-term and long-term capital transactions relating to changes in assets –
both physical and financial.
Components of Balance of payments
Credit Debit
Current A/c
1. Export of Goods 6. Imports of goods
2. Exports of services 7. Imports of services
3. Unilateral transfer receipts 8. Unilateral transfer payments
(Gifts, indemnities to foreigners.) (Gifts, indemnities from foreigners)
4. Income receipts 9. Income payments
Current A/c
5. Capital Receipts 10. Capital Payments
(Borrowings from, Sale of (Lending to, Purchase of foreign
Foreign Assets, Recovery of Assets, Repayment of Loans)
Loans)
 35

Current account transactions

The current account transactions are classified into four broad categories:
1. Export and Import of Goods: This category includes all types of physical
goods exported or imported. If an Indian exporter sells Indian goods abroad,
this appears as a credit item in the Indian balance of payments since this
exporter earns foreign currency. Similarly, imports of goods would appear on
the debit side since we pay for imports, foreign currency will be used. This
section describes visible trade because it comprises physical goods which are
tangible such as cars, sugar, cotton etc.
2. Invisible items: This section consists of those items which are not
tangible and cannot be seen. These invisibles are classified into the following
three categories:
(i) Services: It includes a large variety of non-factor services sold to and
purchased by the residents of a country from rest of the world such as tourism,
banking, shipping, insurance, telecommunication etc. Export or such services
appear under the credit head since they involve inflow foreign currency. In the
same way, payments which the residents of the country make to foreigners for
such services must be recorded under the debit head since foreign currency is
spent.
(ii) Unilateral Transfers: These are the receipts or payments which take
place without any service in return in the current period. For example, gifts,
scholarships, indemnities etc. There is no quid pro quo in return. The transfers
which a country receives from the foreign countries involve inflow of foreign
currency due to which such transfers appear under the credit head. On the other
hand, payments which the country in question makes to other countries appear
on the debit side.
(iii) Incomes: It consists of compensation of employees such as wages,
salaries etc. and investment income such as rent, interest, dividends, etc.
Incomes received by the residents of a country from the non-residents appear
under the credit head due to the inflow of foreign currency. Analogously,
payments for factor or capital services made by the residents of a country to
foreigners appear under the debit head.
Capital account transactions
Capital account transactions show change in stock magnitude. They refer
to the capital receipt and capital payments of both short-term and long-term
nature. Capital movements may be divided in several ways. The following
transactions will appear under the credit head as they involve inflow foreign
currencies into the country:
1. The government, corporations or individuals of the country in question
may take loans from government, corporations or individuals of foreign
countries.
Foreigners might acquire assets in the country with whose balance of
payments we are concerned.
2. Government, firms or individuals may receive sums abroad in repayment
of loan it might have lent abroad.
 36

Analogously, if residents of the country acquire foreign assets such as land

or shares or if the government, firms or individuals were to give loans to
residents of other countries or if loan taken earlier were to be repaid, all these
transactions will be entered as debit items in the balance of payments.
Categories of balance of payments
1. Balance of Trade: Balance of trade shows the balance of imports and
exports of visible goods. It refers to the merchandise portion of balance of
payments meaning that it is the value of exported merchandise minus the value
of imported merchandise. It is also known as the balance of visibles.
Balance of Trade = Export of Goods – Import of Goods
2. Balance of Current Account: It is made up of the balance of visibles,
invisibles and transfers. The current account is a measure of all payments made
for currently produced goods and services plus non-trade flows of funds between
a country and rest of the world.
Balance of Current Account = Balance of Trade + Balance of
Invisibles + Balance of Transfers
3. Balance of Capital Account: Balance of capital account refers to the
balance of capital transfers, borrowing and lending and sales from or purchase
of stocks of gold and foreign exchange. It is the difference between capital
receipts and capital payments.
Balance of Capital Account = Capital Receipts – Capital Payments

Types of capital flows

There are two types of capital flows included in the capital account. They
are autonomous capital flows and accommodating capital flows. The difference
between these two types of flows are discussed below:

Autonomous Capital Flows Accommodating Capital Flows

These capital flows are undertaken These capital flows take place in order
due to the normal economic to wipe out the deficit from the
considerations such as earning of balance of payments account.
profit, interest, dividends and other
incomes by international investment
and lending.
These are ordinary flows These are specific flows
These flows can be undertaken by These flows are taken by the
households, firms or government government only.
The balance of payments may or may The balance of payments is brought to
not be in equilibrium resulting from equilibrium resulting from these flows.
these flows.
 37

Difference between some important terms

Balance of trade Balance of Current Account

It shows the difference between exports It shows the difference between exports
of goods and imports of goods and imports of goods, services, transfers
and international incomes.
It includes the balance of visibles only It includes the balance of both visibles
and invisibles
It is a part of current account It includes balance of trade

Balance of trade Balance of Payments

It shows the difference between exports It shows the difference between exports
of goods and imports of goods and imports of goods, services, transfers
and international incomes and capital
balances
It is a part of current account It includes both current account and
capital account
It includes the balance of visibles only It includes the balance of both visibles
and invisibles plus capital balances
The transactions are recurring in nature Both recurring and non-recurring
and do not affect assets or liabilities. transactions take place which are capable
of affecting the assets both physical and
financial.

Balance of Current Account Balance of Capital Account

It shows the difference between exports It shows the difference between capital
and imports of goods, services, transfers receipts and capital payments.
and international incomes.
The transactions are recurring in natureThe transactions are non-recurring in
and do not affect assets or liabilities.nature and capable of affecting the assets
both physical and financial.
The transactions in this account are of The transaction in this account are of both
autonomous nature autonomous and accommodating nature.

Balance of Current Account Balance of Payments

It shows the balance of exports and It shows the balance of exports and
imports of goods, services, transfers and imports of goods, services, transfers,
international incomes. international incomes plus capital
transfers
The transactions are recurring in nature Both recurring and non-recurring
and do not affect assets or liabilities. transactions take place which are capable
of affecting the assets both physical and
financial.
It is the part of balance of payments It includes both current account as well as
account capital account.

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 38

Exchange rate
Foreign currencies and claims on them in the form of bank deposits,
cheques, etc. payable in those currencies is known as foreign exchange. The
foreign exchange market is the market where foreign currencies are bought and
sold as a result of international transactions of goods and services and
movement of capital. Exchange rate refers to the rate at which the currencies of
one country is traded with the currencies of other countries. The exchange rate
can be defined in either of the two ways:
(i) The number of units of domestic currency that exchanges for one unit of
foreign currency, say $1= Rs 50
(ii) The number of units of foreign currency that exchanges for one unit of
domestic currency, say Rs 1 = $0.02
Exchange rate system
1. Fixed Exchange Rate System: In a fixed exchange rate system, the rate
of exchange is determined by the central bank of the country through an official
action. Central bank of the country intervenes in the foreign exchange market
thorough buying and selling of foreign currency to hold the exchange rate at
some pre-announced level.
In order to ensure that he exchange rate is fixed, the central bank must
hold adequate reserves of foreign exchange so as to provide foreign currency in
exchange of domestic currency. The central bank buys foreign currency at the
fixed exchange rate when there is excess supply of foreign currency and sells it
when there is excess demand for foreign exchange.
However, fixed exchange rate does not mean that the exchange rate is
absolutely fixed. Depending upon the circumstances, the central bank may
revise the exchange rate. Most of the countries including India had fixed
exchange rate against one another until the decade of 1970s.
2. Fixed Exchange Rate System: In a flexible exchange rate system,
exchange rate is left free to be determined by the forces of demand and supply
in the foreign exchange market. The exchange rate is allowed to equate the
supply and demand for foreign exchange. This system is also known as the
floating exchange rate system. It can be of two types:
a) Clean Floating: In the system of clean floating, central bank stands aside
completely and allows exchange rate to be freely determined in the foreign
exchange market. There is no intervention at all.
b) Dirty Floating: In the system of dirty or managed floating, central bank
intervenes to buy and sell foreign currencies in an attempt to influence the
exchange rate. Normally, central bank intervenes only when the rate of
exchange is high or low. India has adopted this system in recent years.

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 39

Depreciation and appreciation

Depreciation refers to the fall in the value of domestic currency or rise in
the value of relative foreign currency due to change in the demand and supply
forces in the exchange market. For example, if Indian rupee depreciates against
American dollar, it means that people pay more rupees for a dollar. Suppose $1
used to be exchanged for Rs 50 but now it exchanges for Rs 60 in the foreign
exchange market. This means that the Indian rupee has become cheaper in
terms of US dollar.
Appreciation, on the other hand means a rise in the value of domestic
currency or fall in the value of relative foreign currency due to change in demand
and supply forces in the exchange market. For example, if Indian rupee
appreciates against American dollar, it means that India will have to pay fewer
rupees per dollar. Suppose that the rate of exchange changes from Rs 50 per
dollar to Rs 40 per dollar, it means appreciation of Indian rupee because it has
become more expensive in terms of American dollar.

Devaluation and revaluation

Devaluation refers to an action undertaken by central bank to decrease
the value of domestic currency relative to the currencies of other countries under
a system of fixed exchange rates. Thus, devaluation is used synonymously with
depreciation.
Revaluation, on the other hand, refers to an action undertaken by central
bank to increase the value of domestic currency relative to the currencies of
other countries under the system of fixed exchange rates. Thus, revaluation is
used synonymously with appreciation.

Depreciation Devaluation
It is the fall in value of domestic It is the fall in value of domestic
currency or rise in the value of relative currency or rise in the value of relative
foreign currency due to demand and foreign currency due to an official
supply forces in the foreign exchange action of the central bank.
market.
It takes place under flexible exchange It takes place under fixed exchange
rate system. rate system.

Appreciation Revaluation
It is the rise in value of domestic It is the rise in value of domestic
currency or fall in the value of relative currency or fall in the value of relative
foreign currency due to demand and foreign currency due to an official
supply forces in the foreign exchange action of the central bank.
market.
It takes place under flexible exchange It takes place under fixed exchange
rate system. rate system.
 40

Determination of exchange rate in a free market

(Under flexible exchange rate system)

Under flexible exchange rate system, the equilibrium rate of exchange is

determined by the forces of demand and supply in the foreign exchange market.
We explain this by taking two countries model trading with each other namely
India and America. Thus, US dollar is considered as the only foreign currency.
The Demand for Foreign Exchange (dollar): The demand for foreign
exchange in a country arises because an importer in this country has to acquire
foreign exchange to buy foreign goods. Thus, increase in imports lead to increase
in demand for dollar. However, the demand for foreign exchange in influenced
by the prevailing exchange rate. Suppose the current price of dollar in terms of
Indian currency is Rs 50. At this price, if an Indian wish to imports goods worth
$20, he must make a payment of Rs 1000 in terms of Indian currency. Now, if
the price of dollar rises to say Rs 60, i.e. if Indian currency depreciates, Indians
will have to pay Rs 1200 for the same goods at this depreciated rate. This will
decrease demand for American goods resulting in a decrease in demand for
dollars. Thus, it follows that the demand curve DD for foreign exchange plotted
against the domestic currency is negatively sloping.
The Supply for Foreign Exchange (dollar): The supply of foreign currency in
a country arises because of export of goods from the domestic country to foreign
countries. The exporter of goods get hold of foreign currency which they would
like to exchange for domestic currency. Like demand, supply is also influenced
by the prevailing exchange rate. In the above example, Indians would earn Rs
1000 if they export goods worth $20 at the current rate of Rs 50 to a dollar.
However, at a higher price, i.e. Rs 60 to a dollar, Indians will earn Rs 1200.
Thus, increase in price of dollar will lead to increase in exports followed by
increase in supply of dollar. Therefore, the supply curve of foreign exchange will
be positively sloping.
Y
D
R1 G H S

Exchange E
Rate R0
(Rs to $)
R2 A B
S D

O Q X
Demand and Supply of Dollar
DD and SS how many dollars Indians demand at different rates and how the
American`s supply of foreign exchange rate differs at different rates
respectively. The equilibrium exchange rate is E corresponding to R0 exchange
rate and OQ quantity of dollar is demanded and supplied. At exchange rate R 1,
excess demand for dollar takes place by AB amount which leads to increase in
its price. Similarly, at R2 exchange rate, excess supply takes place by GH amount
which leads to decrease in price of dollar. Where the two curves intersect, the
quantity demanded of dollar is equal to its quantity supplied and the exchange
rate is in equilibrium.
 41

Flexible exchange rate system

(A system of automatic adjustment)

A system of flexible exchange rate is very elegant as it solves the problem

of disequilibrium in the balance of payments without any effort. It is a system of
automatic adjustment in disequilibrium in the balance of payments. Let us see
how:
Deficit & surplus
We start from a situation in which a country has equilibrium in its balance
of payments. If now, a deficit in the balance of payment occurs, this will be
automatically solved by change in the rate of exchange. A deficit in the country`s
balance of payments implies that the outflow of foreign currency is more than
its inflow. This, in turn, means that the imports are greater than exports which
would create excess demand for foreign currency leading to rise in its price. This
means depreciation in the domestic currency. Thus, deficit in the country`s
balance of payments would lead to depreciation in of its own currency.

Y D1
D S

R1 E1
R0 E0 K
Exchange Rate
(Rs to $) D1
S D

O Q0 Q1 X
Demand and Supply of Dollar
Assuming that the country has equilibrium in its balance of payments at
E0 and the prevailing exchange rate is R0. If demand for foreign exchange rate
increases due to increase in imports, the demand curve DD will shift to its right
to say D1D1. At an exchange rate R0, excess demand by E0K amount emerges.
This leads to depreciation in the domestic currency (India) and increase in the
value of foreign currency (US dollar). Due to increase in demand, Indians
demand a larger amount of dollar which the Americans supply at a higher price.
As a result, the new equilibrium E1, is established corresponding to which R1 is
the new exchange rate.
Similarly, surplus in the balance of payments will lead to an excess supply
of foreign currency and hence appreciation of the domestic currency. This means
that imports now becomes cheaper and demand for imports increases. At the
same time, exports would receive less home currency for a unit of foreign
currency. This will lead to fall in exports. Hence, imports increase and exports
decrease till the surplus in the balance of payments is wiped out. A new
equilibrium in the balance of payments is establishes at the new exchange rate.
 42

Causes of adverse balance of payments

1. Fall in Foreign Demand: The demand for domestic goods may fall in the
foreign countries for a number of reasons. This may be due to changes in tastes
and fashions of foreign consumers or due to lower prices of the product of other
countries or due to fall in income of foreign consumers. A fall in foreign demand
leads to decrease in exports making the balance of payments unfavourable.
2. Inflationary Pressure in the Economy: A high rate of inflation at home
encourages imports because imports become relatively cheaper. A country lose
its competitiveness in the world markets which reduces exports. At the same
time, imports are high since foreign goods become cheaper in comparison to
domestic goods. This creates an adverse impact on the domestic balance of
payments.
3. Developmental Expenditure: The developing countries have to be
dependent on the other developed countries of the world for the supply of
machines, raw materials, etc. during the initial stages of development. Further,
these countries are not in a position to increase their exports. This leads to deficit
in the balance of payments also known as structural deficit.
4. Decrease in supply: A fall in supply at home may increase demand for
foreign goods. Agricultural production may fall due to lack of monsoon, Industrial
production may fall due to labour strikes, etc. As a result, exports fall and
imports increase to overcome scarcity at home.
5. Appreciation in the Exchange Rate: Appreciation of a country`s
currency increases the external value of the currency. This makes imports
cheaper and exports expensive. Consequently, imports increase and exports fall
leading to adverse situation of balance of payments.
6. Demonstration Effect: People of underdeveloped countries try to imitate
the consumption pattern of the people of the developed countries with regard to
luxuries like cars, air-conditioners, etc. This has led to large increase in the
imports of consumer durable goods, leading to deficit in balance of payments.
7. Increased Debt Burden: The developing countries of the world need to
import capital so as to promote their development. This creates a large burden
of interest payments on these countries. These countries, are therefore, required
to make large payments to the developing countries which creates a problem of
deficit.
8. Population Pressure: A rapid increase in population of many developing
countries has increased demand for all types of consumer goods. As a result of
this, export surplus has fallen. A fall in export earnings has an adverse effect on
the balance of payments.

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Measures to overcome disequilibrium

1. Depreciation: Depreciation of a country`s currency will itself wipe out
deficits in the balance of payments. Depreciation will make import costlier and
exports cheaper. As a result, price of imports will rise and thereby imports will
fall. On the other hand, exporters can afford to reduce the prices of exports since
they are earning more in terms of domestic currency. Exports will become
cheaper and hence exports will be stimulated.
2. Devaluation: A country can devalue its currency to wipe out deficit in the
balance of payments. This makes imports expensive to domestic consumers and
exports cheaper to foreign countries. If demand and supply elasticity are fairly
high, this will definitely lead to a fall in imports and a rise in exports and eliminate
balance of payments deficit.
3. Import Control: Imports may be kept in check by applying quotas and
tariffs. Quotas limit the volume of imports by applying quantitative restrictions
and tariffs or import duties will raise the price of imported goods. As a
consequence, balance of payments deficit is reduced.
4. Export Promotion: The government may pursue various export
promotion measure which will boost the export industries and stimulate exports.
Some of these measures may be reducing export duties, providing cash
assistance and subsidies to the exporters, tax exemption for goods meant for
exports, providing raw materials to export industries to reduce their cost of
production, etc.
5. Production of Import Substitutes: The production of import substitutes
at home can reduce the demand for imported goods. Incentives must be
provided to the industries so as to encourage them to produce these goods at
home. These industries may turn out to be export earners in future as well.
6. Exchange Control: The government may try to hold complete control
over all dealings in foreign exchange. This could be done by directing all
exporters to sell their foreign currency earnings to the central bank and all
importers to buy foreign exchange from central bank. Foreign exchange could
be rationed out only to those importers who have been granted license to import
certain specified commodities. This would keep in check, the imports of less
essential goods and encourage imports of necessary goods only.
7. Monetary Policy: The central bank can reduce the volume of credit by
raising bank rate, selling the approved securities in the open market or by
increasing cash reserve ratio. An increase in interest rate and decrease in
availability of credit will decrease the consumption and investment expenditure.
This will result in a fall in income leading to decrease in imports.
8. Fiscal Policy: A restrictive fiscal policy may be used to wipe out balance
of payments deficit. An increase in direct taxes will reduce the disposable income
of the people. Similarly, a cut in the government expenditure or a decrease in
transfer payments will immediately reduce the consumption expenditure of the
people. This will lead to a fall in income and decrease in imports thereby.

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 44

Balance of payments is always at balance

Balance of payments includes total debits and total credits relating to all
the items on account of which a country makes payments to and receives
payments from rest of the world. It is the sum total of balance of current account
and balance of capital account. In the accounting sense, balance of payments is
always in equilibrium. It is kept in standard double entry book keeping system
under which each international transaction undertaken by the residents of a
country is shown on both sides, which results in debit and credit of an equal
amount. For example. An export is credited for the movement of goods and the
payment for that exports in the form of foreign currency is shown as a debit.
The recorded worth of both the goods sold and foreign currency received is
exactly the same. In theory, therefore, balance of payments is always in
equilibrium.
In actuality, however, balance of payments may be normally in deficit or
surplus. Balance of current account is normally in deficit or surplus. Similarly,
capital account excluding accommodating flows may also be in deficit or surplus.
Accommodating flows are made to bring the balance of payments in equilibrium.

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 45

Chapter – 5: government budget

Meaning of government budget
The budget of the central government is an annual financial statement
describing in detail the estimated receipts and proposed expenditures and
disbursements of the government under various heads for the financial year or
fiscal year.
It is prepared under Article 112 of the Indian constitution for every
financial year running from April 1s to March 31. The budget is presented in the
Lok Sabha on the last working day of February or as and when directed by the
President of India. Simultaneously, a copy of the budget is laid on the table of
Rajya Sabha. The budget is discussed on both the houses of the Parliament and
voting on the demand for grants is taken.
While the budget gives the estimates for the coming financial year, it also
gives the actual financial accounts for the previous year and the revised
estimates of the current year. For instance, the budget of 2015-16 gives not
only the budget estimates for the year 2015-16, but it also gives the actual
financial accounts for 2013-14 and revised estimates for the year 2014-15.
Types of budget in India
1. Union Budget: It is prepared by the central government for the entire
country as a whole. It is presented in two parts, i.e. the railway budget which
shows the details of estimated receipts and proposed expenditures with regard
to Indian Railways only and the main budget which shows the financial plans for
the entire economy as a whole.
2. State Budget: It is the budget prepared by the state government such as
the budget of Bihar, budget of Haryana, etc.
3. Plan Budget: It is a document which shows the budgetary provisions for
important projects, programmes and schemes included in the central plan of the
country. It gives the detailed report of the government expenditure on economic,
social, community and general services.
4. Performance Budget: The performance budgets present the main
projects, programmes and activities in the light of specific objectives and the
assessment of the previous year`s budget and achievements. They explain the
scope, estimated cost, targets, achievements, reasons for shortfalls, etc. of the
projects which are already running.
5. Supplementary Budget: The budget which is prepared keeping in mind
the future uncertainties such as war or a natural calamity or political instability
etc. is known as supplementary budget.
6. Zero-Based Budget: It is defined as the budgetary process which
requires each ministry to justify its entire budget request in detail for each new
period without making any reference to the previous level of expenditure.
 46

Components of the government budget

The constitution of the country demand that the budget must distinguish
expenditure on revenue account from the expenditure on capital account.
Revenue account covers those items which are of recurring nature while capital
account covers those which are of the nature of creating or reducing capital
assets. Thus, the government budget is necessarily presented in two main parts:
1. Revenue Budget: It shows revenue receipts of the government and
expenditures met from these revenue receipts. It consists of two parts:
(a) Revenue Receipts: These are all those receipts of the government which
are non-redeemable in nature. They create no liabilities, i.e. they come along
without any repayment obligations nor do they involve sale or reduction of
assets. Some of the examples of such receipts are tax revenue such as income
tax, GST and non-tax revenue such as fee, fines, profits, interest received, etc.
(b) Revenue Expenditures: These expenditures are incurred by the
government on its day-to-day normal functioning and interest payments on its
debts. These expenditures neither reduce any liability of the government nor
involve creation of physical or financial assets. For example, expenditure
incurred on law and order, defence, interest payments, subsidies, etc.
2. Capital Budget: It is made up of capital receipt and capital expenditures
of the government and shows capital requirements and financing of those
expenditures. It consists of two parts:
(a) Capital Receipts: These are the receipts of the government create liabilities
or involve sale or reduction of assets of the government. For example,
borrowings of all kinds, recovery of loans advanced in the past, etc.
(b) Capital Expenditures: The capital expenditures of the government are
those expenditures which lead to creation of physical or financial assets or
reduction of financial liabilities. For instance, expenditures on creation of physical
and financial assets like buildings, machinery, shares etc., and granting loans to
the state governments or repayments of loans taken in the past.
Balanced budget/deficit budget/surplus budget
When the government expenditure is exactly equal to its receipts, the
government has a balanced budget. IF the government expenditure exceeds its
receipts, there is a deficit budget. On the other hand, if the government revenue
is greater than its expenditure, the government runs a budget surplus.
The surplus budget implies that leakages from the circular flow of income
are more than the injections. This leads to contraction in the level of economic
activities leading to decrease in aggregate demand of the economy. Therefore,
it is advisable to have surplus budget to control inflation in the economy.
A deficit budget means that the injections into the circular flow of income
are more than the leakages. This leads to expansion in the level of economic
activity resulting in increase in aggregate demand of the economy. The deficit
budget is, therefore, a good policy to tackle the problem of recession arising
from deficient demand.
 47

Structure of government budget

Receipts
1. Revenue Receipts
2. Tax Revenue (Net to Centre)
3. Non-Tax Revenue
4. Capital Receipts
5. Recovery of loans
6. Other Receipts
7. Borrowings and other liabilities
8. Total Receipts (1+4)
Expenditure
9. Non –Plan Expenditure
10. On Revenue Account of which
11. Interest Payments
12. On Capital Account
13. Plan Expenditure
14. On Revenue Account
15. On Capital Account
16. Total Expenditure (9 + 13)
17. Revenue Expenditure (10 + 14)
18. Capital Expenditure (12 + 15)
19. Revenue Deficit (17 - 1)
20. Fiscal Deficit [16 - (1 + 5 + 6)]
21. Primary Deficit (20 - 11)

The main measures of budgetary deficit in India are Revenue Deficit, Fiscal
Deficit and Primary Deficit.
 48

Revenue deficit
Revenue deficit refers to the excess of revenue expenditure over revenue
receipts. It denotes the difference between revenue receipts and revenue
expenditure.
Revenue Deficit = Revenue Expenditure – Revenue Receipts
Revenue deficit indicates the government`s current financial status. It
means dissaving on government account, i.e. the government is spending more
than its current income. To cover the excess expenditure, the resources have to
be borrowed from the other sectors of the economy. Higher borrowings put
pressure on revenue expenditure in the form of interest payments. As a result,
the revenue deficit further widens.
Fiscal deficit

Fiscal deficit is the difference between the total expenditure and the sum
of revenue and capital receipts excluding borrowings. It is a measure of excess
expenditure over the government`s own income.
Fiscal Deficit = Total Budgetary Expenditure – Revenue Receipts
– Capital Receipts (Excluding Borrowings)
Fiscal deficit is the key indicator of budgetary deficit in India and it
measures the total resource gap of the government. It shows the total borrowing
requirements of the government from all sources. It has a serious implication in
the economy. Government has to borrow to meet this deficit which increases the
future liability of interest payments and repayment of loans. Interest payment
increases revenue deficit which increases revenue expenditure thereby.
Therefore, the government is required to borrow more to pay interest and repay
old loans. This is what is known as debt trap. This is why it is important to reduce
fiscal deficit for smooth functioning of the economy.
Primary deficit
Primary deficit refers to the difference between fiscal deficit and interest
payments.
Primary Deficit = Fiscal Deficit – Interest Payments
Primary deficit indicates the real position of the government finances as it
excludes the interest burden in respect of loans taken in the past. It shows how
much the government is borrowing to meet its expenses other than interest
payments. It is a measure of fiscal discipline of the government and shows the
way the government is conducting its affairs.

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 49

Chapter – 6: fiscal policy

Fiscal policy
Fiscal policy is defined as the policy under which the government uses the
instruments of taxation, public spending and public borrowing to achieve various
objectives of economic policy.
Public revenue
Income from the government from all its sources is called public revenue.
It includes income from taxes and receipts from non-tax revenue like interest
receipts, dividends, and profits of PSUs etc.
Public finance
Public finance is the study of the income and expenditure of public
authorities. The term public includes all kinds of governments, ranging from local
bodies such as municipal boards, district boards to state and national
governments. These public authorities perform various functions such as
maintenance of law and order, defence, social overheads, undertaking
investments and promoting economic development.

Instruments of fiscal policy

Taxation
Taxes are compulsory payments to government without any corresponding
direct return of services or goods by the government to the taxpayers. Seligman
defines a tax as “a compulsory contribution from a person to the government to
defray the expenses incurred in the common interest of all, without reference to
special benefits conferred.” Following are the characteristics of taxation:
1. Compulsory Contribution: Tax is a compulsory contribution to the state
from the people on account of income earned, ownership of property and certain
economic activities carried on by the taxpayers. Refusal to pay taxes is liable to
legal action and punishment by the government.
2. Personal Obligation: Tax imposes a personal obligation on the tax payer.
It is the duty of the taxpayer to pay taxes he is liable to pay. He should not try
to hide his income and should not try to evade taxes.
3. General Benefit: The taxes received from the tax payers may not be
incurred for their benefits alone, but for the general and common benefit. Taxes
collected by the government are spent by it for the general welfare of the people.
4. No Quid Pro Quo: An important characteristic of tax is that there is no
quid pro quo, i.e. nothing in return promised by the government. There is no
direct give and take relationship between the government and the taxpayers.
 50

Impact and incidence of taxation

The impact of tax refers to the person who pays taxes to the government
in the first instance. The incidence of a tax refers to the money burden of a tax
on the person who ultimately pays it.
Accordingly, a direct tax is that tax whose burden is borne by the same
person on whom it is levied. The impact and the incidence of tax is on the same
person. He cannot shift or transfer the burden of tax on some other person. For
example, income tax has to be paid by the person on whom it is levied.
On the other hand, an indirect tax is that tax which is initially imposed on
and paid by one individual, but the burden of which is passed over to some other
individual who ultimately bears it. For example, excise duty on motor cars is
paid in the first instance by the manufacturer of the cars but ultimately he
transfers the burden of this duty to the buyer of the car.
Direct tax and indirect tax
A direct tax is one which imposed on the income and property of the tax
payers and also on certain economic activities carried on by the tax payers. For
example, Income tax, Property tax, Death duty, Capital Gains tax, etc.
Indirect tax, on the other hand, is one which is imposed on the expenditure
of an individual. For example, excise duty, customs duty, GST, etc.
Difference between direct tax and indirect tax

Direct Tax Indirect Tax

It is the form of tax which is It is the form of tax which is imposed
imposed on the income of an on the expenditure of an individual such
individual such as income tax. as excise duty, customs duty, etc.
The impact as well as incidence of The impact may be on some person but
tax generally lies on the same the incidence of tax generally lies on
person in case of direct tax. some other person who ultimately
bears the burden of paying tax.
These taxes are economical in the The administrative cost of collecting
sense that the cost of collecting indirect taxes is generally high because
these taxes is relatively low as they they have to be collected by large
are collected usually at source number of persons.
Direct taxes satisfy the canon of The revenue from indirect taxes are
certainty i.e. the taxpayers know cannot be estimated accurately owing
how much and on what basis they to rise in the market price of
have to pay commodities.
They satisfy the principle of ability These taxes are unjust in the sense that
to pay as their burden can be put the poor people have to pay as much as
more on rich than on the poor the rich people since they are imposed
persons. on consumption.
Direct taxes inculcate a spirit of civic They are collected by traders and
consciousness amongst the manufacturers as a result the tax
taxpayers. payers are not conscious about the
burden of these taxes.
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Classification of taxation – degree of progression

A common classification adopted in taxation is on the basis of the degree of
progression of tax. According to this classification, taxes may be divided into the
following groups:
1. Proportional Taxation: A tax is called proportional when the rate of
taxation remains same as the income of taxpayer increases.
Y
Income Rate of Tax

Rate of Tax
Up to 200,000 10%
200,001 to 500,000 10%
Above 500,000 10%

Income X

2. Progressive Taxation: A tax is called progressive when the rate of

taxation increases as the taxpayer`s income increases.
Y
Income Rate of Tax
Up to 200,000 10% Rate of Tax

200,001 to 500,000 15%

500,001 to 100,00,00 20%

Income X

3. Regressive Taxation: A tax is called regressive when the rate of taxation

decreases as the taxpayer`s income increases. Y
Income Rate of Tax
Rate of Tax

Up to 200,000 20%
200,001 to 500,000 15%
500,001 to 100,00,00 10%

Income X

4. Degressive Taxation: A tax is called degressive when the rate of

progression in taxation does not increase in the same proportion as the increase
income. Y
Income Rate of Tax
Rate of Tax

Up to 200,000 Nil
200,001 to 500,000 10%
500,001 to 100,00,00 20%
Above 100,00,00 30% Income X
 52

Public expenditure
Public expenditure refers to the expenses incurred by the public authorities
– central government, state government and local bodies – for its own
maintenance and also for the satisfaction of collective needs of the citizens and
for promoting their economic and social welfare.
Expenditures incurred by the government in the form of administration
and maintenance of law and order, public health, defence, in providing social
security such as pensions, in communication, transport, power etc. are some of
the examples of public expenditure.
Types of Public expenditure
1. Direct and Transfer Expenditure: Expenditure incurred by the
government on the purchase of goods and services and on current services of
factors of production is called government direct expenditure. For example,
expenditure on defence, civil services, investment etc.
Transfer expenditures, on the other hand, are those expenditures which
take the form of payments which are made without any corresponding returns
to any factor services. For example, payment of interest on national debts,
pension, and sickness benefits, etc.
2. Developmental and Non-developmental Expenditure: Expenditure
which is incurred on economic and social development of the country is known
as developmental expenditure. For example, services like education, scientific
research, public health, labour welfare, etc.
Non-developmental expenditure is that expenditure which is in the form
of essential general services of the government such as defence, police, interest
payments, law and order, etc.
3. Productive and Non-Productive Expenditure: Those expenditures
which help in increasing the productive capacity of the country and are generally
in the nature of investment are called productive expenditures. For instance,
expenses on physical assets such as machines, factories, human capital such as
education, training, etc.
Non-productive expenditures, on the other hand, are those which do not
add to the productive efficiency of the economy directly as they are in the nature
of consumption. Expenditure on administration, defence, maintenance of law
and order are a few examples of such expenditure.

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Importance of public expenditure

Public expenditure is not merely a financial mechanism of incurring
expenditure, it is an instrument of immense importance. It has a considerable
impact on the level of economic activities of a country. The importance of public
expenditure arises from the following facts:
Public expenditure and production
1. Public expenditure on defence and developmental activities creates
demand for various types of goods and services and thereby creates income for
those individuals who produce these goods. This will help in increasing the
purchasing power of the people.
2. Public expenditure on education, medical services, sanitation and cheap
housing facilities increases the productive efficiency of the people at large, which
leads to increase in production and increase in income of the people.
3. Public expenditure can be used to create human capital through education
and training. This will increase the ability of the the people to work and to
produce more.
4. Public expenditure in the production of raw materials and other important
inputs helps in removing various shortages like that of steel, fertilizers etc. and
ensure smooth production.
Public expenditure and investment
1. Public expenditure on maintenance of law and order creates confidence in
the minds of the people and encourages them to undertake investment.
2. Public expenditure can be directly used in creating economic and social
overheads in the form of capital equipment and human capital.
3. The government may provide subsidies and financial assistance to the
private sector and thereby stimulate investment.
Public expenditure and income distribution
1. Public expenditure on welfare measures like free education, free medical
facilities and social security schemes such as unemployment relief etc. can be
given top priority to help the poor.
2. Public expenditure through public production and subsidies on articles of
common consumption like food can also help the poor persons and thereby
improve income distribution.
3. Public expenditure can be effectively used in reducing regional disparities
by providing subsidies and financial assistance to the producers who set up
industries in the backward areas.
Public expenditure and economic growth
1. Public expenditure promotes economic development directly by developing
social overheads and infrastructure, by establishing capital goods industries,
basic and key industries, etc.
2. Public expenditure may stimulate economic development indirectly by
providing education, training and research facilities.
3. Public expenditure in the form of subsidies can help in stimulating
agricultural and industrial development.
 54

Public expenditure and economic stability

Economic stability is a characteristic feature of free market economies.
These economies have been facing business cycles characterised by alternating
periods of booms and depressions. Public expenditure policy can be effectively
used as an anti-cyclical instrument for bringing economic stability.
During the periods of depression, characterised by low level of income and
a very high rate of unemployment, there is deficiency of aggregate demand.
During this time, the government is expected to raise its expenditure largely in
the form of direct public investment will add directly to the aggregate demand
of the economy and will thereby result in increase in income and employment.
During the periods of boom, which is characterised by inflation, there is a
need of curbing down excess demand. This can be done by reducing public
expenditure. This will reduce aggregate demand and as a result, the level of
income and output will fall.
This is how government expenditure can be used as a balancing factor in
order to maintain economic stability, i.e. stability of income, output and
employment.
Public debt
Public debt is the debt which the government owes to its subjects or to
the nationals of other countries. In other words, public debt refers to the loans
raised by the government from within the country or from outside the country.
Types of Public debt
1. Internal and External Public Debt: Internal debt refers to the public
loans floated within the country, i.e. the government borrows funds from the
individuals and institutions located within the country.
External debt refers to the loan taken by the government from the
individuals, institutions and governments of foreign countries as well as the loans
taken from the international financial institutions like the World Bank, IMF.
2. Productive and Unproductive Debt: Productive debt is the debt which
is used by the government directly for productive purposes. For example, power
projects, railways, irrigation, investment in industries, etc. Such debts can be
repaid out of the revenues generated by the projects financed by these debts.
Unproductive debt is that debt which is not used for productive purposes
directly. Such debts do not add to the productive capacity of the country and are
often known as deadweight debts.
3. Short-term and Long-term Debt: Short-term debt is the debt which is
raised for a short period, usually 3 to 9 months. Treasury bills and advances
from the central bank are example of short-term debt.
Long-term debt is that debt which is repayable after a long period, usually
5 years or more. These are generally raised for development purpose.
 55

Methods of debt redemption

Redemption of debt means repayment of a loan. All government debts
need to be repaid. If the government fails to repay debt, its credibility will be
lost and it may not be in a position to raise loans in future. Various methods are
used by the government to redeem its debts. Some of these methods are
discussed below:
1. Repudiation of Debt: Repudiation means refusal to pay a debt by the
government. In this case, it refuses to pay the interest as well as the principal
amount of debt due to financial constraints. Normally the government does not
like to repudiate its debt because it shakes the confidence of people in the
government and the government would find difficulty in raising new loans in
future.
2. Refunding: It is the process by which the government raises new bonds to
pay off the maturing bonds. It takes a fresh loan to repay old loans. Hence, the
money burden of the debt is not is not liquidated but is postponed to some future
date.
3. Debt conversion: In this method, the loan is actually not repaid, but the
form of debt is changed. The government might have borrowed at the time when
the rate of interest was high. If the market rate of interest falls, it may convert
old high interest loan into a new low interest loan and reduce debt burden
thereby.
4. Budgetary Surplus: A surplus in the government can be used to pay off
the debts of the people. The government may use the budgetary surplus to
purchase its own bond and securities from the market. This results in automatic
liquidation of the debt liability of the government.
5. Terminal Annuities: In this method, the government pays its debts in equal
annual instalments which include interest as well as the principal amount of debt.
Thus, this is a method of repayment of loans in instalments and reduces the
debt burden of the government year after year.
6. Sinking Fund: Sometimes, the government establishes a separate fund for
the purpose of repaying its debt by crediting a certain amount of its revenue
every year to this fund. This fund is used for payment of interest and ultimate
payment of loans as they fall due.
7. Statutory Reduction in the Interest Rate: The government may take a
statutory decision to reduce the rate of interest payable on its debts. The
creditors are forced to accept the reduced rate of interest. This method is
normally not followed other than the period of financial crisis.
8. Capital Levy: It refers to a very heavy and once and for all tax on property
and wealth. This method is imposed on rich and propertied individuals on a
progressive scale. This system is suggested to pay off war time debts by
imposing this tax on the rich section of the community.
9. Export Surplus: The external debts of the government are to be paid in
terms of foreign exchange. This can be done by creating an export surplus. The
loans can be easily repaid by utilising the foreign loans in those industries which
produce exportable goods.
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Chapter – 7:
The concept of National income
What is national income?
National income is defined as the value of all final goods and services
produced by the normal residents of a country, whether operating within the
domestic territory of the country or outside, in a year.
Monetary Expression (Value)
The term value suggests that national income is expressed in monetary
terms. There are a vast number of diverse goods and services produced in the
economy during a year. It is necessary to use some common denominator while
adding them. We cannot add together unlike items, such as apples and oranges,
services of a doctor and that of a barber, etc. since they are expressed in
different units like grams and metres. Thus, in order to aggregate all goods and
services, it is essential to express the, in money terms, such as rupee, dollar,
etc. which is a common denominator.
Final goods and services
National income reflects the value of final goods and services. It does not
include the value of intermediate consumption in its measurement. Let us
differentiate between these two terms:
Final products are those goods and services which are sold to the final users
during the year. This means that these goods are meant for final consumption
and are not meant for resale. They are generally purchased by households for
consumption purpose. For example, cars purchased by households.
Intermediate products, on the other hand, are those goods and services which
are used by the producers as inputs into a further stage of production. They are
meant for resale. For example, seeds, fertilizers, etc. purchased by farmers.
To measure national income accurately, all goods and services produced
during a year must be counted once, and not more than once. For example, flour
mills sell flour to bakeries and bakeries use this flour in making breads which
are sold to households. Since flour is used in making bread, the total value of
bread includes the value of flour also. If we add the value of flour to the value
of bread, the value of flour would be included twice. To add the value of
intermediate goods to the final goods would be double counting, i.e. the flour
would be counted more than once.
Thus, Double Counting is an error which arises in national income
estimation if we add up the total output of all the sectors in the economy instead
of adding up the output of final goods and services only.
National income includes the value of bread and not of flour used in making
bread. Hence, national income is the total value of final goods and services
produced.

Gross value Added = Value of Output – Intermediate Consumption

 57

Normal residents
National income is defined as the value of final goods and services
produced by the normal residents of a country. Normal residents are those
persons who ordinarily reside in a country in which they live and whose economic
interest lies in that country. They may or may not be the citizens of that country.
These normal residents of a country produce goods and services by selling their
factor services to production units located within or outside the domestic
territory of a country.
Domestic Territory refers to the geographical or political boundary of a
country excluding foreign embassies and international institutions like UN, WHO
offices, etc. located within the geographical territory and including the embassies
of this country located outside its geographical territory.
During a year (flow)
National income is a flow concept. It is the flow goods and services. A flow
is a quantity which is measured over a period of time, say a day, a month, a
year etc. Conventionally, national income is expressed over one year.
Current output
National income is a measure of the value of currently produced goods and
services. It excludes pure exchange transactions. These transactions are
excluded from national income because nothing new is produces in the country
in the current year. These transactions are discussed below:
The reason for excluding second hand sales, i.e. sale of used goods is that
such sales do not reflect any current production whereas national income relates
to current production only. Sale of goods such as second hand car is not included
in national income because when this car was produced, its value was included
in that year`s national income. Thus, no current production is involved.
Similarly, we consider the construction of new houses but the sale of existing or
old houses are not included in national income. However, the value of the
services of the commission agents involved in the second hand sales are included
in the national income since these services have been rendered in the current
year itself.
Sale and purchase of financial assets like bonds and shares (both old and
new) are also excluded from national income because they are not payments for
goods and services as no direct current production is involved. They represent
transfer of purchasing power and the ownership rights from one person to
another. However, the services of the share brokers are included in national
income as these services are rendered in the current year.
Same reasoning applies to transfer payments, such as social security
payments (old-age pensions, etc.), donations and gifts. They are unilateral
payments for which no corresponding contribution to productive services are
rendered in the current period. The recipients of these transfer payments do not
make any addition to the current production.

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Some other concepts of national income

Per capita income
Per capita income is the average income of the normal residents of a
country in a particular year. It is the income per head of population. It is obtained
by dividing national income of a country by its population.
Per Capita Income = National Income
Population
Per capita income is calculated both at current prices as well as at constant
prices. While estimating per capita income at current prices, we take national
income at current prices (nominal national income) in the above formula.
Similarly, for the purpose of arriving at per capita at constant prices, national
income at constant prices (real national income) must be considered.
Per capita real income is traditionally taken as an index or measure of
economic welfare and development. An increase in per capita real income leads
to an improvement in the living standard of the people. However, per capita
income is not a perfect index of economic development and welfare.
Nominal gdp and Real Gdp
Nominal GDP or GDP at current prices is the money value of all final goods
and services produced in a country in a particular year expressed in the market
price prevailing in that year. We use the total output and market prices of the
same year to measure GDP at current prices.
Real GDP or GDP at constant prices, on the other hand, measures the final
goods and services constituting the GDP at the market prices prevailing in a
particular year, which becomes the base year.
GDP at current prices can change partly because of a change in the
physical quantities of final goods and services produced and partly because of
change in the market prices at which these goods and services are valued.
Therefore, nominal GDP does not reflect growth in the real domestic output, i.e.
goods and services produced.
GDP at constant prices is affected by changes in the physical quantities of
final goods and services only. Therefore, an increase in GDP at constant prices
indicates a real increase in the physical quantities of goods and services. That is
why GDP at constant prices is known as real GDP as it reflects real growth of an
economy.
GDP at current prices is converted into GDP at constant prices by
eliminating the effect of price changes on GDP with the help of a suitable price
index. Price index is that number which measures the changes in prices between
different years. The price index of base year is invariably taken as 100. The price
index of the current year is obtained by multiplying the ratio of current prices to
the prices of the base year by 100.

GDP at Constant Prices = GDP at Current Prices × 100

Price Index of Current Year
 59

GDP and economic welfare

Welfare is taken to mean a sense of satisfaction and happiness, a sense of
well-being or feeling better off. Total welfare may be divided into economic
welfare and non-economic welfare.
Economic Welfare means the total satisfaction or utility derived from the
use of goods and services that can be purchased for money. It can be expressed
as a function of goods and services and their prices.
Non-Economic Welfare relates to social, political, moral and other such
non-economic values. For example, love and affection of the family members for
each other, moral welfare and political welfare like the feeling of patriotism.
National income (GDP) as an index of economic welfare

An increase in national income results in an increase in economic welfare

through the increased availability of goods and services. In fact, it is the real per
capita income which is generally taken as the index of economic welfare. The
following points must be noted in this regard:
1. Economic welfare increases the availability of goods and services on
average which is indicated by per capita income rather than total income. Higher
total income need not result in increased availability of goods and services on
average if increase in GDP is accompanied by still higher increase in population.
This may actually result in a fall in the standard of living and thereby a fall in
economic welfare. Therefore, per capita income is a better index than total
income like GDP.
2. While taking national income as an indicator of economic welfare, national
income should be taken in real terms and not in nominal terms. Real national
income is a better index because it eliminates the impact of price changes on
national income.
Limitation of GDP as an indicator economic welfare
An increase in real per capita income is not a sufficient condition for
increase in economic welfare. Economic welfare is a function of various other
factors which are not taken into account by real per capita income. The major
limitations of per capita income as an index of economic welfare are as follows:
1. Distribution of Income: An increase in per capita income will increase
economic welfare only when the distribution of income accompanying this
increase in per capita income is desirable. If, increase per capita income results
in inequalities of income, economic welfare of the people as a whole may
decrease.
2. Composition of Output: If GDP increases as a result of production of more
of capital goods than consumer goods, economic welfare may not increase in the
same proportion as increase in GDP. Moreover, if increase in GDP is a result of
production of non-civilian war time goods such as guns, tanks, etc. rather than
the production of civilian goods such as bread, butter, etc. economic welfare
may not increase.
3. Manner if Increase in GDP: If increase in GDP is a result of longer working
hours, child labour, ruthless exploitation of natural resources, air and water
pollution, etc. GDP will not increase welfare of the people.
 60

4. Expenditure on Regrettable Necessities: Certain expenditures such as

transport to reach the workplace, medical treatment resulting from pollution in
the cities, etc. are forced on consumers. All such expenditures are included in
GDP, but they do not raise economic welfare.
5. Monetization of Goods and Services: GDP consists of those goods and
services which are exchanged in the market at a market price. However, there
are certain non-monetized services which increase welfare but are not included
in GDP. For example, services of a housewife, teaching one`s own child, etc.
6. Exclusion of some items from GDP: There are many goods and services
which influence economic welfare but these are excluded from GDP. Some of
these items are as follows:
a. Leisure: More leisure and shorter working hours may make people happy
and thereby increase economic welfare. But the amount of leisure is
excluded from GDP estimates.
b. Quality of life: Economic welfare depends upon the quality of life, but GDP
does not include many indicators of quality of life such as child mortality
rate, adult literacy, years of schooling etc.

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 61

Chapter – 8:
National income aggregates
Domestic product and national product
Domestic Product or domestic income is defined as the value of all final
goods and services produced by all the enterprises located within the domestic
territory of a country during a year. These goods and services are produced
domestically both by the nationals (citizens) of the country as well as foreign
nationals working in this country. The concept of domestic product is thus
domestic in character.
National Product, on the other hand, refers to the amount of final goods and
services produced by the normal residents of a country whether operating within
the domestic territory of the country or outside. The concept of national product
is thus related to citizens of a country.
Why does the difference between Domestic Product
and National Product Arise
The difference between domestic product and national product arise due to
the fact that modern economies, being open economies, means that some part
of the domestic product of a country may have been produced by foreign
companies situated within that country. This give rise to income received by
foreigners from enterprises located within the domestic territory of a country.
For instance, Maruti Udyog in India produces cars which is a domestic
product of India. However, part of this domestic product accrues to Suzuki
Company of Japan in terms of profits earned by it from its production activity in
India.
Similarly, Indian nationals may own some enterprises abroad, and hence,
a part of the output originating in those enterprises accrue to them. Also, some
Indian nationals may work abroad and earn income thereby. This gives rise to
factor income received by Indian nationals from abroad.
The difference between the factor income received from the rest of the
world and the factor income accruing to rest of the world is the net factor income
from abroad.
National Product = Domestic Product + Net Factor Income from Abroad

Domestic product at market price and factor cost

Domestic Product at market prices is the value of all final goods and
services produced by all enterprises located within the domestic territory of a
country during a year calculated at their market prices.
On the other hand, Domestic Product at factor cost expresses domestic
product as the sum of all factor payments in the form of wages, interest, rent,
profits, etc. The payment made to these factors for their contribution to the
production process is called factor cost and the resultant product is called
product at factor cost.
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Why does the difference between market price

And factor cost arise?
The difference between market price and factor cost arises because the
prices that the consumers pay for goods is different from the price that the firms
receive. Market prices of goods are inclusive of indirect taxes, such as GST,
excise duty, etc. These taxes are not a part of factor earnings. These indirect
taxes must be deducted from market prices to get factor cost.
On the other hand, subsidies, makes the market price lower than the factor
cost. For instance, the government may like to provide wheat to consumers at
Rs 37 instead of the original price of Rs 40. For this, the government may provide
a subsidy of Rs 3 to the producers. These subsidies must be added to the market
prices to get factor cost.
Indirect taxes minus subsidies are known as Net Indirect Taxes. Market
prices of goods differ from their factor earnings to the extent of net indirect
taxes.
Factor Cost = Market Prices – Indirect Taxes + Subsidies
OR
Factor Cost = Market Prices – Net Indirect Taxes

Gross product and net product

Income can be measured either on gross basis or on a net basis. There is
a distinction between gross product and net product on the basis of whether
investment is taken in gross or net terms, i.e. whether depreciation is included
or not. In the process of production of commodities, some amount of economy`s
stock of plants and equipment is used up of wears out during the year. The
consumption of fixed capital in the process of production is known as
depreciation. If we deduct depreciation from gross investment, we get net
investment.
Net Product = Gross Product – Depreciation

Space for Class Notes:

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Aggregates of national income

1. Gross domestic product at market price (GDPMP)
Gross domestic product at market prices is defined as the value of all final
goods and services at prices prevailing in the market produced in the domestic
territory of a country during a given year.
Being gross, it is inclusive of depreciation and that is why it does not reveal
complete flow of goods and services among various sectors in the economy. GDP
at market prices measures the value of final goods and services at their market
price. The market value of these goods and services is calculated by multiplying
their physical quantities by their market prices.
2. Gross national product at market price (GNPMP)
It is defined as the aggregate market value of all final goods and services
produced by the normal residents of a country during a year.
It differs from GDPMP to the extent of net factor income from abroad. GNPMP
of a country can be greater than, less than or equal to GDPMP depending on
whether NFYA is positive, negative or zero.
GNPMP is an important tool as it is used to measure the performance of the
economy over time by comparing the production of goods and services during
one period with that of the other period. However, it does not exclude
depreciation and hence it does not reveal true or actual flow of goods and
services produced in the economy.
3. Net domestic product at market price (nDPMP)
It is the market value of all final goods and services at prices prevailing in
the market produced in the domestic territory of a country during a given year
after making allowance for depreciation.
NDPMP is a measure of net availability of final products. It is the measure of
national income which is available for consumption and investment in the
economy.
4. net national product at market price (nNPMP)
It shows the market value of all final goods and services produced by normal
residents of a country during a year after making allowance for depreciation.
It is considered to be a more accurate measure of the true output of the
economy then GNPMP. It reflects how much is produced over and above that
amount which is required to keep the nation`s stock of capital intact. It clearly
gives a better indication of long-run economic growth than GNPMP does.
5. Gross domestic product at factor cost (GDPfc)
It is the sum total of earnings received by various factors of production in
terms of wages, rent, interest and profits etc. within the domestic territory of a
country during a year.
Being gross, it makes no provision for depreciation. Therefore, it shows
income generated by all the producers in the domestic territory of a country
inclusive of depreciation.
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6. Gross national product at factor cost (GnPfc)

It is the sum total of earnings received by various factors of production in
terms of wages, rent, interest, etc. by normal residents of a country in a year.
It differs from GNPMP to the extent of net indirect taxes.
7. net domestic product at factor cost (nDPfc)
Net domestic product at factor cost is the estimate of the domestic product
in terms of earnings of factors of production within the domestic territory of a
country in a year.
It is also known as domestic factor income as it shows the income generated
within the domestic territory of the country by all the producers in a year. It
includes the following forms of income:
(a) Compensation of Employees which includes wages and salaries and all
kinds of payments made in cash and kind in return of labour services.
(b) Operating Surplus which includes income earned from ownership of
property and entrepreneurship such as rent, interest, profits, etc.
(c) Mixed Incomes which covers the incomes of own-account workers like
doctors, carpenters, etc.
8. net national product at factor cost (nnPfc)
National income can be defined as factor income accruing to the normal
residents of a country during a year. When we calculate the value of all final
goods and services produces by normal residents of a country, whether
operating within the domestic territory of a country or outside it, at their factor
cost, it is called net national product at factor cost.

Disposable income aggregates

In addition to the national income aggregates explained above, there is
another set of aggregates derived from national income known as disposable
income aggregates. These disposable income aggregates are derived from
national income aggregates by taking account of certain type of transfer
payments.
Transfer payments are payments received without any contribution to
current output. These payments are received by households, enterprises and
others without making any contribution to the production process in the current
period. For example, old-age pensions, gifts, donations, scholarships, etc.
Disposable income
A person may receive income not only in the form of factor payment, but
also in the form of transfer payments. Thus, income inclusive of all current
transfers is called disposable income. It is the income received from all sources
available to people.
Disposable Income = Income + Net Current Transfers
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National Disposable income

National disposable income is defined as the sum total of national income
at market prices and net current transfers received from rest of the world. It is
the income received by the residents of a country from all the sources for
spending as well as for saving during the year.
It is the current transfers from and to other countries that affect national
disposable income. However, current transfers from one sector to another sector
within a country do not affect national disposable income of a country. Such
intra-country transfers from one sector to another sector merely increase the
income of the recipient sector and reduce the income of the payer sector by the
same amount.
While estimating national disposable income, we take national product at
market prices as the relevant national income aggregate. Accordingly, we use
the following two concepts of national disposable income:
1. Gross national disposable income which is the sum total of gross national
product at market prices and net current transfers received from the rest of the
world.
GNDI = GNPMP + Net Current transfers from Abroad
2. Net national disposable income which is the sum total of net national
product at market prices and net current transfers received from the rest of the
world.
NNDI = NNPMP + Net Current transfers from Abroad

Disposable income aggregates of the private sector

1. PRIVATE INCOME
It is the total of factor income (including retained profits of the corporations)
from all sources and current transfers from the government and rest of the world
accruing to private sector.
It can be obtained from national income by deducting the following types of
income from national income:
(a) Income from property and entrepreneurship accruing to the government
commercial enterprises and administrative departments.
(b) Savings of non-departmental enterprises of the government.
Thus, private income does not include the income accruing to the
government sector because this part of national income is not available for
distribution and hence does not form a part of the income of the private sector.
(a) Interest on national debts paid by the government. The government
sometimes borrows funds from the public to meet its consumption
expenditure. It has to pay interest on this debt. Since public debt was
traditionally used by the government for consumption purposes, the
interest on national debt is treated as transfer payment and it forms a part
of private income.
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(b) Net current transfers received from the government administrative

departments in the form of old-age pensions, unemployment allowances,
gifts, scholarships, etc.
(c) Net current transfers like gifts and grants from other countries.
Thus,
Private Income = National Income – Income
from Property and Entrepreneurship
accruing to The Government Commercial
Enterprises and Administrative Departments
– Savings of Non-Departmental Enterprises
of the Government + Interest on National
Debts + Net Current transfers from
Government + Net Current Transfers from
Abroad.
2. PERSONAL INCOME
It is the income actually received by persons from all sources in the form
of factor incomes and current transfers payments during a year.
A certain part of the income which people have earned may not be actually
received by them. Some part of the income earned by the firms is not distributed
among the shareholders. A part of it is retained by the firms for further
investment in the firms. These are called undistributed profits or retained
earnings. A part of the income of the firms is used to pay corporate tax on the
profits earned. It is called corporate profit tax which accrues to the government.
Similarly, retained earnings of foreign companies in India are part of the private
income. Thus,
Personal Income = Private Income – Undistributed Profits
– Corporate Profit Tax – Retained Earnings of Foreign companies

3. PERSONAL DISPOSABLE INCOME

It is that part of personal income which is available to the individuals to be
used as the way they like. It is the income available to the households which
they can spend on consumption or can save as they desire.
Disposable income is always less than personal income. A part of the
personal income is taken away by the government by way of personal taxes such
as income tax, wealth tax, etc. In addition, there are miscellaneous receipts of
the government administrative departments in the form of fees, fines, etc. paid
by households. Therefore,

Personal Disposable Income = Personal Income – Personal Taxes

– Miscellaneous Receipts of the Government
Administrative Departments.

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Chapter – 9:
Measurement of National income
While measuring national income, it is important to keep in mind that
national income is taken in the sense of net national product at factor cost. In
the production process, goods and services are produced by the combination of
factors of production. These goods and services are distributed as factor incomes
to the owners of factors of production. The incomes earned are spent on the
consumer goods and capital goods. Thus, production gives rise to income,
income gives rise to expenditure and expenditure gives rise to income again. We
can put this relationship in terms of circular flow of income:
(i) Production of goods and services by producers with the use of productive
resources,
(ii) Distribution of incomes to the owners of productive resources, and
(iii) Expenditure of incomes on the purchase of final consumer and capital
goods.
Corresponding to these three phases of circular flow of income – production,
income and expenditure – national income of a country can be viewed in three
ways: as a flow of goods and services, as a flow of income generated and as a
flow of expenditure on goods and services.

Income

Production Expenditure

Accordingly, there are three different ways or methods of measuring national

income:
1. Net Product Method or Value Added Method
2. Income Method
3. Expenditure Method
All three methods give the same measure of national income but they refer to
conceptually different activities in the economy and provide different ways of
looking at national income.
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Net product or value added method

The net product or value added method measures national income as the
sum total of net final output produced or net value added by all the producing
units in an economy during a year. It involves the following steps:
Identifying and classifying various productive
units into industrial sectors:
All the production units in an economy are generally classified into the
following three broad industrial sectors on the basis of nature of production:
➢ Primary sector: It includes all those production units which produce
commodities by exploiting natural resources such as agriculture, fishing, forestry
etc.
➢ Secondary sector: It includes all those production units which produce
various products with the help of the primary sector such as manufacturing,
trade, electricity, gas, etc.
➢ Tertiary sector: This sector provides various types of non- tangible goods
i.e. services such as transport, banking etc.
Estimating Gross value Added by Each Enterprise:
The value of gross output of each enterprise is estimated by multiplying
its product by appropriate market prices. This can also be calculated by adding
the sales and change in stocks. The value so computed contains many duplicate
items in the form of intermediate goods, such as raw materials, fuel, coal etc. It
is called gross because it is estimated without deducting depreciation.
Gross value added by each enterprise is calculated by deducting the value
of intermediate consumption from the value of gross output. This is done so as
to avoid the problem of double counting.
Estimating Net Value Added by Each Enterprise:
Net value added at market price by each enterprise is estimated by
deducting the value of depreciation from the gross value added by an enterprise
estimated in the above step.
From the net value added at market price, net indirect taxes are deducted
so as to arrive at net value added at factor cost by an enterprise. By adding net
value added at factor cost by all the producing enterprises in a sector, we get
the net value added at factor cost of that industrial unit. The sum total of net
value added at factor cost of all the industrial enterprise in the domestic territory
of a country gives us the net domestic product at factor cost.
Estimating National Income:
The final step is to estimate Net factor income from abroad. This is done
by finding the difference between factor income received from rest of the world
and factor income paid to rest of the world. Net national product at factor cost,
i.e. national income is obtained by adding net factor income from abroad to the
net domestic product at factor cost.

National income = Net Domestic Product at

factor cost + Net factor income from abroad
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Precautions (Value Added Method):

✓ Value of goods produced for self-consumption such food grains produced
by farmers must be imputed or estimated. These goods are not sold in the
market and therefore do not have market price.
✓ Own account production of fixed assets, such as factory buildings of firms
and residential buildings of households must be included
✓ We should include imputed rent of owner occupied houses by estimating
the value from market rent of similar accommodation.
✓ Services of housewives, such as cooking meals, looking after their children
are excluded as these services have no market value.
✓ Sale of second hand goods such as old cars, old buildings etc. must be
excluded since nothing new is currently produced in the economy.
✓ Sale and purchase of share and bonds must be excluded since they reflect
only transfer of asset. However, services provided by the brokers must be
included for these services are rendered in the current year.

Difficulties in estimation (Value Added Method):

✓ Unsold amount of goods add to inventories which is to be included in
national income since it reflects current production of goods and services.
However, there is a problem of valuation of inventories in view of changes in
their prices.
✓ There is a problem with regards to depreciation as to take it on historical
cost basis or replacement cost basis.
✓ There is a confusion as to consider certain products like education.
Transport expenses etc. as final products or intermediate products.
✓ There is a difficulty to identify and demarcate final goods with intermediate
goods. For example, flour is a final good when sold to consumers but
intermediate goods when sold to a baker.
✓ Lack of adequate and reliable data, particularly in case of unincorporated
sector causes a serious problem in correctly estimating national income.

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Income Method
The income method measures national income at the phase of factor
payments made to the primary factors for the use of their factor services. It
involves the following steps:
1. Classification of enterprise and income categories:
In the first stage, production enterprises which employ factor services are
identified and classified into groups such as agriculture, trade, banking etc.
In the second stage, factor incomes are grouped under different categories:
Labour income or Compensation of employees:
It is a form of income which is earned by working for others. It is the payment
to workers for their labour. Labour income includes:
(i) Wages in cash, including wages and salaries, bonus, commission, house
rent allowance, dearness allowance, travelling allowance to travel to and from
workplace, leave travel concession, sick leave allowance, etc.
(ii) Wages in Kind, like rent free accommodation, free medical facilities, free
educational facilities, free or subsidised food, recreational and holidaying
facilities, free provision of goods and services, crèches for children of employees,
imputed interest on interest free loans etc.
(iii) Supplementary labour income in the form of employer`s contribution
to social security schemes for employees such as old age pension, group
insurance, gratuity, provident fund, etc.
Operating surplus
It is the income earned form the ownership and control of capital. Capital income
includes:
(i) Rent: It is the income earned by people who own land and buildings to
rent them out.
(ii) Interest: Income received from lending others.
(iii) Royalty: It is the income received for granting the rights of mining to
others and royalty earned from patents and copyrights.
(iv) Corporation Tax: It is the tax imposed on the profits earned by
companies.
(v) Dividend: Part of profits which is distributed to shareholders.
(vi) Undistributed profits: it is kept in the form of corporate saving to be
used for undertaking investment by the company.
Mixed Income
It is composed of labour income and capital income of those people who
provide both labour and capital services in the production process.
It is a mix of income from work and income from property and
entrepreneurship. It includes income of own account workers and income from
unincorporated sectors such as earnings from agriculture, trading, sole
proprietorship, income from own account workers like plumbers, carpenters, etc.
2. Estimation of Domestic Factor Income:
In this stage, income paid out by each producer enterprise is estimated by
adding together the three kinds of income namely compensation of employees,
operating surplus and mixed incomes. Thus, the income earned by all producing
units in the domestic territory of the economy during the accounting year gives
the measure of domestic factor income. (NDPFC)
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3. Estimating National Income:

In the last step, net factor income from abroad is estimated by taking the
difference between factor income received from rest of the world and factor
income accruing to rest of the world. Net factor income from abroad is then
added to domestic factor income to get national income.

National income = Compensation of employees + Operating

surplus + Mixed income of self-employed + Factor income from
abroad
Precautions (Income Method)
✓ Value of production for self-consumption, such as agricultural products
used by the farmers for the consumption of their families must be included.
✓ Imputed rent of the self-occupied houses by the owners of these houses
must be included.
✓ All transfer incomes such as old age pensions, unemployment allowances,
scholarships to students, etc. must be excluded as they have been received
without rendering any productive services in exchange.
✓ Illegal incomes like income for smuggling, drug dealings etc. must not be
included as these incomes earned from illegal activities and are unaccountable.
✓ Income from sale of second hand goods, bonds, shares must be excluded
as no contribution is made to the current flow of goods and services.
✓ Private transfer payments, such as pocket money given by parents to
children are excluded as they are mere transfer of money from one individual to
another.
✓ Windfall gains, such as income from lotteries, should not be included as
they do not contribute to current flow of goods and services.
✓ While calculating national income, we include profits before deducting
corporation tax. Therefore, corporation tax should not be added separately.
✓ Wealth tax, death duties, gift tax, etc. are paid out of current income or
out of past savings. Hence they should not be regarded as part of national
income.

Difficulties in estimation (Income method):

✓ Mixed incomes are earned by unincorporated sectors and it becomes
difficult to get reliable information from these sectors.
✓ Interest on national debt must not be included as per the assumption that
government borrowings are used for unproductive purposes. However, some
economists object to this since a part of the government borrowing is used for
productive purposes.
✓ Incomes received are generally calculated from income tax returns which
is of limited use in underdeveloped countries because a very small part of the
income earners are tax payers in these countries.

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Expenditure Method
It measures national income at the disposition stage, i.e. the disposition
of final products. In other words, it measures national income by estimating
expenditure on final products. Steps to calculate national income are as follows:
1. Classification of sectors and expenditure:
All the economic units which incur expenditure on final products are
divided into four broad categories along with their expenditures:
Households: Consumption expenditure.
Business sector: Investment expenditure.
Government sector: Government expenditure.
Foreign sector: Net Exports.
2. Measurement of Expenditure:
Private final consumption expenditure:
It comprises expenditures on the purchase of consumer goods and services
(except houses) by households and private non-profit institutions serving
households like schools, clubs, hospitals, etc. It is divided into three major sub-
categories:
1. Expenditure on non-durable goods such as food, beverages, etc. used
within a short span of time.
2. Expenditure on durable goods like TV`s, cars, etc. used for a longer period
of time.
3. Expenditure on services like transportation, medical services, etc.
We calculate final consumption by multiplying the volume of sale of these
goods and services in the market with their retail prices.
Estimation of Investment Expenditure:
It is the expenditure on investment or capital goods produced by firms and
they may be bought by firms, by governments or by households. It os divided
into three sub-categories:
1. Expenditure on business fixed investment: It includes expenditure on
purchase of new plants, machinery, equipment, etc. It is estimated by taking
the value of final sale of capital goods at market value.
2. Inventory investment: It includes change in inventories of the firm which
are in the warehouse, on store shelves or showroom floors, raw materials or
finished goods with producers. Inventory investment is calculated by taking the
difference between opening stock and closing stock.
3. Expenditure on residential housing: It can be found by estimating the total
money spent on construction of new houses. Expenditure on residence is taken
as investment because house is something that gives utility gradually over a
long period of time.
The expenditures incurred on the above three items are called gross investment.
However, a part of this expenditure is incurred to replace the worn out capital.
The amount necessary for replacement is called depreciation. By deducting
depreciation from gross investment, we get net investment.
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Net domestic investment = Gross fixed investment + Inventory

investment + Gross residential investment - Depreciation

Estimation of government expenditure:

Government expenditure is valued in terms of cost to government since
government services have no market price. The cost of these services is the sum
total of compensation of employees and the cost of goods and services
purchased by the government to provide these services. For example, cost of
defence services comprises wages and salaries paid to military personnel and
cost of military equipment.
Capital expenditure of the government is generally taken along with
investment expenditure. Therefore, we take here general government final
expenditure.
Estimation of Net Exports:
It is the difference between the value of goods and services exported to
other countries and the value of goods and services imported from other
countries. Net Exports are added to national income for two reasons:
1. Export represent foreign spending on domestic goods. When foreigners
purchase goods and services we produce, their spending adds to the demand for
domestically produced goods and services. Thus, exports need to be added to
get the measure of production.
2. Expenditure on imports of goods and services is a part of aggregate
spending by the residents of a country, though it is a part of the domestic
product of other countries. Thus imports must be subtracted to find out what is
the total production in the economy.
3. Estimation of Net Domestic Production:
The sum total of four items namely consumption, net investment,
government spending and net exports gives us Net Domestic Product at market
price. By deducting net indirect taxes, we get net domestic product at factor
cost.
4. Estimating National Income:
In the last stage, Net factor income from abroad is added to net domestic product
at factor cost to arrive at national income.

Y = C + In + G + (X - M) – NIT + NFYA
Precautions (Expenditure Method):
1. Expenditure on intermediate goods must be exclude to avoid the problem
of double counting.
2. All Expenditures on second hand goods must be excluded as they do not
add to the economy`s output.
3. Expenditures on financial assets like shares and bonds is excluded
because it reflects only transfer in the ownership of these assets.
4. Expenditure on transfer payments is not included as these are payments
which are made without any factor services rendered in the current period.
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Practical problems
Question 1: How will you treat the following items in estimating a country`s
national income?
(i) Sale of an old car (vi) Purchase of shares
(ii) Services of housewives (vii) Intermediate goods
(iii) Pocket allowance of children (viii) Owner-occupied houses
(iv) Pensions (ix) Income from smuggling
(v) Interest on national debt (x) Winning a lottery

Question 2: From the data given below, estimate the compensation of

employees.
(Rs. in thousand)
(i) Wages and salaries received by staff in cash 528
(ii) Value of free housing facilities 162
(iii) Subsidy on Lunch/Dinner to the staff 32
(iv) Employer`s contribution to social security 28
(v) Compensation received by injured worker from
Insurance company 10
Question 3: From the following data relating to a firm, calculate compensation
of employees.
(Rs.in thousand)
(i) Wages and Salaries 45
(ii) Commission paid to sales staff 15
(iii) Value of free medical facilities 5
(iv) Value of subsidised food 10
(v) Travel allowance 25
(vi) Interest free loan given to staff 20
Question 4: Calculate operating surplus from the following data:
(Rs.in Crore)
(i) Royalty 5
(ii) Rent 75
(iii) Interest 30
(iv) Gross Domestic Product at Factor Cost 400
(v) Profit 45

Question 5: Find out compensation of employees from the following data:

(Rs. in lakh)
(i) Rent 20
(ii) Interest 35
(iii) Profits 15
(iv) Gross Domestic Product at Factor Cost 350
(v) Consumption of fixed capital 60
(vi) Mixed-income of self-employed 100
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Question 6: Estimate compensation of employees from the following data:

(Rs. In crore)
(i) Value of output 570
(ii) Net indirect taxes 60
(iii) Interest 20
(iv) Rent 35
(v) Profit 25
(vi) Intermediate consumption 120
(vii) Consumption of fixed capital 50
(viii) Mixed income of self-employed 100

Question 7: From the data given below, estimate operating surplus:

(Rs. in Lakhs)
(i) Wages and salaries 232
(ii) Value of output at market prices 845
(iii) Intermediate consumption 418
(iv) Indirect taxes 80
(v) Subsidies 10
(vi) Consumption of fixed capital 25

Question 8: From the following data, calculate national income by (a) Income
method and (b) Expenditure method
(Rs. in crore)

(i) Compensation of employees 800

(ii) Private final consumption expenditure 1200
(iii) Profits 500
(iv) Rent 200
(v) Government final consumption expenditure 800
(vi) Interest 150
(vii) Net factor income from abroad 20
(viii) Net indirect taxes 190
(ix) Mixed income of self-employed 630
(x) Net exports -(30)
(xi) Net domestic capital formation 500
(xii) Consumption of fixed capital 150