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What is Macroeconomics?, Basic concepts in macroeconomics: consumption, , goods, capital goods, final goods, intermediate, goods; stocks and flows; gross investment and, depreciation., Circular flow of income (two sector model);, Methods of calculating National Income - Value, Added or Product method, Expenditure method,, Income method., Aggregates related to National Income: Gross, National Product (GNP), Net National Product, (NNP), Gross Domestic Product
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(GDP) and Net Domestic Product (NDP) - at, , market price, at factor cost; Real and Nominal, GDP., GDP and Welfare
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What is Macroeconomics?, In macroeconomics, we study the economic behaviour, of the economy as a whole by focusing our attention on, aggregate measures such as total output, employment, and aggregate price level., Here, we are interested in finding out how the levels of, these aggregate measures are determined and how the, levels of these aggregate measures change over time., Some of the important questions that are studied in macroeconomics are as follows:, • What is the level of total output in the economy?, • How is the total output determined?, • How does the total output grow over time?
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• Are the resources of the economy (e.g. labour) fully, employed?, • What are the reasons behind the unemployment of, resources?, • Why do prices rise?, Thus, instead of studying the different markets as is done in microeconomics, in macroeconomics, we try to, study the behaviour of aggregate or macro measures of, the performance of the economy.
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1.1, Some Basic Concepts of, National Income Accounting
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Final Goods and Intermediate Goods, Goods are classified as final goods and intermediate goods on the basis of the end use of the goods., , Final Goods, If goods are purchased for consumption, i.e., for satisfaction of wants, or for investment, these are called final, goods (or final products)., Expenditure on them is called final expenditure., Examples:, (i) Machine purchased by a firm for installation in, factory is a final good because it is purchased for, investment.
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(ii) Milk purchased by households is a final good as, it is purchased for consumption., (iii) Furniture purchased by a school is a final product because it is purchased for investment., (iv) Computers installed in an office is a final product because it is purchased for investment., (v) Printer purchased by a lawyer for office use is a, final product because it is purchased for investment., (vi) Blackboard used in a school is a final good because it is for investment. It is not used up completely in a year but remains for production of, educational services., (vii) Second hand car purchased by a house hold is a, final good because it is purchased for consumption.
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Intermediate Goods, Goods and services purchased by a production unit from other production units with the purpose of reselling or with the purpose of using them completely during the same year are called intermediate goods (or, intermediate products)., , , , Top Tip, , • Raw materials or non-factor inputs purchased for producing, goods are intermediate goods., • Intermediate goods are also called ‘single use producer goods’., • The expenditure on the intermediate goods is called intermediate cost or intermediate consumption.
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Examples:, (i) Steel sheets used for making automobiles and copper used for making utensils are intermediate, goods since they are purchased with the purpose, of using them completely during the same year for, production of steel gates/utensils., (ii) Mobile sets purchased by a mobile dealer are intermediate products because these are purchased for, resale., (iii) Chalks, dusters, etc. purchased by a school are intermediate products because these are used up, completely during the same year in the production, of educational services., (iv) Paper purchased by a publisher is an intermediate
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(v), (vi), , (vii), (viii), , product because it is used as raw material for production of books in the same year., Purchase of rice by a grocery shop is an intermediate product because it is purchased for resale., Coal used by a manufacturing firm is an intermediate product because it is used as a nonfactor input for production of other commodities, during the same year., Fertilisers used by the farmers are intermediate, products because these are used up completely, for producing grains during the same year., Cotton used by a spinning mill is an intermediate, product because it is used for further production, of clothes during the same year.
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, , Top Tip, , National income includes the value of final goods only., The value of intermediate goods is not included in the, national income estimates because it is already included, in the value of the final goods. Including intermediate goods separately will inflate or overestimate the national, income.
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Consumption Goods and Capital Goods, Final goods produced in an economy in a given period, of time are either in the form of consumption goods, (both durable and non-durable) or capital goods. As final, goods they do not undergo any further transformation at, the hands of any producer. Thus, of the final goods, we, can distinguish between consumption goods and capital, goods.
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Consumption Goods, The final goods which are consumed (or used) for satisfaction of wants by the consumers are called consumption goods* or consumer goods, e.g., food, clothing, television sets, etc., Those consumer goods like television sets, automobiles, home computers, etc. which are of durable, character are called consumer durables., Those consumer goods like food, clothing, etc. which are extinguished by immediate or short period, consumption are known as consumer non-durable goods., *This also includes services like recreation which are consumed but for convenience, we may refer to them as consumer goods.
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Capital Goods, The final goods of durable character which are used in, the production of other goods and services are called, capital goods or investment goods, e.g., machines, tools and equipments., Capital goods are also called durable use producer, goods having a long span of life, say 5 years or 10, years.
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, , Top Tip, , Basis of classification of final goods into consumption, goods and capital goods, The same good can be consumption good and also capital, good. It depends on the economic nature of its use. For, example, a machine purchased by a household is a consumption good whereas, if it is purchased by a firm for use, in the business, then it is a capital good. Similarly, a car, purchased by a household is a consumption good whereas if it is purchased by a firm for use in business, then it is, a capital good.
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Stocks and Flows, Stocks, , Stocks are economic variables measured at a given point of time., For example, Capital, Wealth, Money supply, Population,, Inventories, Foreign debts, Buildings and machines in, a factory, Balance in a bank account, etc. are stock, variables since they are measured at a particular point, of time.
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Flows, Flows are economic variables measured over a period, of time., National income or Gross domestic product (GDP) or, Production or Output, Sales, Savings, Expenditure, Profits, Losses, Exports, Imports, Net capital formation, or net investment, Depreciation, Interest, Change in, inventories, Change in money supply, Value added, etc. are flow variables since they are measured over a, period of time.
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, , Top Tip, , An example to understand the difference between stock, variables and flow variables, Suppose a tank is being filled with water coming from a tap., The amount of water which is flowing into the tank from the, tap per minute is a flow. But how much water there is in the, tank at a particular point of time is a stock concept.
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Gross Investment and Depreciation, Investment, , In economics, the term ‘investment’* is defined as, addition to the stock of fixed capital (such as machines) and change in inventories during a year., That part of final output which comprises of capital, goods constitutes gross investment of an economy. For, example, machines, tools and implements, buildings,, office spaces, store houses or infrastructure like roads,, bridges, airports or jetties, etc., * The term ‘investment’ must not be confused with the commonplace notion of, investment which implies using money to buy physical or financial assets. Thus, use of, the term investment to denote purchase of shares or property or even having an, insurance policy has nothing to do with how economists define investment.
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Depreciation, A part of the capital goods produced this year goes for, maintenance or replacement of existing capital goods, because the existing capital stock suffers wear and tear, and needs maintenance and replacement. This portion, of the capital goods produced is not an addition to the, stock of capital goods and its value needs to be subtracted from gross investment to arrive at net investment. This deletion made from the value of gross investent in order to accommodate regular wear and tear of, capital, is called depreciation., Depreciation is an annual allowance for normal wear, and tear and foreseen obsolescence of a fixed capital, asset.
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New addition to capital stock in an economy is called, net investment (or net capital formation)., Thus, investment is defined as capital formation, a gross, or net addition to capital stock., Let us examine the concept of depreciation a little more, in detail:, , Example: Suppose a new machine is purchased for, `20 lakh having useful life of service 10 years, after, which it falls into disrepair and needs to be replaced., Suppose, the scrap value of the machine will be nil, after 10 years.
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Therefore, Depreciation on the machine, =, , lakh per year., , Thus, the machine is gradually used up in each year’s, production process and each year 1/10th of its original, value, i.e. `2 lakh gets depreciated. So, instead of, considering a bulk investment for replacement after 10, years, we consider an annual depreciation cost every, year., Note that depreciation does not take into account, unexpected/unforeseen, obsolescence, or, sudden, destruction or disuse of capital as can happen with, accidents, natural calamities or other such extraneous, circumstances. This is called ‘capital loss’.
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, , Top Tip, , Depreciation is also defined as:, 1. Consumption of fixed capital, 2. Value of capital consumption, 3. Current annual replacement cost of fixed capital assets, 4. Annual replacement investment to keep the value of fixed, capital assets constant, 5. Annual allowance for normal wear and tear and foreseen, obsolescence, 6. Annual maintenance and replacement cost of existing capital goods, 7. Regular wear and tear of capital, 8. Part of capital stock used up in each year’s production process
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Industrial classification – Primary,, Secondary and Tertiary Sectors, Industrial classification means grouping production, units into distinct industrial groups, or sectors. This is, the first step required to betaken in estimating national income, irrespective of the method of estimation. It, is statistically more convenient to estimate national, income originating in a group of similar production, units rather than for each production unit separately., It is now a matter of general practice to group all the, production units of a country into three broad groups, – primary sector, secondary sector and tertiary sectors., Each of these sector can be further subdivided into, smaller groups depending upon the requirement. Let
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us now explain each sector., , Primary Sector, Primary sector includes production units exploiting, natural resources like land, water, subsoil assets, etc., Growing crops, catching fish, extracting minerals,, animal husbandry, forestry, etc. are some examples., Primary means of first importance. It is primary because it is a source of basic raw materials for the secondary sector.
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Secondary Sector, Secondary sector includes production units which are, engaged in transforming one physical good into another, physical good. Such an activity is called manufacturing, activity. These units convert raw materials into finished, goods. Factories, construction, power generation, water, supply, etc. are some examples., It is called secondary because it is dependent upon the, primary sector for raw materials.
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Tertiary Sector, Tertiary sector includes production units engaged in, producing services. Transport, trade education, hotels, and restaurant, finance, government administration,, etc. are some examples., This sector finds third place because its growth is mainly dependent on the primary and secondary sectors.
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Indirect Tax and Subsidy, Indirect Tax, , Indirect tax is a tax imposed by government on production and sale of goods and services. It is a tax where, the payer and the bearer of the tax are different people., Examples: Goods and services tax (GST),* excise tax,, customs duties (export duty and import duty), service, tax, sales tax etc., Imposition of indirect taxes by the government increases the market prices of goods and services., * In India, Goods and Services Tax (GST) has replaced various indirect taxes,, levied by the Central and State/UT Governments. Some of the major taxes that, were levied by Centre were Central Excise Duty, Service Tax, Central Sales Tax,, etc. The major State taxes were VAT/Sales Tax, Entry Tax, Luxury Tax, Octroi,, Entertainment Tax, etc. These have been subsumed in GST.
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Subsidy, Subsidy is a from CBSE 2020 assistance given by the, government to the firms and households, with a motive of general welfare., Examples: Cash grants, interest-free loan to the firms,, subsidy on price of cooking gas to the households, etc., Subsidies granted by the government reduce the market prices of goods and services.
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Market Price and Factor Cost, Market Price, , Market prices are the prices as paid by the consumers., Market prices also include indirect taxes., , Factor Cost, , Factor cost refer to the prices of products as received, by the producers. In other words, factor cost is what is, actually available to production units for distribution, of income among the owners of factors of production., Indirect taxes are deducted from and subsidies are, added to market price to calculate what production, units actually receive., OR,, , Factor Income and Transfer Income
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Factor Income and Transfer Income, Factor Income, , The payment for the services rendered to the production, units by the owners of factors of production is called factor payment or factor income. Examples: Wages and, salary, rent, interest profit, etc.
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Transfer Income, Any payment for which no service is rendered is called, a transfer payment or transfer income. It does not involve any production of goods and services., Examples: Gifts, donations, charity, etc., , , , Top Tip, , National income includes only factor payments which are received in return for the factor services provided in production, of goods and services., On the other hand, transfer payment is not included in national income. This is because national income is a measure of, the value of production activity of a country, whereas transfer, payment does not involve any production activity.
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Inventory and Change in Inventories, Inventory, , The stock of unsold finished goods, or semi-finished, goods, or raw materials which a firm carries from one, year to the next is called inventory., Inventory is measured at a given point of time, e.g. value of inventory in the beginning of the year or value, of inventory at the end of the year. So, it is a stock variable.
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Change in Inventories, Change in inventories equals closing inventory minus, opening inventory., Change in inventories (or stock) takes place over a, period of time. Therefore, it is a flow variable., , , , Top Tip, , Inventory is treated as capital. So, it is a stock variable. On the, other hand, change in the inventory of a firm is treated as, investment, i.e., addition to the stock of capital of a firm. So, it, is a flow variable.
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Net product taxes and Net production, taxes, Net product taxes, , Product taxes and subsidies are paid or received per, unit of product, e.g., excise tax, service tax, export and, import duties, etc.
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Net production taxes, Production taxes and subsidies are paid or received in, relation to production and are independent of the, volume of production, e.g. land revenues, stamp and, registration fee.
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, •, , •, •, , Top Tip, Market prices include both Net Product taxes and Net, Production taxes., Basic prices include net production taxes but not net, product taxes., Factor cost includes only the payment to factors of, production, it does not include any tax.
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Key Terms, Final goods—Goods purchased for final consumption, i.e., for, satisfaction of wants, or final investment., Intermediate goods—Goods purchased by a production unit from, other production units with the purpose of reselling or with the, purpose of using them completely during the same year., Consumption goods—The final goods which are consumed (or, used) for satisfaction of wants by the consumers., Capital goods—The final goods of durable character which are, used in the production of other goods and services., Stocks—Economic variables measured at a given point of time,, e.g. capital, wealth, etc., Flows—Economic variables measured over a period of time, e.g., income, output, etc., Gross investment—That part of final output which comprises of, capital goods such as machines., Depreciation—An annual allowance for normal wear and tear and, foreseen obsolescence of a fixed capital asset.
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Net investment—New addition to capital stock in an economy is, called net investment or net capital formation.
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RECAP, , Macroeconomics, In macroeconomics, we study the economic behaviour of the, economy as a whole, e.g. aggregate demand, aggregate supply,, levels of income, employment and price in the economy., Final Goods and Intermediate Goods, Goods are classified as final goods and intermediate goods on, the basis of the end use., Final goods are the goods which are used for final, consumption (i.e., for satisfaction of wants) or for, investment., Examples: (i) Machine purchased by a firm for installation in, factory, (ii) Milk or bread purchased by households, (iii), Printer purchased by a lawyer for office use, etc., Intermediate goods (or single use producer goods) are the, goods which are purchased during the year by a firm from
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another for the purpose of further production or resale., Examples: (i) Raw materials such as steel sheets used for, making automobiles and copper used for making utensils,, (ii) Mobile sets purchased by a mobile dealer, (iii) Chalks,, dusters, etc. purchased by a school, (iv) Paper purchased by, a publisher, (v) Purchase of rice by a grocery shop, (vi), Fertilisers used by the farmers, etc., , Consumption Goods and Capital Goods, Consumption goods (or consumer goods) are that part of, the final goods which are consumed (or used) for, satisfaction of wants by the consumers, e.g., food, clothing,, TV sets, refrigerators, etc., Capital goods (or investment goods or durable use, producer goods) are that part of the final goods which are, bought not for meeting immediate needs of the consumers, but are for producing other goods, e.g., machines and
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equipments. They are of durable character., Stocks and Flows, Stocks are economic variables which can be measured at a, given point of time, e.g. Capital, Wealth, Money supply,, Inventories, Buildings and machines in a factory, Balance in, a bank account, etc., Flows are economic variables which can be measured over a, period of time, e.g, National income or GDP or Production, or Output, Sales, Savings, Expenditure, Profits, Losses,, Exports, Imports, Gross/Net capital formation or Gross/Net, Investment, Depreciation, Interest, Change in inventories,, Change in money supply or money creation, Value addition,, etc., Gross Investment and Depreciation, Gross investment (or gross capital formation) refers to the
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addition to capital stock of an economy during an, accounting year., Depreciation is an annual allowance for normal wear and, tear and foreseen obsolescence of a fixed capital asset., Depreciation is also defined as value of consumption of fixed, capital or annual maintenance and replacement cost of fixed, capital assets., Depreciation on fixed capital asset =, , Note: Unexpected/unforeseen obsolescence or sudden, destruction of capital assets is not depreciation. It is called, capital loss., Net investment (or net capital formation) is the new, addition to capital stock in an economy. A part of the capital
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goods produced goes for maintenance or replacement of, existing capital goods. Thus, Net Investment = Gross, investment – Depreciation., Indirect Tax and Subsidy, Indirect tax is a tax imposed by government on production, and sale of goods and services. Examples: Goods and, services tax (GST), excise tax, etc. Indirect taxes increase, market prices of goods and services., Subsidy is a form of financial/economic assistance given by, the government to the firms and households, with a motive, of general welfare. Examples: Cash grants, interest-free loan, to the firms, subsidy on price of cooking gas to the, households, etc. Subsidies reduce the market prices of goods, and services., Net indirect tax = Indirect taxes – Subsidies
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Market Price and Factor Cost, Market price is what the buyers pay. It includes indirect, taxes but excludes subsidies., Factor cost is what is actually available to production units., Factor cost = Market price – Indirect taxes + Subsidies, Factor Income and Transfer Income, The payment for the services rendered to the production, units by the owners of factors of production is called factor, payment or factor income, e.g. wages and salary, rent,, interest profit, etc., Any payment for which no service is rendered is called a, transfer payment or transfer income. It does not involve, any production of goods and services. Examples: Gifts,, donations, charity, etc.
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Inventory and Change in Inventories, The stock of unsold finished goods, or semi-finished goods,, or raw materials which a firm carries from one year to the, next is called inventory., Net change (or increase) in inventories = Closing inventory – Opening inventory
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NUMERICAL 1, Calculate ‘Depreciation on Capital Asset’ from the, following data:, (CBSE Sample Question Paper 2020) (4 marks), S. No, , Particulars, , Amount (in `crore), , i., , Capital value of the asset, , 1,000, , ii., , Estimated life of the asset, , 20 years, , iii., , Scrap Value, , Solution: Depreciation on capital asset, , Nil
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Do it yourself 1, Arrange the following coefficients of price elasticity of, demand in ascending order:, (1 mark), (–) 3·1, (–) 0·2, (–) 1·1
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Question 1, The good or service purchased by an individual or an, enterprise is for :, (Choose the correct alternative), (a) Final use, (b) Use in further production, (c) Both (a) and (b), (d) Consumption, , Objective Type Questions 1.1
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Answer 1, (c) Both (a) and (b), , Objective Type Questions 1.1
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Question 2, A good that is meant for final use and will not pass, through any more stages of production or transformations, at the hands of any producer is called __________ ., (Fill in the blank), , Objective Type Questions 1.1
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Answer 2, a final good, , Objective Type Questions 1.1
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Question 3, A final good may also undergo transformations., True/False? Give reason., , Objective Type Questions 1.1
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Answer 3, True: Final goods may be transformed during their, consumption, e.g. the tea leaves purchased by the, consumers are used to make drinkable tea., , Objective Type Questions 1.1
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Question 4, It is not in the nature of the good but in the _______, that a good becomes a final good., (Fill in the blank), , Objective Type Questions 1.1
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Answer 4, economic nature of its use, , Objective Type Questions 1.1
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Question 5, If tea leaves are used in a restaurant for tea brewing ,, and the drinkable tea is sold to the customers, then the, tea leaves will be________________., (Choose the correct alternative), (a) Final goods, (b) Intermediate good, (c) Consumption goods, (d) Capital goods, , Objective Type Questions 1.1
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Answer 5, (b) Intermediate good, , Objective Type Questions 1.1
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Question 6, Final goods are:, (Choose the correct alternative), (a) Consumption goods, (b) Capital goods, (c) Both (a) and (b), (d) Intermediate goods, , Objective Type Questions 1.1
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Answer 6, (c) Both (a) and (b), , Objective Type Questions 1.1
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Question 7, Goods of durable character which make production of, other commodities feasible but they themselves don’t, get transformed in the production process, are called, __________., (Fill in the blanks), , Objective Type Questions 1.1
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Answer 7, Consumption goods or consumer goods, , Objective Type Questions 1.1
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Question 8, Goods like food and clothing and services like, recreation that are consumed when purchased by their, ultimate consumers are called ________________., (Fill in the blank), , Objective Type Questions 1.1
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Answer 8, Capital goods, , Objective Type Questions 1.1
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Question 9, The durable goods which undergo wear and tear with, gradual use, and thus are repaired or gradually replaced, over time are :, (Choose the correct alternative), (a) Intermediate goods, (b) Capital goods, (c) Consumer durables, (d) Both (b) and (c), , Objective Type Questions 1.1
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Answer 9, (d) Both (b) and (c), , Objective Type Questions 1.1
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Question 10, All the final goods and services produced in an economy, in a given period of time are either in the form of, ________________ or __________ ., (Fill in the blanks), , Objective Type Questions 1.1
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Answer 10, Consumption goods (both durable and non-durable);, Capital goods, , Objective Type Questions 1.1
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Question 11, Of the total production taking place in the economy, a, large number of products don’t end up in final, consumption and are not capital goods either. These are, ________________., (Fill in the blank), , Objective Type Questions 1.1
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Answer 11, Intermediate goods, , Objective Type Questions 1.1
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Question 12, Raw materials or non-factor inputs used for production, of other commodities are:, (Choose the correct alternative), (a) Capital goods, (b) Final goods, (c) Intermediate goods, (d) Consumer durables, , Objective Type Questions 1.1
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Answer 12, (c) Intermediate goods, , Objective Type Questions 1.1
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Question 13, Income, or output, or profits are concepts that make, sense only when a time period is specified. These are, called ___________., (Fill in the blank), , Objective Type Questions 1.1
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Answer 13, flows, , Objective Type Questions 1.1
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Question 14, (i) ______________ (Stock / Flows) are defined over a, period of time, whereas (ii) ______________ (Stock /, Flows) are defined at a particular point of time., (Choose the correct option), , Objective Type Questions 1.1
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Answer 14, (i) Flows (ii) Stocks, , Objective Type Questions 1.1
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Question 15, Capital goods (e.g. buildings or machines in a factory) or, consumer durables (e.g. television sets, home computers, etc), once produced do not wear out or get consumed in a, delineated time period. In fact, capital goods continue to, serve us through different cycles of production. There, can be addition to, or deduction from, these if a new, machine is added or a machine falls in disuse and is not, replaced. These are called ____________ . (Stock /, Flows), (Choose the correct option), , Objective Type Questions 1.1
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Answer 15, Stocks, , Objective Type Questions 1.1
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Question 16, Change in stocks are _____________. (Stocks /, Flows)., (Choose the correct option), , Objective Type Questions 1.1
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Answer 16, Flows, , Objective Type Questions 1.1
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Question 17, Suppose a tank is being filled with water coming from a, tap. The amount of water which is flowing into the tank, from the tap per minute is a (i) _________________, (Stock concept / Flow concept). But how much water is, in the tank is a (ii) _________________ (Stock, concept / Flow concept)., (Choose the correct option), , Objective Type Questions 1.1
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Answer 17, (i) Flow concept (ii) Stock concept, , Objective Type Questions 1.1
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Question 18, The part of final goods that comprises of capital goods, constitutes ______________ of an economy., (Fill in the blank), , Objective Type Questions 1.1
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Answer 18, Gross investment, , Objective Type Questions 1.1
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Question 19, All the capital goods produced in a year do not, constitute net addition to the capital stock already, existing., True/False Give reason, , Objective Type Questions 1.1
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Answer 19, True: Significant part of current output of capital, goods goes in maintaining or replacing part of the, existing stock of capital goods in an economy. This, is because the already existing capital stock suffers, wear and tear and needs maintenance and, replacement., , Objective Type Questions 1.1
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Question 20, A part of the capital goods produced this year goes for, replacement of existing capital goods and is not an, addition to the stock of capital goods already existing, and its value needs to be subtracted from gross, investment for arriving at the measure of net investment., This deletion, which is made from the value of gross, investment in order to accommodate regular wear and, tear of capital is called __________ . (Fill in the blank), , Objective Type Questions 1.1
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Answer 20, Depreciation/Consumption of fixed capital, , Objective Type Questions 1.1
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Question 21, New addition to capital stock in an economy is, ________________., , Objective Type Questions 1.1
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Answer 21, Net investment/Net capital formation, , Objective Type Questions 1.1
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Question 22, Which of the following does not explain the concept of, depreciation?, (Choose the correct alternative), (a) An annual allowance for wear and tear of a capital, good., (b) Cost of the capital good (minus scrap value) divided, by number of years of its useful life., (c) Unexpected or sudden destruction or disuse of, capital as can happen with accidents, natural, calamities etc., (d) Maintenance and replacement cost of existing, capital goods., , Objective Type Questions 1.1
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Answer 22, (c) Unexpected or sudden destruction or disuse of, capital as can happen with accidents, natural, calamities etc., , Objective Type Questions 1.1
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Question 23, Depreciation is an accounting concept., True/False? Give reason., , Objective Type Questions 1.1
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Answer 23, True: No real expenditure may have actually been, incurred each year yet depreciation is annually, provided for., , Objective Type Questions 1.1
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Question 24, Which of the following define ‘investment’ in Economics, ?, (Choose the correct alternative), (a) Purchase of share or property., (b) Having an insurance policy., (c) Using money to buy physical or financial assets., (d) Capital formation ,i.e. a gross or net addition to, capital stock., , Objective Type Questions 1.1
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Answer 24, (d) Capital formation ,i.e. a gross or net addition to, capital stock., , Objective Type Questions 1.1
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Question 25, In economics, investment implies using money to buy, physical or financial assets., True/False? Give reason., , Objective Type Questions 1.1
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Answer 25, False: In economics, ‘investment’ implies capital, formation, i.e. a gross or net addition to capital, stock/goods, e.g. machines, tools, and, implements, buildings, office spaces, store, houses, or infrastructure like roads, bridges,, airports or jetties., , Objective Type Questions 1.1
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Question 26, Total final output produced in an economy in a given, year are used :, (Choose the correct alternative), (a) To substain the consumption of the entire, population of the economy., (b) For maintenance and replacement of the existing, capital stock., (c) For new addition to the capital stock., (d) All of the above, , Objective Type Questions 1.1
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Answer 26, (d) All of the above, , Objective Type Questions 1.1
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Question 27, More capital goods would always mean more consumer, goods., True/False?, , Objective Type Questions 1.1
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Answer 27, False, , Objective Type Questions 1.1
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Question 28, _________ add to, or maintain, the capital stock of an, economy and thus make production of other, commodities possible., (Fill in the blank), , Objective Type Questions 1.1
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Answer 28, Capital goods, , Objective Type Questions 1.1
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Question 29, Match the following:, Column I, , Column II, , (i) Fertilisers or pesticides used (a) Intermediate goods, by, a farmer to produce wheat, (ii) Bread produced by a baker, for, , (b) Final goods, selling it to consumers or, restaurants, , Objective Type Questions 1.1
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Answer 29, (i) - (a), (ii) - (a), , Objective Type Questions 1.1
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Question 30, Depreciation is also known as:, (Choose the correct alternative), (a) Consumption of fixed capital, (b) Annual replacement cost, (c) Value of capital consumption, (d) All of the above, , Objective Type Questions 1.1
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Answer 30, (d) All of the above, , Objective Type Questions 1.1
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Question 31, Inventory is a stock variable., , True/False? Give reason., , Objective Type Questions 1.1
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Answer 31, True: Inventory is measured at a particular point of, time. It may have a value at the beginning of the, year or it may have a value at the end of the, year., , Objective Type Questions 1.1
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Question 32, Change in inventories is a stock variable ., True/False? Give reason., , Objective Type Questions 1.1
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Answer 32, False: Change in inventories is a flow variable. It takes, place over a period of time (say one year)., , Objective Type Questions 1.1
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Question 33, ‘Exports’ is a flow variable., , True/False? Give reason., , Objective Type Questions 1.1
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Answer 33, True: as exports are measured on an annual basis, i.e., over a period of time., , Objective Type Questions 1.1
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Question 34, Which of the following is a flow concept?, (Choose the correct alternative), (a) Foreign exchange reserves, (b) Inventory, (c) Capital, (d) Exports, , Objective Type Questions 1.1
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Answer 34, (d) Exports, , Objective Type Questions 1.1
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Question 35, Which of the following is a stock variable?, (Choose the correct alternative), (a) Money supply, (b) Depreciation, (c) Interest, (d) Output, , Objective Type Questions 1.1
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Answer 35, (a) Money supply, , Objective Type Questions 1.1
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Question 36, Losses are classified as:, (a) Stock variable, (b) Flow variable, (c) Either (a) or (b), (d) Neither (a) nor (b), , (Choose the correct alternative), , Objective Type Questions 1.1
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Answer 36, (b) Flow variable, , Objective Type Questions 1.1
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Question 37, Which of the following is not a flow?, (Choose the correct alternative), (a) Capital, (b) Income, (c) Investment, (d) Depreciation, , Objective Type Questions 1.1
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Answer 37, (a) Capital, , Objective Type Questions 1.1
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Question 38, Which of the following is a stock?, (Choose the correct alternative), (a) Wealth, (b) Saving, (c) Exports, (d) Profits, , Objective Type Questions 1.1
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Answer 38, (a) Wealth, , Objective Type Questions 1.1
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Question 39, Which of the following is a flow?, (Choose the correct alternative), (a) Deposits in a bank, (b) Capital, (c) Depreciation, (d) Wealth, , Objective Type Questions 1.1
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Answer 39, (c) Depreciation, , Objective Type Questions 1.1
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Question 40, Which one of the following is an intermediate product?, (Choose the correct alternative), (a) Purchase of pulses by consumers, (b) Machine purchased by a firm, (c) Wheat used by a flour mill, (d) Wheat used by households, , Objective Type Questions 1.1
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Answer 40, (c) Wheat used by a flour mill, , Objective Type Questions 1.1
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Question 41, Which of the following is an example of an intermediate, good?, (Choose the correct alternative), (a) Copper purchased for making utensils, (b) Steel and cement used to construct a flyover, (c) Fertilizers purchased by a farmer, (d) All of these, , Objective Type Questions 1.1
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Answer 41, (d) All of these, , Objective Type Questions 1.1
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Question 42, Depreciation of fixed capital assets refers to:, (Choose the correct alternative), (a) Normal wear and tear, (b) Foreseen obsolescence, (c) Normal wear and tear and foreseen obsolescence, (d) Unforeseen obsolescence, , Objective Type Questions 1.1
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Answer 42, (c) Normal wear and tear and foreseen obsolescence, , Objective Type Questions 1.1
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Question 43, Unforeseen obsolescence of fixed capital assets during, production is:, (Choose the correct alternative), (a) Consumption of fixed capital, (b) Capital loss, (c) Income loss, (d) None of the above, , Objective Type Questions 1.1
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Answer 43, (b) Capital loss, , Objective Type Questions 1.1
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Question 44, Refrigerator purchased by a confectionery shop is an, example of:, (Choose the correct alternative), (a) Final good, (b) Intermediate good, (c) Capital good, (d) Both (a) and (c), , Objective Type Questions 1.1
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Answer 44, (d) Both (a) and (c), , Objective Type Questions 1.1
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Question 45, Which of the following is an example of consumer nondurable good?, (Choose the correct alternative), (a) Milk, (b) Bread, (c) Both (a) and (b), (d) Clothes, , Objective Type Questions 1.1
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Answer 45, (c) Both (a) and (b), , Objective Type Questions 1.1
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Question 46, Addition to the capital stock of an economy is termed, as:, (Choose the correct alternative), (a) Investment, (b) Capital loss, (c) Consumption of fixed capital, (d) All of these, , Objective Type Questions 1.1
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Answer 46, (a) Investment, , Objective Type Questions 1.1
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Question 47, Goods purchased for the following purpose are final, goods :, (Choose the correct alternative), (a) For satisfaction of wants, (b) For investment in firm, (c) Both (a) and (b), (d) None of these, , Objective Type Questions 1.1
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Answer 47, (c) Both (a) and (b), , Objective Type Questions 1.1
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Question 48, Match the following:, (Choose the correct alternative), (i) Profits, (a) Stock variable, (ii) Savings, (b) Flow variable, (iii) Balance in a bank account, (iv) Gross Domestic Product (GDP), , Objective Type Questions 1.1
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Answer 48, (i) – (b), (ii) – (b), (ii) – (a), (iv) – (b), , Objective Type Questions 1.1
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Question 49, State giving reason whether the following statement is, True or False:, Capital formation is a flow concept., , Objective Type Questions 1.1
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Answer 49, True: Capital formation is measured over a period of, time., , Objective Type Questions 1.1
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Question 50, State giving reason whether the following statement is, True or False:, Bread is always a consumer good., , Objective Type Questions 1.1
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Answer 50, False: It depends on the economic use of bread. When, it is purchased by a household, it is a consumer, good. If it is purchased by restaurant, it is a, producer (intermediate) good., , Objective Type Questions 1.1
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Question 51, State giving reason whether the following statement is, True or False:, Savings are a stock., , Objective Type Questions 1.1
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Answer 51, False: It is a flow variable as it is measured over a, period of time., , Objective Type Questions 1.1
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Question 52, State giving reason whether the following statement is, True or False:, Butter is only a final product., , Objective Type Questions 1.1
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Answer 52, False: It will be an intermediate product if it is for, resale or used by a restaurant for preparing, meals., , Objective Type Questions 1.1
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Question 53, State giving reason whether the following statement is, True or False:, National income of a country is a stock variable., , Objective Type Questions 1.1
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Answer 53, False: National income is flow variable since it is, measured over a period of time., , Objective Type Questions 1.1
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Question 54, State giving reason whether the following statement is, True or False:, Capital goods are used up to produce other goods., , Objective Type Questions 1.1
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Answer 54, False: Capital goods like machines make production of, other goods feasible, but they themselves don’t, get transformed in the production process, i.e.,, they are not used up to produce other goods., , Objective Type Questions 1.1
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Question 1, 'Machine purchased is always a final good.' Do you agree, with the given statement? Give reasons., (3 marks), , HOTs 1.1— Analysing, Evaluating & Creating Type Questions
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Answer 1, The given statement is not correct. Whether ‘machine’, is a final good or not depends on how it is being used., • If the machine is bought by a household, then it is a, final good because it is used for final consumption., • If the machine is bought by a firm for its own use,, then also it is a final good because it is used for, investment., • If the machine is bought by a firm for re-sale, then it, is an intermediate good., , HOTs 1.1— Analysing, Evaluating & Creating Type Questions
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Question 2, Which of the following is a stock variable and which is a, flow variable? Give reasons., (3 marks), (a) Inventory, (b) Change in inventory, , HOTs 1.1— Analysing, Evaluating & Creating Type Questions
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Answer 2, (a) Inventory is a stock variable because it is measured, at a particular point of time, i.e., at the beginning or, end of the year., Inventories are treated as capital and hence it is a, stock variable., (b) Change in inventory (closing inventory – opening, inventory) is a flow variable because it takes place, over a period of time., Change in the inventory of a firm is treated as, investment, i.e., addition to the stock of capital of a, firm. So, it is a flow variable., HOTs 1.1— Analysing, Evaluating & Creating Type Questions
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Question 3, Distinguish between stock and flow. Between net, investment and capital which is a stock and which is a, flow? Compare net investment and capital with flow of, water into a tank., (NCERT) (3 marks), , HOTs 1.1— Analysing, Evaluating & Creating Type Questions
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Answer 3, Stocks are defined at a particular point of time; whereas, flows are defined over a period of time., Capital is a stock variable as it is measured on a particular, day, i.e., at the beginning of the year or at the end of the, year. On the other hand, net investment, i.e., net addition, to the stock of capital is a flow variable as it takes place, over a period o For example, suppose a tank is being filled, with water coming from a tap. The amount of water, which is flowing into the tank from the tap per minute is a, flow. On the other hand, how much water there is in the, tank at a particular point of time is a stock., HOTs 1.1— Analysing, Evaluating & Creating Type Questions
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Question 4, Which among the following are final goods and which, are intermediate goods ? Give reasons., (a) Milk purchased by a tea stall, (b) Bus purchased by a school, (CBSE 2018) (3 marks), , HOTs 1.1— Analysing, Evaluating & Creating Type Questions
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Answer 4, (a) Intermediate good, Reason: Since it is used up completely in the, production process (making tea) in the same year., (b) Final good, Reason: Since it is for final investment., , HOTs 1.1— Analysing, Evaluating & Creating Type Questions
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Question 5, Which of the following products are intermediate, products and final products? Give reasons. (3 marks), (i) Wheat and rice purchased by households, (ii) Purchase of ticket for train journey by an individual, (iii) Purchase of a car by an employer for office use by, his employees, , HOTs 1.1— Analysing, Evaluating & Creating Type Questions
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Answer 5, (i), , Final products; because these are used for, consumption., (ii) Final product; because it is a final consumption, expenditure., (iii) Final product; because it is a final investment, expenditure., , HOTs 1.1— Analysing, Evaluating & Creating Type Questions
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1.2, Domestic Territory and, Resident: Implications
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Domestic territory (or Economic territory), The first thing to note is that economic territory of a, country is not simply political frontiers of that country., The two may have common elements, but still they are, conceptually different. Let us first see how it is defined., According to the United Nations:, Economic territory (or Domestic territory) is the geographical, territory administered by a government within which persons, goods and capital circulate freely., The above definition is based on the criterion "freedom of, circulation of persons, goods and capital."The above, definition is based on the criterion "freedom of circulation, of persons, goods and capital." Clearly, those parts of the
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political frontiers of a country where the government of, that country does not enjoy the above 'freedom' are not to, be included in economic territory of that country. One, example is embassies. Government of India does not enjoy, the above freedom in the foreign embassies located within, India. So, these are not treated as a part of economic, territory of India. They are treated as part of the economic, territories of their respective countries. For example, the, U.S. embassy in India is a part of economic territory of the, U.S.A. Similarly, the Indian embassy in Washington is a part, of economic territory of India., Based on the criterion ‘freedom of circulation of persons,, goods and capital’, the scope of domestic territory is defined, to cover:
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1. Political frontiers or geographical boundaries, , including territorialwatersand airspace., , For example:, (i) Branch of an American Bank in India is included in, the domestic territory of India because it is located, within the geographical boundaries of India., (ii) Office of Tata Industries in America is not included in, the domestic territory of India because it is outside the, geographical boundaries of India.
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2. Embassies, consulates, military bases, etc., located abroad., For example:, (i) Indian embassy in Japan is a part of the domestic, territory of India., (ii) Russian embassy in India is not a part of the domestic, territory of India. It is a part of domestic territory, of, Russia.
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3. Ships, aircrafts etc. operated by the residents, between two or more countries., For example, aircrafts operated by Air India between, Russia and Japan are treated as a part of the domestic, territory of India.
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4. Fishing vessels, oil and natural gas rigs, etc., operated by the residents in the international, waters or other areas over which the country, enjoys the exclusive rights or jurisdiction., For example, fishing vessels operated by Indian fishermen, in international waters of Indian Ocean are treated as a, part of the domestic territory of India.
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Resident, A resident is defined as follows:, A resident, whether a person or an institution, is one, whose centre of economic interest lies in the domestic, territory of the country in which he lives., The ‘centre of economic interest’ implies two things:, (i), the resident lives or is located within the, domestic territory, and, (ii) the resident carries out the basic economic activities of earnings, spending and accumulation, from that location., Examples:, (i) Indians working in the office of the United Nations, Organisation (UNO) in India are normal residents
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of India since they live in India and their centre of, economic interest also lies in India., (ii) Indians going abroad for medical treatment are, residents of India. Normally, visit for medical, treatment is a short period visit., (iii) Foreign tourists who visit India for recreation,, holidays, medical treatment, study, sports,, conferences, etc. are not residents of India, e.g., foreign tourists visiting India to see the Taj Mahal., Normally, visit to see historical monuments like, Taj Mahal is a short period visit., (iv) Indian officials working in the Indian Embassy in, USA are not residents of India because although, they are living within the domestic territory of, India but they do not carry out the basic economic
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activities of earnings, spending and accumulation in, India. activities of earnings, spending and accumulation in India., (v) Americans working in Indian embassy in America, are not residents of India, but residents of America, because they live in America.
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, , Top Tip, , Resident versus Citizen, Note that citizen and resident are two different terms. This, does not mean that a citizen is not a resident, and a resident, not a citizen. A person can be a citizen as well as a resident,, but it is not necessary that a citizen of a country is necessarily, the resident of that country. A person can be a citizen of one, country and at the same time a resident of another country., For example a NRI, Non-resident Indian. A NRI is citizen of, India but a resident of the country in which he lives., Citizenship is basically a legal concept based on the place of, birth of the person or some legal provisions allowing a person, to become a citizen. On the other hand, residentship is, basically an economic concept based on the basic economic, activities performed by a person.
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Implications of the Concepts of Economic Territory and Resident, National income and related aggregates are basically, measures of production activity. There are two categories of national income aggregates: domestic income, and national income, or domestic product and national product., , Domestic product, Domestic product includes production activity of the, production units located in the economic territory, irrespective of whether carried out by the residents or, non-residents., Gross Domestic Product (GDP), Net Domestic Product, (NDP) are some examples.
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Illustrative example:, How will you treat the following while estimating domestic, product (or domestic factor income) of India?, (i) Rent received by an Indian resident from his, property in Singapore, (ii) Salaries received by Indian residents working in, Russian embassy in India, (iii) Profits earned by a foreign company or a foreign bank in, India, (iv) Salaries paid to Koreans working in Indian embassy in, Korea, (v) Compensation of employees to the resident of Japan, working in Indian embassy in Japan, (vi) Profits earned by a branch of State Bank of India in Japan
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Answer:, (i) No, it will not be included in domestic factor income, of India because this income is earned outside the, domestic territory (economic territory) of India. It is, factor income from abroad., (ii) No, it will not be included in domestic factor income, of India because Russian embassy in India is not a, part of domestic territory of India. So, this income is, not earned within the domestic territory of India. It is, factor income from abroad., (iii) Yes, it will be included in domestic factor income of, India because the foreign company or the foreign, bank is located within the domestic territory of India., So, it is an income earned within the domestic, territory of India.
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(iv) Yes, it will be included in domestic factor income, of India because this income is earned within the, domestic territory of India. Indian embassy in, Korea is a part of the domestic territory of India., (v) Yes, it will be included as it is part of Factor, Income earned in domestic territory of India,, though earned by non-resident., (vi) No, as profits are not earned within the domestic, territory of India. It is factor income from abroad.
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National product, National product includes production activities of residents irrespective of whether performed within the economic territory or outside it., Gross National Product (GNP), Net National Product, (NNP) are some examples., Illustrative example:, Will the following be included in Gross National, Product (GNP)? Give reasons., (i) Profits earned by a foreign company or a foreign, bank in India, (ii) Salary paid to Americans working in Indian, Embassy in America, (iii) Salaries received by Indian residents working in
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Russian Embassy in India, (iv) Dividend received by an Indian from his investment in, shares of a foreign company, Answers:, (i) No, because it is a factor income earned by a nonresident (a foreign company or a foreign bank) from its, contribution to production inside the domestic, territory of India, i.e., factor income paid to abroad., (ii) No, because this factor income is paid to nonresidents, i.e., factor income to abroad., (iii) Yes, because it is a factor income earned by Indian, residents outside the domestic territory of India i.e.,, factor income from abroad., (iv) Yes, because it is a factor income earned by a resident
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from outside the domestic territory of India, i.e., factor, income from abroad.
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, , Top Tip, , It can be realised that a factor income which is included in, domestic factor income of India may not be included in national, income. For example, profits earned by a branch of a foreign, bank in India will be included in the domestic factor income of, India because these profits are earned within the domestic, territory of India. However, it will not be included in national, income of India as it is a factor income paid to abroad. (Foreign, Bank is not a resident of India.), Similarly, an income which is included in national income may not be, included in the domestic factor income. For example, salaries received, by Indian residents working in Russian Embassy in India will be included, in the national income as it is residents’ contribution to production,, though outside the domestic territory of India. However, it will not be, included in domestic income since this income is earned outside the, domestic territory of the country i.e. factor income from abroad.
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Relation between national product and, domestic product, The concept of domestic product is based on the, production units located within economic territory,, operated both by residents and non-residents., The concept of national product is based on residents, and, includes their contribution to production both within and, outside the economic territory., Normally, in practical estimates, domestic product is, estimated first. National product is then derived from the, domestic product by making certain adjustments. Let us, see how?, National product is derived in the following way:, National product = Domestic product
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+Residents' contribution to production outside the, economic territory, –Non-residents' contribution to production inside the, economic territory, In practical estimates, the residents' contribution outside, the economic territory is called "factor income received, from abroad" and the non-residents' contribution inside, the economic territory is called "factor income paid, to abroad". Therefore:, National product =, Domestic product, +, Factor income received from, abroad, –, Factor income paid to abroad, 'Factor income received from abroad' is added to
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domestic product because this contribution of residents is in addition to their contribution to domestic, product., 'Factor income paid to abroad' is subtracted because, this part of domestic product, does not belong to, the residents., By subtracting "factor income paid to abroad" from, "factor income received from abroad", we get a net, figure, "Net factor income from abroad" popularly, abbreviated as NFIA.
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Net factor income from abroad, It is the excess of factor incomes (rent, wages, interest,, profit) earned from abroad over factor incomes (rent,, wages, interest, profit) paid to abroad., NFIA can be positive, negative or zero., 1. Positive NFIA: NFIA is positive when factor income, from abroad is more than factor income paid to, abroad., Note that if NFIA is positive, national product (or, national income) will be greater than domestic product, (or domestic income)., 2. Negative NFIA: NFIA is negative when factor income, from abroad is less than factor income paid to abroad., If NFIA is negative, national income will be less than
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domestic income., 3. Zero NFIA: NFIA is zero when factor income from, abroad is equal to factor income paid to abroad., If NFIA is zero, national product (or national income), will be equal to domestic product (or domestic, income)., It is important to note that ‘Net factor income paid, to abroad’ is opposite/negative of NFIA. If Net factor, income to abroad = `100 crore, then NFIA = (–) `` 100, crore.
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, , Top Tip, , Calculation of NFIA in different cases: Calculation of NFIA in, different cases:, 1. If factor income from abroad = `1000 crore and factor, income to abroad = `800 crore, then, NFIA = 1000 – 800 = `200 crore, 2. If factor income from abroad = `700 crore and factor, income to abroad = ` 1100 crore, then, NFIA = 700 – 1100 = (–) ` 400 crore, 3. If factor income to abroad = `200 crore and factor income, from abroad is not given, then we assume that factor, income from abroad is zero. Therefore, NFIA = 0 – 200 = (–, ) ` 200 crore, 4. If factor income to abroad = (–) `300 crore and, from abroad is not given, then we assume that factor, income from abroad is zero. Therefore, NFIA = 0 – (–)300, = `300 crore
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5. If factor income from abroad = (–) `50 crore and factor, income to abroad is not given, then we assume that factor, income to abroad is zero. Therefore, NFIA = –50 – 0 = (–) `, 50 crore5. If factor income from abroad = (–) `50 crore, and factor income to abroad is not given, then we assume, that factor income to abroad is zero. Therefore, NFIA = –, 50 – 0 = (–) ` 50 crore
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Key Terms, Domestic territory (or economic territory)—The geographical, territory administered by a government within which persons,, goods and capital circulate freely. Domestic territory (or economic, territory)—The geographical territory administered by a, government within which persons, goods and capital circulate, freely., Resident—A person or an institution whose centre of economic, interest lies in the domestic territory of the country in which he, lives., Domestic product—It includes production activity of the, production units located in the economic territory irrespective of, whether carried out by the residents or non-residents., National product—It includes production activities of residents, irrespective of whether performed within the economic territory, or outside it., Factor income received from abroad—Resident’s contribution, to production outside the economic territory of the country.
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Factor income paid to abroad—Non-resident’s contribution to, production inside the economic territory., Net factor income from abroad (NFIA)—Difference between, factor income from abroad and factor income to abroad.
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RECAP, , Domestic territory (or Economic territory), Domestic territory (or Economic territory) is the geographical, territory administered by a government within which, persons, goods and capital circulate freely. For example, (i), Branch of an American Bank in India, (ii) Embassies located, abroad, e.g. Indian embassy in America, etc. are included in, the domestic territory of India., , Resident, Resident is a person or an institution whose centre of, economic interest lies in the domestic territory of the country, in which he lives, for example, Indian officials working in the, Indian Embassy in USA, etc. are normal residents of India., , Implications of the Concepts of Domestic territory, and Resident., Domestic product includes production activity of the
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units located in the domestic territory of the country, irrespective of whether carried out by the residents or nonresidents, for example, (i) Profits earned by a foreign, company or a foreign bank in India (ii) Salaries paid to Koreans, working in Indian embassy in Korea (iii) Compensation of, employees to the residents of Japan working in Indian embassy in, Japan are included in domestic product as it is a factor income, earned in domestic territory of the country., National product includes production activity of residents, only irrespective of whether performed within the domestic, territory of the country or outside it, for example, (i) Salaries, received by Indian residents working in Russian Embassy in, India (ii) Dividend received by an Indian from his, investment in shares of a foreign company are included in, national product as it is a factor income earned by Indian, residents from abroad.
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Net factor Income from Abroad (NFIA), Net Factor Income from Abroad is the difference between, factor income earned from abroad and factor income paid to, abroad. (NFIA = Factor income from abroad – Factor income, to abroad), In other words, NFIA = Residents’ contribution to, production outside the domestic territory – Non-residents’, contribution to production inside the economic territory., NFIA is negative when factor income from abroad is less, than factor income paid to abroad (i.e., Net factor income, paid to abroad)., , Relation between Domestic Product and National, Product, National product = Domestic Product + Factor income, received from abroad – Factor income paid to abroad
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• Factor income received from abroad is added to domestic, product to calculate national product because this contribution of residents is in addition to their contribution to, domestic product., • Factor income paid to abroad is subtracted because this, part of domestic product does not belong to the residents.
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Question 1, Which of the following is within the domestic territory of, India?, (Choose the correct alternative), (a) State Bank of India in UK, (b) Google office in India, (c) Office of Tata Motors in USA, (d) Russian Embassy in India, , Objective Type Questions 1.2
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Answer 1, (b) Google office in India, , Objective Type Questions 1.2
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Question 2, Foreign embassies in India are a part of India’s :, (Choose the correct alternative), (a) Economic territory, (b) Geographical territory, (c) Both (a) and (b), (d) None of the above, , Objective Type Questions 1.2
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Answer 2, , , (b) Geographical territory, , Objective Type Questions 1.2
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Question 3, Out of the following, who are residents of India?, (Choose the correct alternative), (a) Indians working permanently in the office of the, United Nations Organisation in New York, (b) Indians working in Indian Embassy in America, (c) Indians working in a branch of an American Bank in, India, (d) Americans working in India embassy in America, , Objective Type Questions 1.2
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Answer 3, (c) Indians working in a branch of an American Bank in, India, , Objective Type Questions 1.2
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Question 4, Which of the following will be included in gross national, product of India?, (Choose the correct alternative), (a) Profits earned by a foreign company in India, (b) Salary paid to Americans working in Indian Embassy, in America, (c) Salaries received by Indians working in Russian, Embassy in India, (d) Salaries received by Indians working in Indian, Embassy in Korea, Objective Type Questions 1.2
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Answer 4, (c) Salaries received by Indians working in Russian, Embassy in India, , Objective Type Questions 1.2
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Question 5, National income is the sum of factor incomes accruing, to:, (Choose the correct alternative), (a) Nationals, (b) Economic territory, (c) Residents, (d) Both residents and non-residents, , Objective Type Questions 1.2
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Answer 5, (c) Residents, , Objective Type Questions 1.2
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Question 6, Which of the following will be included in Gross, Domestic Product (GDP) of India?, (Choose the correct alternative), (a) Rent received by an Indian resident from his, property in Singapore, (b) Salaries received by Indian residents working in, Russian embassy in India, (c) Profits earned by a branch of State Bank of India in, Japan, (d) Profits earned by standard Chartered Bank in India, Objective Type Questions 1.2
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Answer 6, (d) Profits earned by standard Chartered Bank in India, , Objective Type Questions 1.2
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Question 7, Factor income earned by the domestic factors of, production employed in the rest of the world – Factor, income earned by the factors of production of the rest, of the world employed in the domestic economy = ?, (Choose the correct alternative), (a) Net exports, (b) Net factor income from abroad, (c) Net compensation of employers, (d) Net retained earnings, Objective Type Questions 1.2
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Answer 7, (b) Net factor income from abroad, , Objective Type Questions 1.2
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Question 8, National income is always more than the domestic, income., True/False? Give reason., , Objective Type Questions 1.2
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Answer 8, False: National income can be less than domestic, income when net factor income from abroad, (NFIA) is negative. National income can also be, equal to domestic income if NFIA is zero., , Objective Type Questions 1.2
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Question 9, Wages earned by a citizen of India working in Saudi, Arabia will be included in GDP of India., True/False? Give reason., , Objective Type Questions 1.2
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Answer 9, False: It will be included in Saudi Arabian GDP , not in, GDP of India as it is not earned within the domestic, territory of India., , Objective Type Questions 1.2
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Question 10, Profits earned by the Korean-owned Hyundai car, factory in India will be included in National income of, India., True/False?, , Objective Type Questions 1.2
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Answer 10, False: It is a factor income paid to abroad. It will be, subtracted from the GDP of India to arrive at, the National income., , Objective Type Questions 1.2
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Question 11, GDP can be greater than GNP. True/False? Give reason., , Objective Type Questions 1.2
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Answer 11, True: GDP can be greater than GNP if factor income, paid to abroad is greater than factor income, received from abroad, i.e., when net factor, income from abroad (NFIA) is negative. True:, GDP can be greater than GNP if factor income, paid to abroad is greater than factor income, received from abroad, i.e., when net factor, income from abroad (NFIA) is negative., , Objective Type Questions 1.2
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Question 1, Will the following factor income be included in domestic, factor income of India? Give reasons., (i) Compensation of employees to the resident of Japan, working in Indian embassy in Japan., (ii) Rent received by an Indian resident from Russian, embassy in India., (CBSE Sample Question Paper 2018) (3 marks), , HOTs 1.2— Analysing, Evaluating & Creating Type Questions
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Answer 1, (i), , Yes, it will be included as it is part of factor income, earned in domestic territory of the country., (ii) No, as rent received by Indian resident from, Russian embassy will be part of Factor Income, received from abroad as Russian Embassy is not, part of domestic territory of the country., , HOTs 1.2— Analysing, Evaluating & Creating Type Questions
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Question 2, How will you treat the following in the calculation of, Gross Domestic Product of India? Give reasons., (i) Profits earned by a branch of foreign bank in India., (ii) Salaries of Indian employees working in embassy of, Japan in India., (iii) Salary of resident of Japan working in Indian, embassy in Japan., (3 marks), , HOTs 1.2— Analysing, Evaluating & Creating Type Questions
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Answer 2, (i), (ii), , (iii), , Yes, it will be included because profits are earned, within the domestic territory of India., No, it will not be included because the embassy of, Japan is not a part of the domestic territory of, India., Yes, it will be included because the Indian Embassy, is a part of the domestic territory of India., , HOTs 1.2— Analysing, Evaluating & Creating Type Questions
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Question 3, Will the following be included in domestic factor income, of India? Give reasons., (i) Profits earned by a resident of India from his, company in Singapore., (ii) Profits earned by a company in India which is owned, by a non-resident., (iii) Profits earned by a branch of State Bank of India in, England., (3 marks), , HOTs 1.2— Analysing, Evaluating & Creating Type Questions
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Answer 3, (i) No, it will not be included as the company is located, outside the domestic territory of India., (ii) Yes, it will be included as profits are earned within the, domestic territory of India., (iii) No, it will not be included as State Bank of India is, located outside the domestic territory of India., , HOTs 1.2— Analysing, Evaluating & Creating Type Questions
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Question 4, How will you treat the following in the calculation of, Domestic Income of India? Give reasons., (i) Compensation of employees to the residents of, Japan working in Indian embassy in Japan., (ii) Rent paid by the embassy of Japan in India to a, resident Indian., (iii) Salaries to Indian residents working in the Russian, embassy in India., (iv) Profits earned by Indian employees working in the, US embassy in India., (4 marks), HOTs 1.2— Analysing, Evaluating & Creating Type Questions
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Answer 4, (i), , Yes, it will be included as the Indian embassy in Japan, is a part of the domestic territory of India., (ii) No, it will not be included as the Japanese embassy is, not a part of the domestic territory of India., (iii) No, it will not be included as the Russian embassy is, not a part of the domestic territory of India., (iv) No, it will not be included as the US embassy is not a, part of the domestic territory of India., , HOTs 1.2— Analysing, Evaluating & Creating Type Questions
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1.3, Circular Flow of Income, (Two- Sector Model)
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Circular flow of income refers to flow of income across, different sectors of an economy in a circular way., In a closed economy* without a government, external, trade or any savings, there are only two sectors, namely,, households and firms., Households are owners of factors of production. They, provide factor services (in the form of labour, capital,, land and entrepreneurship) to the firms (producing, units). Income is generated in production units in the, form of value of total final goods and services, produced in the economy., Firms distribute the entire income generated to make, factor payments (in the form of wages and salaries,, interest, rent and profit). Thus, factor payments flow, from firms to households.
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*Closed economy is one that does not trade with other nations in goods and, services, and in financial assets., •Leakages refer to withdrawal of money from the circular flow of income. It is that, part of income, which does not pass through the circular flow. For example,, savings, taxes and imports are leakages from the circular flow of income.
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In this simplified economy, there is only one way in, which the households may dispose off their earnings –, by spending their entire income to buy the goods and, services produced by the firms. Households do not save,, they do not pay taxes to the government – since there is, no government, and neither do they buy imported, goods since there is no external trade in this simple, economy. So, households buy goods and services from, firms for which they make payment to the firms. Thus,, consumption expenditure (i.e., spending on goods and, services) flows from households to the firms, making, the circular flow of income complete. Hence, circular, flow of income in a two sector economy is based on the, axiom that one’s expenditure is other’s income.
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The entire income of the economy, therefore, comes, back to the producers in the form of sales revenue., There is no leakage from the circular flow of income., Note that the same amount of money is moving in a, circular way. Thus, national income can be calculated, by three methods, which give us the same value., 1. Production method: Product method measures, aggregate value of final goods and services, produced by all the firms in the economy during a, year (Annual flow at A)., 2. Income method: Income distribution method, measures aggregate factor payments made in the, economy during a year (Annual flow at B).
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3. Expenditure method: Expenditure method, measures the aggregate final expenditure on goods, and services in the economy during a year (Annual, flow at C)., , , •, •, , Top Tip, Nominal Flow and Real Flow, Nominal Flow/Money Flow is the flow of factor payments, and payments for goods and services between households, and firms., Real Flow is the flow of factor services and the flow of, goods and services between households and firms.
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RECAP, , Circular flow of income in a two sector economy, In a two sector economy, households are owners of factors of, production. They provide factor services (in the form of, labour, capital, land and entrepreneurship) to the firms., Firms produce goods and services and make factor payments, (in the form of wages and salaries, interest, rent and profit) to, the households. So, factor payments flow from firms to, households., The factor income earned by the households will be used to, buy the goods and services produced by the firms, for which, they make payment to the firms. So, consumption, expenditure (i.e., spending on goods and services) flows from, households to the firms. Thus, aggregate final consumption, expenditure by the households in the economy is equal to the, aggregate factor income received by the households.
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Hence, circular flow of income in a two sector economy is, based on the axiom that one’s expenditure is other’s income.
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Question 1, Match the following:, Contribution made by factors of production Remuneration, (i) Human labour, , (a) Rent, , (ii) Capital, , (b) Wage, , (iii) Fixed natural resources (called ‘land’), , (c) Interest, , (iv) Entrepreneurship, , (d) Profit, , Objective Type Questions 1.3
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Answer 1, (i) – (b) , (ii) – (c) (iii) – (a) (iv) – (d), , Objective Type Questions 1.3
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Question 2, In a two sector economy, in which of the following way, the households may dispose off their entire earning or, income?, (Choose the correct alternative), (a) Spending on the goods and services produced by, the domestic firms., (b) Payment of taxes to the government., (c) To buy imported goods., (d) Savings, , Objective Type Questions 1.3
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Answer 2, (a)Spending on the goods and services produced by the, domestic firms., , Objective Type Questions 1.3
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Question 3, The sum of final expenditure in the economy must be, equal to ___________________., (Fill in the blank), , Objective Type Questions 1.3
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Answer 3, Aggregate factor payments (i.e. wages and salaries , rent ,, interest and profits)., , Objective Type Questions 1.3
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Question 4, In __________________ method we calculate the, aggregate value of all final goods and services produced, by all the firms within the domestic territory of the, country in a year., (Fill in the blank), , Objective Type Questions 1.3
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Answer 4, product or value added, , Objective Type Questions 1.3
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Question 5, Match the following:, (a) Sum total of all factor payments, , (i) Product method, , (b) Aggregate value of final goods and, services produced by all the firms., , (ii) Income method, , (c) Aggregate value of spending that the, firms receive for the final goods and, services which they produce., , (iii) Expenditure, method, , Objective Type Questions 1.3
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Answer 5, (a) – (ii), (b) – (i), (c) – (iii), , Objective Type Questions 1.3
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Question 6, Flow of factor payments and payments for goods and, services between households and firms is called, ______________ ., (Fill in the blank), , Objective Type Questions 1.3
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Answer 6, Nominal flow/Money flow, , Objective Type Questions 1.3
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Question 7, Looking at the demand side of the final goods and, services to calculate the GDP is referred to as the, __________ ., (Product method / Expenditure method / Income method), (Choose the correct option), , Objective Type Questions 1.3
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Answer 7, Expenditure Method., , Objective Type Questions 1.3
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Question 1, "Circular flow of income in a two sector economy is, based on the axiom that one’s expenditure is other’s, income." Do you agree with the given statement? Support, your answer with valid reasons., (CBSE Sample Question Paper 2020) (3 marks), , HOTs 1.3— Analysing, Evaluating & Creating Type Questions
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Answer 1, Yes, the given statement is correct. In a two sector, economy, the firms produce goods and services and, make factors payments to the households. The factor, income earned by the households will be used to buy, the goods and services which would be equal to, income of firms. The aggregate consumption, expenditure by the households in the economy is equal, to the aggregate expenditure on goods and services, produced by the firms in the economy (Income of the, producers)., HOTs 1.3— Analysing, Evaluating & Creating Type Questions
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1.4, Production Method of, Calculating National Income
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In product method or value added method, we, calculate the aggregate annual value of goods and, services produced during a year. How to go about doing, this? Do we add up the value of all goods and services, produced by all the firms in an economy? The, following example will help us to understand., Let us suppose that there are only two kinds of, producers in the economy – wheat producers (or the, farmers) and the bread makers (the bakers). The wheat, producers grow wheat and they do not need any input, other than human labour. They sell a part of the wheat, to the bakers. The bakers do not need any other raw, materials besides wheat to produce bread. Let us, suppose that in a year the total value of wheat that the, farmers have produced is `100. Out of this they have
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sold `50 worth of wheat to the bakers. The bakers have, used this amount of wheat completely during the year, and have produced `200 worth of bread., What is the value of total production in the economy?, If we follow the simple way of aggregating the values of, production of the sectors, we would add `200 (value of, production of the bakers) to `100 (value of production, of farmers). The result will be `300., A little reflection will tell us that the value of aggregate, production is not `300. The farmers had produced `, 100 worth of wheat for which it did not need assistance, of any inputs. Therefore, the entire `100 is rightfully, the contribution of the farmers. But the same is not, true for the bakers. The bakers had to buy `50 worth of, wheat to produce their bread. The `200 worth of bread
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that they have produced is not entirely their own, contribution. To calculate the net contribution of the, bakers, we need to subtract the value of the wheat that, they have bought from the farmers. If we do not do this, we shall commit the mistake of ‘double counting’., This is because `50 worth of wheat will be counted, twice. First, it will be counted as part of the output, produced by the farmers. Second time, it will be, counted as the imputed value of wheat in the bread, produced by the bakers., Therefore, the net contribution made by the bakers is,, `200 – `50 = `150., Hence, aggregate value of goods produced by this simple, economy is `100 (net contribution by the farmers) + `150, (net contribution by the bakers) = ` 250.
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The term that is used to denote the net contribution, made by a firm is called its 'value added'. We know, that the raw materials that a firm buys from another, firm which are completely used up in the process of, production are called ‘intermediate goods’. Therefore:, The value added of a firm is distributed among its four factors, of production, namely, labour, capital, entrepreneurship and, land. Therefore wages, interest, profits and rents paid, out by the firm must add up to the value added of the, firm. Value added is a flow variable., We can represent the example given above in terms of, the following Table.
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Value of output, Intermediate consumption, Value added, , Farmer, 100, 0, 100, , Baker, 200, 50, 200 – 50 =150
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Problem of Double Counting, The problem of double counting arises when the value, of same goods and services are counted more than, once while estimating national income., There are two approaches/methods to avoid the problem, of double counting:, (i) Take the value of final goods and services only, ignoring all intermediate products., (ii) Take value added at different stages in production, process instead of total output.
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Steps for calculation of national income, by product method, Step 1: Estimation of value of output produced by, each firm in all the sectors of the economy during, the year., Value of output is the market value of goods and, services produced by a firm during an accounting year., (a) If a firm had no initial unsold stock in the, beginning of the year:, Note: Sales = Output sold (in units) × Market price, Sales = Sale of goods and services to domestic, buyers + Exports of goods and services.
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(b) If a firm had some unsold stock in the, beginning of the year:, or, Value of output = Sales + Closing stock – Opening, stock, Example: Suppose that a firm had an unsold stock, worth `100 at the beginning of the year. During the, year it produced ` 1000 worth of goods by using, raw materials and other inputs worth ` 400 and, managed to sell ` 800 worth of goods., (i) Value of closing stock = Opening stock + Value of, output produced – Sales, = 100 + 1000 – 800 = `300, (ii) Change in stock, = Closing stock – Opening
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stock = 300 – 100 = `200, Or, change in stock = Value of output produced – Sales, - = 1000 – 800 = `200, (iii) Value of output produced = Sales + Change in, stock = 800 + 200 = `1000
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Step 2: Calculation of Value Added/Value Addition, (VA) and Gross Domestic Product at market price, (GDPmp), Value added/value addition is the difference between, value of output and intermediate consumption., , , , Top Tip, , Intermediate consumption = Purchase of raw materials etc. +, Imports of raw materials etc., , In our example of farmers and bakers, the Value Added, by farmers and bakers are their Gross Value Added at, market price (GVAmp).
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Now, if we sum the GVAmp of all the firms in all the, sectors of the economy, we get Gross Domestic Product, at market price (GDPmp)., GDPmp is the money value of all final goods and, services produced within the domestic territory of a, country during an accounting year. All production done, by the national residents or the non-residents in the, domestic territory of the country gets included, regardless, of whether that production is owned by a local company, or a foreign entity. Everything is valued at market prices., Why is GDPmp called gross?, GDPmp is final products valued at market price. This is, what buyers pay. But this is not what production units, actually receive. Out of what buyers pay, the production
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units have to make provision for depreciation and payment, of indirect tax like excise, sales tax, etc. This explains why, GDPmp is called 'gross'. It is called gross because no, provision has been made for depreciation. However, if, depreciation is deducted from the GDP, it becomes Net, Domestic Product (NDP). Naturally, depreciation does, not become part of anybody’s income., Why is GDPmp called ‘at market price’ ?, Out of what buyers pay, the production units have to, make payments of indirect taxes, if any. Indirect taxes, accrue to the government, and not to the production, units. Payment of indirect taxes to the government is a, transfer payment as no good or service is provided in, return. Hence, indirect taxes are deducted from, GDPmp to calculate what production units actually
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receive., Sometimes production units receive subsidy on, production. This is in addition to the market price which, production units receive from the buyers. Therefore, what, production units actually receive is not the 'market-price', but "market price – indirect tax + subsidies".
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Step 3: Calculation of Net Domestic Product at, factor cost (NDPfc), If we make adjustment of depreciation, indirect taxes, and subsidies in GDPmp, we get Net Domestic Product, at Factor Cost (NDPfc)., or,, or,, , NDPfc = GDPmp – Depreciation – Net indirect taxes, NDPfc = GDPmp – Depreciation – Net product taxes, – Net production taxes, NDPfc is the income earned by the factors of production in, the form of wages, profits, rent, interest, etc., within the, domestic territory of a country. This is also called domestic, income because this is the income generated in the, production process within the domestic territory of the, country.
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Step 4: Calculation of Net National Product at, factor cost (NNPfc) or National Income (NI), Net National Product at factor cost (NNPfc) is the net, domestic factor income added with the net factor, income from abroad. In other words:, or,, , NNPfc = GDPmp – Depreciation – Net indirect, taxes + NFIA, or, NNPfc = GDPmp – Depreciation – Net product, taxes – Net production taxes + NFIA, NNP at factor cost is the sum of income earned by all, factors in the production in the form of wages, profits,, rent and interest, etc., belonging to a country during a, year. It is the National Product and is not bound by, production in the national boundaries.
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, , Top Tip
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Other Basic National Income, Aggregates, 1. Net Domestic Product at Market Price, (NDPmp), This measure allows policy-makers to estimate how, much the country has to spend just to maintain their, current GDP. If the country is not able to replace the, capital stock lost through depreciation, then GDP will, fall.
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2. Gross National Product at Market Price, (GNPmp), GNPmp is the value of all the final goods and services, that are produced by the normal residents of India and, is measured at the market prices, in a year. GNP refers, to all the economic output produced by a nation’s, normal residents, whether they are located within the, national boundary or abroad. Everything is valued at, the market prices.
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3. Net National Product at Market Price, (NNPmp), This is a measure of how much a country can consume, in a given period of time. NNP measures output, regardless of where that production has taken place (in, domestic territory or abroad).
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4. Gross Domestic Product at Factor Cost, (GDPfc), GDP at factor cost is gross domestic product at market, prices less net indirect taxes., or, , GDPfc = GDPmp – Net Product Taxes –, Net Production Taxes, GDP at factor cost measures money value of output, produced within the domestic boundaries of a country, in a year, as received by the factors of production.
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5.Gross National Product at Factor Cost, (GNPfc), GNP at factor cost is gross domestic product at market, prices less net indirect taxes plus NFIA., or, , GNPfc = GDPmp – Net Product Taxes –, Net Production Taxes + NFIA, GNP at factor cost measures value of output received, by the factors of production belonging to a country in a, year.
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Precautions in calculating national, income by value added method, 1. Avoid double counting., Value of intermediate goods is not included in the, estimation of value added because value of intermediate, goods is reflected in the value of final goods. So, avoid, double counting of goods and services as these tend to, inflate national income estimates.
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2. Do not include sale of second hand goods., Value of second hand goods (or used goods) being sold, should not be included in national income as their, value was accounted for at the time of first production., Sale of the second hand goods is not a production, activity. The second hand good should not be treated, as fresh production, and therefore is not included in, national income., However, any brokerage or commission paid to, facilitate the sale of second hand goods is a fresh, production activity. It should be included in, production but to the extent of brokerage or, commission only.
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3. Self-consumed output must be included., Output produced but retained for self-consumption,, rather than selling in market, is output and must be, included in estimates. Services of owner-occupied, buildings, farmer consuming its own produce, etc. are, some examples.
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Key Terms, Value of output — It is the market value of goods and services, produced by a firm during an accounting year., Double counting — The problem of double counting arises when the, value of same goods and services are counted more than once while, estimating national income., Value added/value addition — It is the difference between value of, output and intermediate consumption., Gross Domestic Product (GDP) — It is the money value of all final goods, and services produced within the domestic territory of a country during, an accounting year., NDP at factor cost — It is the income earned by the factors in the form, of wages, profits, rent, interest, etc., within the domestic territory of a, country. It is also called net domestic factor income or domestic income., National Income (NI)/NNP at factor cost — It is the sum of factor, incomes earned by the normal residents in the form of wages,, profits, rent and interest, etc., during an accounting year within, the domestic territory or abroad.
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RECAP, , Steps for calculation of national income by, product method, Step 1 : Estimation of value of output produced by each, firm in all the sectors of the economy during the year., Value of output is the market value of goods and services, produced by a firm during an accounting year. Value of, output = Sales + Change in stock, Step 2 : Calculation of Value Added (VA) and Gross, Domestic Product at market price (GDPmp)’, Value added/Value addition is the excess of value of output, over the value of intermediate consumption., Sum of Value added of all firms in the economy is Gross, Domestic Product (GDP), which refers to the money value, of all final goods and services produced in an economy, during an accounting year.
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GDPmp = Value of output of all the sectors – Intermediate, consumption, Step 3 : Calculation of Net Domestic Product at factor, cost (NDPfc), NDPfc (net domestic factor income) = GDPmp –, Depreciation – Indirect taxes + Subsidies, NDPfc is the income earned by the factors in the form of, wages, profits, rent, interest, etc., within the domestic, territory of a country., Step 4 : Calculation of Net National Product at factor, cost (NNPfc) or National Income (NI), National income or NNPfc = NDPfc + NFIA, Precautions in calculating national income by, production method (or value added method), 1. Avoid double counting. Value of intermediate goods is, not included in the estimation of value added because it is
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reflected in the value of final goods. So, avoid double, counting of goods and services as these tend to inflate, national income estimates., 2. Do not include sale of second hand goods. Their, value was accounted for at the time of first production., However, any brokerage or commission paid to sell the, second hand goods is a fresh production activity, so, included., 3. Self-consumed output must be included. Output, produced but retained for self-consumption rather than, selling in the market should be included since output, has been produced during the year. E.g. Farmer, consuming its own produce, services of owner occupied, buildings etc.
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NUMERICAL 2, Suppose in an imaginary economy GDP at market, price in a particular fiscal year was `4000 crore,, National Income was ` 2500 crore, Net Factor Income, paid by the economy to Rest of the World was ` 400, crore and the value of Net Indirect Taxes is ` 450, crore. Estimate the value of consumption of fixed, capital for the economy from the given data., (NCERT) (3 marks), Solution: National Income (NNPfc)= GDPmp –, Consumption of fixed capital – Net indirect taxes + NFIA, 2500 = 4000 – Consumption of fixed capital – 450 + (–)400, Consumption of fixed capital = 4000 – 450 – 400 – 2500 =, `650 crore
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Note: Net factor income paid by the economy to rest of, the world = `400 crore. Therefore, NFIA = (–) ` 400 crore
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Do it yourself 2, GNPmp of an imaginary economy is ` 120000 crore and its, capital stock is worth `300000 crore. If capital stock, depreciates @ 20% per annum, indirect taxes amount to `, 30000 crore and subsidies are put at ` 15000 crore. What is, national income?, (3 marks), [Ans. ` 45000 crore]
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Solution of Do it yourself 2, National Income (NNPfc), = GNPmp – Depreciation – Indirect Taxes + Subsidies, = 120000 – 60000 (20% of 300000) – 30000 + 15000, = `45000 crore
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NUMERICAL 3, In an economy, the following transactions took place., (i) Firm A sold to firm B goods of `80 crore; to firm C `, 50 crore; to households ` 30 crore and goods of, value ` 10 crore remains unsold., (ii) Firm B sold to firm C goods of ` 70 crore; to firm D `, 40 crore; goods of value ` 30 crore were exported, and goods of value ` 5 crore was sold to government., Calculate: (i) Value of output of Firm A and Firm B., (ii) Value added by Firm B, (CBSE Sample Question Paper 2019) (3 marks), Solution: (i) Value of output of Firm, = Total sales + Value of unsold stock, = (Sales to Firm B + Sales to Firm C + Sales to Households)
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+ Value of unsold stock, , =(80 + 50 + 30) + 10 = `170 crore, Value of output of Firm B = Sales to Firm C + Sales to Firm, D + Exports + Sales to Government, = 70 + 40 + 30 + 5 = `145 crore, (ii) Value added by Firm B= Value of output of Firm B –, Purchases by Firm B from Firm A, = 145 – 80 = `65 crore
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Do it yourself 3, From the following data, calculate the value added by firm, A and firm B., (3 marks), S. No., , Items, , (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), , Closing stock of firm A, Closing stock of firm B, Opening stock of firm A, Opening stock of firm B, Sales by firm A, Purchases by firm A from firm B, Purchases by firm B from firm A, Domestic sales by firm B, Import of raw material by firm A, Exports by firm B, , [Ans. (a) `165 lakh (b) ` 205 lakh ], , (` in lakh), 20, 15, 5, 10, 300, 100, 80, 250, 50, 30
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Solution of Do it yourself 3, (a) Value Added by Firm A, = Value of output of firm A – Intermediate consumption, = [sales + change in stock (closing stock – opening stock)], – (purchases from firm B + Import of raw materials), = [300 + (20 – 5)] – (100 + 50) = `165 lakh
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NUMERICAL 4, In a single day, Raju, a barber, collects `500 from haircuts., Over this day, his equipment depreciates in value by `50., Of the remaining In a single day, Raju, a barber, collects `, 500 from haircuts. Over this day, his equipment, depreciates in value by ` 50. Of the remaining ` 450, Raju, pays sales tax ` 30, takes home ` 200 and retains ` 220 for, improvement and buying of new equipment. He further, pays ` 20 as income tax., Based on this information, calculate Raju's contribution to, GDP, NDP and National Income. (3marks)450, Raju pays, sales tax `30, takes home `200 and retains ` 220 for, improvement and buying of ne, Solution: equipment. He further pays ` 20 as income, tax.
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Based on this information, calculate Raju's contribution to, GDP, NDP and National Income., (3 marks), (i) GDP = Value of haircuts service produced by him =, `500, (ii), NDP = GDP – Depreciation of equipment, = 500 – 50 = `450, (iii) National Income (NNP at factor cost) = NDP –, Sales Tax, = 450 – 30 = ` 420
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Do it yourself 4, From the following data about a firm, calculate the firm’s, net value added at factor cost., 3 marks, S. No., , Items, , (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), , Subsidy, Sales, Depreciation, Exports, Closing stock, Opening stock, Intermediate purchases, Purchase of machinery for own use, Import of raw material, , [Ans. `280 lakh], , (` in lakh), 40, 800, 30, 100, 20, 50, 500, 200, 60
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Solution of Do it yourself 4, Net value added at factor cost, = Sales + Closing stock – Opening stock – Intermediate, purchases, – Depreciation + Subsidy, = 800 + 20 – 50 – 500 – 30 + 40 = `280 lakh
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NUMERICAL 5, Calculate GVA at factor cost of a firm: (3 marks), S. No., , Items, , (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), , Net production taxes, Product taxes, Price per unit of output, Net change in stocks, Purchases of raw materials, Import of raw materials, Import of machines, Product subsidies, , (`), 600, 400, 10, (–)50, 10,000, 3,000, 20,000, 100, , Additional information: Output sold is 2000 units.
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Solution:, Particulars, Sales (note 1), (+) Net change in stocks, Value of output (–) Intermediate consumption, (Purchases of raw materials), , (`), 20,000, (–) 50, 19,950, (–)10,000, , GVA at market prices, (–) Net product taxes (note 3), , 9,950, (–) 300, , GVA at basic prices, (–) Net production taxes, , 9,650, (–) 600, , GVA at factor cost, , 9,050, , Note:, 1. Sales = Output sold × Price per unit = 2,000 units × `10 = `, 20,000, 2. Import of raw materials is already included in, Purchase of raw materials. Import of machines is not
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included in intermediate consumption., 3. Net product taxes = Product taxes – Product subsidies, = 400 – 100 = `300
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Do it yourself 5, Find net value added at factor cost:, S. No., (i), (ii), (iii), (iv), (v), (vi), , Items, Sales, Closing stock, Excise, Opening stock, Current replacement cost, Intermediate consumption, , [Ans. `33 lakh], , 3 marks, (` in lakh), 100, 20, 15, 10, 12, 50
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Solution of Do it yourself 5, Net value added at factor cost, = Sales + Closing stock – Opening stock – Intermediate, consumption, – Current replacement cost – Excise, = 100 + 20 – 10 – 50 – 12 + 15 = `33 lakh
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NUMERICAL 6, Find NVA at factor cost of a firm., , (3 marks), , S., No., , Items, , (`), , (i), (ii), (iii), (iv), (v), , Durable use producer goods with a life span of 10 years, Single use producer goods, Sales, Unsold output produced during the year, Net indirect taxes, , 10, 5, 20, 2, 1
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Solution:, Particulars, , (` in lakh), , Sales, (+) Unsold output, , 20, 2, , Value of output, (–) Intermediate consumption (Single use, producer goods), , 22, (-)5, , GVA at market prices, (–) Depreciation (note), (–) Net indirect taxes, , 17, (-)1, (-)1, , GVA at factor cost, , 15
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Do it yourself 6, Find Net Value Added at market price of a firm:, S. No. Items, (i), (ii), (iii), (iv), (v), , Fixed capital good with a life span of 5 years, Raw materials, Sales, Net change in stock, Taxes on production, , [Ans. `14 lakh], , 3 marks, (` in, lakh), 15, 6, 25, (-)2, 1
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Solution of Do it yourself 6, Net Value Added at market price = (iii) + (iv) – (ii) –, Depreciation, = 25 + (–2) – 6 – 3 = `14 lakhs, Note: Depreciation = 15/5 = ` 3 lakhs
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NUMERICAL 7, Calculate ‘Sales’ from the following:, S., No., , Items, , (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), , Subsidies, Opening stock, Closing stock, Intermediate consumption, Consumption of fixed capital, Profit, Net value added at factor cost, Exports, , (3 marks), (`), 200, 100, 600, 3000, 700, 750, 2000, 100
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Solution:, Net value added at factor cost, = Sales + Closing stock – Opening stock – Intermediate, consumption – Consumption of fixed capital + Subsidies, 2,000 = Sales + 600 – 100 – 3,000 – 700 + 200, Sales = 2,000 – 600 + 100 + 3,000 + 700 – 200, Sales = `5,000 lakh
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Do it yourself 7, Calculate ‘Value of output’ from the following:, S. No., (i), (ii), (iii), (iv), (v), , Items, Net value added at factor cost, Intermediate costs, Excise duty, Subsidy, Depreciation, , [Ans. `200 lakh], , 3 marks, (` in lakh), 100, 75, 20, 5, 10
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Solution of Do it yourself 7, Net value added at factor cost = Value of output –, Intermediate costs – Depreciation – Excise duty + Subsidy, 100 = Value of output – 75 – 10 – 20 + 5, Value of output = 100 + 75 + 10 + 20 – 5, Value of output = `200 lakhs
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NUMERICAL 8, Calculate (a) Gross Domestic Product at Market Price, and (b) National Income., (6 marks), S. No. Items, (i), , Value of output, (a) Primary sector, (b) Secondary sector, (c) Tertiary sectorOpening stock, Cost of intermediate inputs, (ii), (a) Primary sector, (b) Secondary sector, (c) Tertiary sector, (iii) Indirect taxes paid by all sectors, ()()kokokokkp, (iv) Consumption of fixed capital of all, sectors, , (`in crore), 800, 200, 300, 400, 100, 50, 50, 80
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(v), (vi), (vii), , Factor income received by the residents, from rest of the world, Factor income paid to non-residents, Subsidies received by all sectors, , 10, 20, 20, , Solution:, Particulars, , (` in crore), , Value of output of all sectors (note 1), (–) Cost of intermediate inputs purchased by all, sectors (note 2), , 1300, (–)550, , (a) Gross Domestic Product at Market Price, (GDPmp), Adjustments:, (–) Consumption of fixed capital of all sectors, (–) Indirect taxes paid by all sectors, (+) Subsidies received by all sectors, (+) Net factor income from abroad (NFIA) (note, 3), , 750, (-) 80, (–)50, 20, (–)10
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(b) National Income (NNPfc), , 630, , Note:, 1.Value of output of all sectors = Value of output of, primary, secondary and tertiary sectors, = 800 +200 + 300 = `1300 crore, 2. Cost of intermediate inputs purchased by all sectors, = 400 +100 + 50 = ` 550 crore, 3. NFIA = Factor income received by the residents from, rest of the world – Factor income paid to non-residents, = 10 – 20 = (–) ` 10 crore
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Do it yourself 8, From the following data calculate the (a) Gross National, Product at Market Price (b) National Income., 3 marks, S. No. Items, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), , Value of output in primary sector, Net factor income from abroad, Value of output in tertiary sector, Intermediate consumption in secondary sector, Value of output in secondary sector, Intermediate consumption in primary sector, Intermediate consumption in tertiary sector, Net Indirect Taxes, Consumption of fixed Capital, , [Ans. (a) `1,380 crore (b) ` 980 crore], , (` in lakh), 1,000, (–)20, 700, 400, 900, 500, 300, 300, 100
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Solution of Do it yourself 8, (a) Gross National product at market price (GNPmp), = Value of output of all the sectors, – Intermediate consumption of all the, sectors + NFIA, = (1,000 + 900 + 700) – (500 + 400 + 300) +, (–20) = `1,380 crore, (b) National Income (NNPfc), = GNPmp – Consumption of fixed capital –, Net indirect taxes, = 1,380 – 100 – 300 = `980 crore
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Question 1, Though intermediate goods are crucial inputs to any, production process, yet we measure final goods only. This, is because _________________., (Complete the sentence), , Objective Type Questions 1.4
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Answer 1, the value of final goods already includes the value of the, intermediate goods also., , Objective Type Questions 1.4
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Question 2, Match the following:, Column I, , Column II, , (a) Inventories, , (i) Investment, , (b) Change in inventories, , (ii) Capital, , Objective Type Questions 1.4
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Answer 2, (a) – (ii) , (b) – (i), , Objective Type Questions 1.4
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Question 3, __________ is what production units actually receive, for distribution of income among the owners of factors, of production., (Choose the correct alternative), (a) GDPmp, (b) NDPfc, (c) NNPfc, (d) NNPmp, , Objective Type Questions 1.4
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Answer 3, (b) NDPfc, , Objective Type Questions 1.4
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Question 4, The problem of ‘Double counting’ can be avoided by, __________., (Choose the correct alternative), (a) counting only value added, (b) counting only value of final products, (c) not counting value of intermediate products, (d) All of these, , Objective Type Questions 1.4
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Answer 4, (d) All of these, , Objective Type Questions 1.4
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Question 5, Market price and factor cost will be equal when there is:, (Choose the correct alternative), (a) No direct tax, (b) No indirect tax, (c) No subsidy, (d) No indirect tax and no subsidy, , Objective Type Questions 1.4
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Answer 5, (d) No indirect tax and no subsidy, , Objective Type Questions 1.4
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Question 6, Market price is always more than factor cost., True/False? Give reason., , Objective Type Questions 1.4
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Answer 6, False: Market price can be less than factor cost if net, indirect tax (i.e., indirect taxes – subsidy) is, negative, subsidy is more than indirect taxes., Market price can also be equal to factor cost if, net indirect tax is zero., , Objective Type Questions 1.4
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Question 7, Goods produced for self-consumption will be included, in national income., True/False? Give reason., , Objective Type Questions 1.4
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Answer 7, True: Such goods represent the current output and, their imputed value will be included in national, income., , Objective Type Questions 1.4
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Question 8, Counting intermediate goods separately will lead to the, error of ____________ , which will highly exaggerate, the ____________ ., (Fill in the blanks), , Objective Type Questions 1.4
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Answer 8, Double counting ; National income, , Objective Type Questions 1.4
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Question 9, In a simple economy, suppose there are only two, producers/firms — the farmers who produce wheat and, the bakers, i.e. the bread makers. The total value of, wheat produced by the farmers is `100, for which they, do not need any input other than human labour. Out of, this, the farmers have sold `50 worth of wheat to the, bakers, who have used it completely during the year and, have produced ` 200 worth of bread. The aggregate, value of final goods produced by this simple, economy will be :, (Choose the correct alternative), (a) `300, Objective Type Questions 1.4
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Question 9, (b) `250, (c) `350, (d) `200, , Objective Type Questions 1.4
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Answer 9, (b) `250, , Objective Type Questions 1.4
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Question 10, Match the following:, Column I, (a), , Net contribution made by a, firm, , Column I, (i) Value of output, , (b) Raw materials that a firm, (ii) Intermediate goods, buys from another which, are completely used up in, the process of production., (iii) Value added, , Objective Type Questions 1.4
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Answer 10, (a) – (iii), (b) – (ii), , Objective Type Questions 1.4
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Question 11, Value of production of a firm – value of intermediate, goods used by the firm = ____________., (Fill in the blank), , Objective Type Questions 1.4
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Answer 11, Value added of the firm, , Objective Type Questions 1.4
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Question 12, Value added is a flow variable., , True/False? Give reason., , Objective Type Questions 1.4
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Answer 12, True: Since value added (= value of output – intermediate, costs) is the net contribution of a firm during a, period of time (say one year), , Objective Type Questions 1.4
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Question 13, To calculate the net contribution made by a firm, we, need to deduct (i) ___________ from the value of, production. If we do not do this, we shall commit the, mistake or error of (ii) __________. (Fill in the blanks), , Objective Type Questions 1.4
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Answer 13, (i) Intermediate costs / Intermediate consumption, (ii) Double counting, , Objective Type Questions 1.4
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Question 14, A firm produces `100 worth of goods per year, `20 is, the value of intermediate goods used by it during the, year and ` 10 is the value of capital consumption. The, net value added will be:(Choose the correct alternative), (a) ` 100, (b) ` 80, (c) ` 70, (d) ` 130, , Objective Type Questions 1.4
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Answer 14, (c) `70, , Objective Type Questions 1.4
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Question 15, Match the following:, A firm buys raw materials from other firms., Column I, , Column II, , (a) The part of raw materials, which gets used up in the, same year., , (i) Intermediate good., , (b) The part of raw material, which does not get used up., , (ii) Final good, (iii) Inventory, (iv) Value added, Objective Type Questions 1.4
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Answer 15, (a) – (i) , (b) – (iii), , Objective Type Questions 1.4
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Question 16, In economics, ‘inventory’ includes the stock of unsold, finished goods only., True/False? Give reason., , Objective Type Questions 1.4
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Answer 16, False: In economics, ‘inventory’ includes the stock of, unsold finished goods, or semi finished goods, or, raw materials which a firm carries from one, year to the next., , Objective Type Questions 1.4
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Question 17, Match the following:, Column I, , (i) If the value of inventories at, the end of the year is higher, than that at the beginning of, the year., , Column II, , (a) Inventories have increased (or, accumulated), , (ii) If the value of inventories is, Inventories have decreased, less at the end of the year, (or decumulated), compared to the beginning of, the year, , Objective Type Questions 1.4
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Answer 17, (i) – (a) , (ii) – (b), , Objective Type Questions 1.4
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Question 18, Production of a firm during a year – Sales of the firm, during the year = ___________ ?, (Fill in the blank), , Objective Type Questions 1.4
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Answer 18, Change in inventories of the firm during a year., , Objective Type Questions 1.4
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Question 19, In case of an unexpected fall in sales, there will be, _________________ of inventories., (unplanned accumulation / unplanned decumulation), (Fill in the blank with correct option), , Objective Type Questions 1.4
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Answer 19, Unplanned accumulation, , Objective Type Questions 1.4
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Question 20, In case, there is unexpected rise in sales, there will be, ___________________ of inventories., (unplanned accumulation / unplanned decumulation), (Fill in the blank with correct option), , Objective Type Questions 1.4
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Answer 20, Unplanned decumulation, , Objective Type Questions 1.4
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Question 21, Suppose a firm produces shirts. It starts the year with an, inventory of 100 shirts. During the coming year it, expects to sell 1,000 shirts. Hence, it produces 1,000, shirts, expecting to keep an inventory of 100 shirts at, the end of the year. However, during the year, the firm, could sell only 600 shirts. The unexpected rise of, inventories by ________ units is an example of, _________ inventories., (Fill in the blank), , Objective Type Questions 1.4
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Answer 21, 400, unplanned accumulation, , Objective Type Questions 1.4
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Question 22, A firm produces computers. It has opening inventory of, 100 computers. During the coming year it expects to, sell 1,000 computers. Hence, it produces 1,000, computers expecting to keep an inventory of 100 at the, end of the year. But the sales during the year is 1,050, computers. The reduction, in inventory by, ____________ computers is called ______________, of inventories., (Fill in the blanks), , Objective Type Questions 1.4
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Answer 22, 50 , unplanned decumulation, , Objective Type Questions 1.4
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Question 23, A firm wants to raise the inventories from 100 to 200, shoes during the year. Expecting sales of 1,000 shoes, during the year, the firm produces 1,100 shoes. The sales, are actually 1,000 shoes and the firm ends up with an, inventory of 200 shoes. This rise in inventories is called, _____________ (Planned accumulation of inventories/, unplanned accumulation of inventories)., (Fill in the blank with correct option), , Objective Type Questions 1.4
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Answer 23, Planned accumulation of inventories, , Objective Type Questions 1.4
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Question 24, A firm wants to reduce the inventories from 100 to 25, mobile phones. Expecting sales of 1,000 mobile phones, during the year, the firm produces 925 mobile phones., The sales turn out to be 1,000 as expected by the firm, and the firm ends up with an inventory of 25 mobile, phones. This reduction in inventories is called, ____________________., (Planned decumulation of inventories / Unplanned, decumulation of inventories)., (Fill in the blank with correct option), Objective Type Questions 1.4
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Answer 24, planned decumulation of inventories, , Objective Type Questions 1.4
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Question 25, The sum total of gross value added of all the firms in the, economy is called ______________. (Fill in the blank), , Objective Type Questions 1.4
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Answer 25, Gross Domestic Product (GDP)., , Objective Type Questions 1.4
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Question 26, Sales by a firm includes sales to domestic buyers only., True/False? Give reason., , Objective Type Questions 1.4
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Answer 26, False: Sales by a firm includes sales not only to, domestic buyers but also to buyers abroad (i.e., exports)., , Objective Type Questions 1.4
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Question 27, To calculate GVA at factor cost from GVA at market, prices, which of the following is deducted :, (Choose the correct alternative), (a) Net product taxes (product taxes – product, subsidies), (b) Net production taxes (production taxes –, production subsides), (c) Both (a) and (b), (d) Net factor income from abroad., Objective Type Questions 1.4
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Answer 27, (c) Both (a) and (b), , Objective Type Questions 1.4
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Question 28, Production taxes are paid per unit of production., True/False? Give reason., , Objective Type Questions 1.4
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Answer 28, False: Production taxes are paid in relation to, production and are independent of the volume, of production, e.g. land revenues, stamp and, registration fee., , Objective Type Questions 1.4
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Question 29, Excise tax, service tax, export and import duties, etc are, product taxes., True/False? Give reason., , Objective Type Questions 1.4
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Answer 29, True: There are paid per unit of product., , Objective Type Questions 1.4
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Question 30, Basic prices include both product taxes (less product, subsidies) and production taxes (less production, subsidies)., True/False? Give reason., , Objective Type Questions 1.4
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Answer 30, False: Basic prices include the production taxes (less, production subsides) but not product taxes, (less product subsidies)., , Objective Type Questions 1.4
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Question 31, __________ measures the aggregate production of, final goods and services taking place within the domestic, territory of the country during a year. (Fill in the blank), , Objective Type Questions 1.4
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Answer 31, Gross Domestic Product at market price (GDPmp), , Objective Type Questions 1.4
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Question 32, A part of the capital which gets consumed during the, year due to wear and tear is called _________. If we, deduct it from GNP the measure of aggregate income, we obtain is called __________., (Fill in the blanks), , Objective Type Questions 1.4
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Answer 32, Depreciation; Net National Product, , Objective Type Questions 1.4
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Question 33, Depreciation is deducted from GDP while calculating, national income because ______________., (Fill in the blank), , Objective Type Questions 1.4
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Answer 33, depreciation does not become part of anybody’s income, , Objective Type Questions 1.4
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Question 34, Column I, , Column II, , (a) Subsidies, , (b) Indirect taxes, , (c) Intermediate consumption, , (d) Depreciation, , Objective Type Questions 1.4
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Answer 34, (b) Indirect taxes, , Objective Type Questions 1.4
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Question 35, _____________ are deducted and ______________, are added from NNP at market prices in order to, calculate that part of NNP which actually accrues to the, factors of production., (Fill in the blanks), , Objective Type Questions 1.4
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Answer 35, Indirect taxes ; Subsidies, , Objective Type Questions 1.4
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Question 36, Indirect taxes are deducted from NNP at market prices, to calculate national income because _________., (Complete the sentence), , Objective Type Questions 1.4
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Answer 36, Indirect taxes accrue to the government. It is a transfer, payment, not a factor payment., , Objective Type Questions 1.4
Page 387 :
Question 37, That part of NNP which actually accrues to the owners, of factors of production is called ___________ ., (Fill in the blank), , Objective Type Questions 1.4
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Answer 37, Net National Product at factor cost or National, Income., , Objective Type Questions 1.4
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Question 38, GDPmp includes market value of all final goods and, services produced by the normal residents or the nonresidents in a country., True/False? Give reason., , Objective Type Questions 1.4
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Answer 38, True: GDPmp includes the market value of all final, goods and services produced within the, domestic territory of a country in a year,, regardless of whether production unit is owned, by a local company or a foreign entity., , Objective Type Questions 1.4
Page 391 :
Question 39, The prices of products as received by the owners of, factors of production is called _____________ ., (Fill in the blank), , Objective Type Questions 1.4
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Answer 39, Factor cost, , Objective Type Questions 1.4
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Question 40, ______________ is the value of all the final goods and, services that are produced by the normal residents of, India and is measured at the market prices, in a year,, regardless of whatever they are located within the, economic territory or abroad., (Fill in the blank), , Objective Type Questions 1.4
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Answer 40, GNP at market prices, , Objective Type Questions 1.4
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Question 41, _______________ measures value of output received, by the factors of production belonging to a country in a, year of (in domestic territory or abroad)., (Choose the correct alternative), (a) GNP at market price, (b) GNP at factor cost, (c) GDP at market price, (d) GDP at factor cost, , Objective Type Questions 1.4
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Answer 41, (b), , GNP at factor cost, , Objective Type Questions 1.4
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Question 42, This is a measure of how much a country can consume, in a given period of time. It measures output regardless, of where that production has taken place (in domestic, territory or abroad)., (Choose the correct alternative), (a) GNP at market price, (b) GDP at market price, (c) NNP at market price, (d) NDP at market price, , Objective Type Questions 1.4
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Answer 42, (c), , NNP at market price, , Objective Type Questions 1.4
Page 399 :
Question 43, It is the net domestic factor income added with the net, factor income from abroad., (Choose the correct alternative), (a) GNP at market price, (b) GNP at factor cost, (c) NNP at market price, (d) NNP at factor cost, , Objective Type Questions 1.4
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Answer 43, (d), , NNP at factor cost., , Objective Type Questions 1.4
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Question 44, ______________ is the sum of income earned by all, factors of production in the form of wages, profits, rent, and interest, etc, belonging to a country during a year (in, the domestic territory or abroad)., (Fill in the blank), , Objective Type Questions 1.4
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Answer 44, Net National Product at factor cost (NNPfc) or, National Income (NI)., , Objective Type Questions 1.4
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Question 1, What is the difference between planned and unplanned inventory accumulation? Write down the relation between, change in inventories and value added of a firm., (NCERT) (4 marks), , HOTs 1.4— Analysing, Evaluating & Creating Type Questions
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Answer 1, In case of an unexpected fall in sales, a firm will have, unsold stock of goods which it had not anticipated., Hence, there will be unplanned inventory accumulation., On the other hand, if the firm wants to raise the inventory, during the year and produces goods accordingly; and the, sales also happen to be the same as expected, then there, will be planned accumulation of inventories., Relation between change in inventories and value added of, a firm:, Value added of a firm = Sales during the year + Change, in inventories – Value of intermediate goods used, HOTs 1.4— Analysing, Evaluating & Creating Type Questions
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Question 2, Explain why subsidy is added to and indirect tax is, deducted from domestic product at market price to, arrive at domestic product at factor cost., (3 marks), , HOTs 1.4— Analysing, Evaluating & Creating Type Questions
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Answer 2, Domestic product at market price is what buyers pay., But this is not what production units actually receive., Out of what buyers pay the production units have to, make payment of indirect tax, e.g., Goods and Services, Tax (GST). Therefore, indirect tax is deducted., Sometimes, production units get subsidy on production, from the government.Therefore, subsidy is added., What production units actually receive is not the, ‘Market Price’ but ‘Market Price – Indirect tax +, Subsidies’. This is what is actually available to production, units for distribution of income among the owners, HOTs 1.4— Analysing, Evaluating & Creating Type Questions
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of factors of production. Therefore, Market Price (mp) –, Indirect Tax (IT) + Subsidies = Factor Cost (fc) or, factor payments., , HOTs 1.4— Analysing, Evaluating & Creating Type Questions
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Question 3, State, giving reason, whether the following will be included, in the estimation of national income:, (3 marks), (i) Services of owner-occupied building, (ii) Payment of indirect taxes by a firm, (iii) Wheat grown by a farmer but used entirely for his, family’s consumption., , HOTs 1.4— Analysing, Evaluating & Creating Type Questions
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Answer 3, (i), , Yes, imputed value of free services provided by the, owners of production units must be included in, national income., (ii) No, it is not included in national income because, an indirect tax paid to the government is a transfer, payment as no good or service is provided in, return., (iii) Yes, its imputed value is included in national, income because it adds to the current flow of, goods and services., HOTs 1.4— Analysing, Evaluating & Creating Type Questions
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1.5, Income Method of, Calculating National Income
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Steps for calculating national income, by income method, Step 1: Estimate the factor payments by each, firm in all the sectors of the economy during, the year., The sum of factor payments equals Net Value Added at, Factor Cost (NVAfc) of a firm.
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Step 2: Take the sum total of NVAfc by all firms, in all the sectors of the economy to arrive at, NDPfc., The components of NDPfc are compensation of employees,, operating surplus and mixed income., 1. Compensation of employees: It is defined as the, total remuneration in cash or in kind, payable by, the employers to employees in return for work done, by them during an accounting year., The main components of compensation of employees, are:, (a)Wages and salaries in cash and in kind. For example,, • Payment of bonus by a firm to its employees, •Free medical facilities, free meals and rent-free house
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given by the employer, • House rent allowance or leave travel allowance paid, by the employer, • Medical treatment of employee’s family, (b) Social security contributions by the employers., For example,, • Contribution to provident fund by the employer, • Insurance premium paid by the employer
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, , Top Tip, , Contribution to provident fund or insurance premium paid by, employees is not included in national income because it is, paid out of compensation of employees, which is already, included., Similarly, compensation given by insurance company to an, injured worker is not included as compensation is given by, insurance company to the employee, and not by employer., Also, gifts received from employer, e.g. festival gift, gifts on, independence day, etc. is not included in national income as it, is a transfer payment., , 2. Operating surplus: Operating surplus is defined as, the sum of rent, royalty, interest and profits. Operating, surplus can also be termed as 'Income from property
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and entrepreneurship', i.e. incomes earned by property, owners. It includes rent and royalty, profit and interest., (a) Rent is defined as the amount receivable by a, landlord from a tenant for the use of land., (b) Royalty is defined as the amount receivable by the, owner for granting the leasing rights of sub-soil, assets, e.g., royalty income received by an author of, a book from the publisher., (c) Interest is defined as the amount payable to the, owners of financial assets in the production unit., The production unit uses these assets for, production and in turn makes interest payment,, imputed or actual.
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, , Top Tip, , Payment of interest by banks to its depositors or Payment of, interest by a firm (government firm or a private firm) to, households or Payment of interest by a firm to a bank is, included in national income because it is factor payment. The, borrowed money is used for carrying out production of goods, and services., However, payment of interest on a loan taken by an employee, from the employer or payment of interest by an individual to a, bank on a loan to buy a car or interest received on loans given, to a friend for purchasing a car will not be included in national, income because the individual is a consumer, and the loan is, taken to meet consumption expenditure. There is no, contribution to production of goods and services. Therefore, it, is not a factor payment.
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(d) Profit is a residual factor payment by the, production unit to the owners of the production, unit. The production unit uses profit for (i) payment, of corporation tax to the government, (ii) dividend, payments to the owners of the production unit, and, (iii) undistributed profits/ retained earnings for, investment in new projects and ventures., Profits = Corporation tax, + Dividend, + Undistributed profits/Retained, earnings/savings of private, corporate sector, or, Profits = Corporate profit tax + After-tax, profit
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(Note: After-tax profit = Dividend + Retained earnings), , , , Top Tip, , Payment of corporate tax by a firm is also not included in, national income as it is a transfer payment. Corporate tax is, already included in profits. Corporate tax accrues to the, government. It is not received by the owners of factors of, production. Hence, it is not a factor income., , 3. Mixed income of self-employed: The income of self, employed people like doctors, chartered accountants,, consultants, etc. has two or more factor incomes. For, example, a doctor’s income may consist of salary from a, hospital, fees earned by him from the patients in his, own clinic, rental income from his property, and profits, of a business owned by him. In such cases, total
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income is estimable, but not its different components., So, mixed income of self-employed is another factor, payment, which is added to the national income.
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, , Top Tip, , The main source of factor payments are the accounts of, production units. Since accounts of most production units are, not available to the estimators, and also since the accounting, practices differ, it is not possible for the estimators to clearly, identify the components. Therefore, in cases where total, factors payment is estimable but not its different components,, an additional factor payment item called 'mixed income‘is, added. Since this problem arises mainly in case of self, employed people like doctors, chartered accountants,, consultants, etc, this factor payment is popularly called, "mixed income of the self-employed".
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Step 3: Once we estimate NDPfc, we can find, NNPfc (national income) by adding NFIA, to it., , , , Top Tip, , Components of National Income by Income Method are:, (i) Compensation of employees, (ii) Operating surplus, (iii) Mixed income of self-employed, (iv) Net factor income from abroad (NFIA), National income (NNPfc) = Compensation of employees +, Operating surplus + Mixed income + NFIA
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Precautions in making estimates of national income by income method, 1. Avoid transfers., National income includes only factor payments, i.e., payment for the services rendered to the production, units by the owners of factors of production., Any payment for which no service is rendered is called, a transfer (e.g. gifts, donations, charity, etc.), and not a, production activity. Hence, transfer payment is not, included in national income.
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2. Avoid capital gain., Capital gain refers to the income from the sale of, second hand goods and financial assets., Income from the sale of old cars, old house, bonds,, debentures, etc are some examples., These transactions are not production transactions. So,, any income arising to the owners of such things is not a, factor income.
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3. Include income from self-consumed output., When a house owner lives in that house, he does not, pay any rent. But in fact he pays rent to himself. Since, rent is a payment for services rendered,even though, rendered to the owner itself,it must be counted as a, factor payment.
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4. Include free services provided by the, owners of the production units., Owners work in their own unit but do not charge, salary. Owners provide finance but do not charge any, interest. Owners do production in their own buildings, but do not charge rent., Although they do not charge, yet the services have, been performed. The imputed value of these must be, included in national income
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Treatment of Items in the Estimation, of National Income by Income Method, S. No., , Items, , Treatment, , Reason, , 1, , Value of bonus shares, received by shareholders of, a company, , No, it will not be, included in the, national income., , As bonus shares, are financial assets, and do not contribute, to the production of, goods and services., , 2, , Payment of interest on No, it is not, a loan taken by an, included in, employee from the, national income., employer/Payment of, interest by an individual to a, bank on a loan to buy a, car/Interest received on, loans given to a friend for, purchasing a car., , Because the, individual is a, consumer, and the, loan is taken to meet, consumption, expenditure. There is, no contribution to, production of goods, and services., Therefore, it is not a, factor payment.
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3, , Paymentof interestby banks Yes, it is included in, to its depositors/Paymentof national income., interestbyafirm to, households., , Because it is a factor, income paid by a, production unit (bank, or firm). Banks borrow, forcarrying out, banking services./The, firms borrow money, forcarrying out, production., , 4, , Payment of interest by a Yes, it is included in, firm (government firm national income., or a private firm) to a, bank, , Because it is a factor, payment by the firm., The firm borrows, money for carrying, out production of, goods and services., , 5, , Interest received on loan Yes, it will be, As it is a factor, given to a foreign company included in the national income from abroad., in India., income.
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6, , Interest received on, debentures., , Yes, it will be, included in the, national income., , 7, , Payment of interest on, borrowings by general, government (National, debt interest), , No, it will not be, included in the, national income., , Because interest, received on debentures, is a factor income, because debenture is a, sort of loan taken by a, production unit, which, uses the money in, producing goods and, services., Because it is a transfer, payment as general, government borrows, only for consumption, purpose.
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8, , Money received by a family in No, it will not be, India from relatives working included in national, abroad, i.e., remittances from income., abroad/Scholarship given to, Indian students studying in, India by a foreign, company/Financial help, received by flood, victims/Expenditure on old, age pensions by, government/Gift received, from employer, e.g. festival, gift, gifts on independence, day, etc., , As it is a transfer, payment, which is, received without, any contribution to, production of goods, and services. It is, not a factor income.
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9., , 10, , Free medical facilities or free Yes, it will be, As it is a part of the, meals or house rent, included in the, compensation of, allowance or leave travel, national income. employees., allowance paid by the, employer/Rent-free house, given to an employee by an, employer/ Expenditure on, medical treatment of, employee’s family/Payment, of bonus by a firm to its, employees/Contribution to, provident fund by employer, Payment of corporate No, it is not included As it is a transfer, tax by a firm, in national income. payment. Corporate tax, accrues to the, government. It is not, received by the owners, of factors of production., Hence, it is not a factor, income.
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11, , 12, , 13, , 14, , Contribution to provident No, it is not included Because it is paid out of, fund or insurance premium in national income., compensation of, paid by employees, employees, which is, already included., Compensation given by No, it is not included As compensation is, insurance company to an in national income. given to the employee, injured worker., by insurance company,, not by employer., Salaries paid to Russians It will be included As it is a factor income, working in Indian, in domestic income paid to abroad. It is, Embassy in Russia., of India (since the, subtracted from, factor income is earned domestic income to get, within the domestic national income., territory). But it will not, be included in national, income of India., Imputed rent of self, occupied houses., , Yes, it will be, included in the, national income., , Because self-occupied, houses provide housing, services similar to those, as rented houses.
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15, , 16, , 17, , Earnings of shareholders No, it will not be, from the sale of shares. included in the, national income., , Because financial, assets (shares, bonds,, etc.) are neither goods, nor services, and do not, contribute to any, production of goods and, services., Capital gains to Indian, No, capital gains As they do not add, residents from sale of shares from sale of shares to the current flow, will not be included of goods and, of a foreign company., in national income. services in the, economy., Money received from sale No, it will not be, Because sale of second, of second-hand goods/ included in national hand goods is not a fresh, Money received from sale income., production transaction., of old house or old car., So any income arising to, the owners of such, goods is not a factor, income, but a capital, gain.
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18, , 19, 20, 21, , Commission received by Yes, it will be included As it is a factor, a dealer from the buyer in national income., income because any, and seller of a house., commission paid to, facilitate the sale of, house is a fresh, production activity., Prize won in a lottery, No, it will not be, Because it is a windfall, included in national gain, not a factor, income., income., Receipts from sale of land No, it will not be, As land is a free gift of, included in national nature and cannot be, produced., income., Profit earned by foreign It will be included in As it is a factor income, banks in India., domestic income of paid to abroad. It is, India (since the factor subtracted from, domestic factor income, income is earned, within the domestic to get national income., territory). But it will not, be included in national, income of India.
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22 Profits earned by an Indian Yes, it will be, bank from its branches, included in national, abroad., income., 23 Dividend received by a No, it will not be, foreigner from, included in national, investment in shares of income., an Indian company., 24 Dividend received by, Yes, it will be, shareholders., included in national, income., , As it is a factor, income from abroad., As it is a factor, income paid to, abroad., , As it is a part of the, profits of production, units, which is, distributed to the, owners. Hence, it is a, factor income., 25 Rent received by Indian Yes, it will be, This factor income, residents on their, included in national is earned by the, buildings rented out to income., residents., foreigners in India., 26 Royalty, Yes, it will be, As royalty is a, included in national productive income., income.
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Key Terms, Compensation of employees — It is defined as the total, remuneration in cash or in kind, payable by the employers to, employees in return for work done by them during an accounting, year. It includes (a) Wages and salaries in cash and in kind and (b), Employers’ contribution in social security schemes., Operating surplus — Operating surplus is defined as the sum of, rent, royalty, interest and profits., Income from property and entrepreneurship — are incomes, earned by property owners. It includes rent and royalty, profit, and interest. It can also be termed as operating surplus., Mixed Income — Income of self-employed people like doctors,, chartered accountants, consultants, etc. has two or more factor, incomes. Total income is estimable, but not its different, components. So, mixed income is added to national income.
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RECAP, , National income by income method, In this method, we first estimate factor payments by each, sector. The sum of such factor payments equals Net Value, Added at factor cost (NVAfc) by that sector., Then we take sum total of NVAfc by all the sectors to arrive at, NDPfc. The components of NDPfc are:, (i) Compensation of employees: It includes:, (a) Wages and salaries in cash and in kind, e.g. bonus, free, medical facilities, free meals, house rent allowance, etc., (b) Social security contributions by the employers, e.g.,, provident fund or insurance premium paid by, employers., (ii) Operating surplus: Operating surplus is defined as the, sum of rent, royalty, interest and profits., Operating surplus can also be termed as 'income from property
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and entrepreneurship'., Note: Profit = Corporation tax + Dividend + Retained, earnings/undistributed profits., Alternately, Profit = Corporation tax + After tax profit, (iii) Mixed income: The income of self employed people, like doctors etc. has two or more factor incomes; total, income is estimable, but not its different, components. So, mixed income is another factor, payment., Once we estimate NDPfc, we can find NNPfc or national, income, by adding net factor income from abroad., National income = Compensation of employees, + Operating surplus, + Mixed income of self employed, + Net factor income from abroad
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Precautions in making estimates of national, income by income method, 1. Avoid transfers. National income includes only, factor payments, i.e. payment for the services, rendered to the production units by the owners of, factors of production., Any payment for which no service is rendered is, called a transfer, e.g. gifts, donations, charity, etc., Since transfers are not a production activity it must, not be included in national income., 2. Avoid capital gain. Capital gain refers to the, income from the sale of second hand goods and, financial assets. Income from the sale of old cars,, old house, bonds, debentures, etc are some, examples.
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These transactions are not production transactions., So, any income arising to the owners of such things, is not a factor income., 3. Include income from self-consumed output., When a house owner lives in that house, he does not, pay any rent. But in fact he pays rent to himself., Since rent is a payment for services rendered,even, though rendered to the owner itself,it must be, counted as a factor payment., 4. Include free services provided by the owners of, the production units. Owners work in their own, unit but do not charge salary. Owners provide, finance but do not charge any interest. Owners do, production in their own buildings but do not charge, rent.
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Although they do not charge, yet the services have been, performed. The imputed value of these must be, included in national income.
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NUMERICAL 9, From the following data relating to a firm:, (a) Estimate the net value added at market prices., (b) Show that net value added at factor cost is equal, to the sum of factor incomes., (6 marks), S. No. Items, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), , Purchase of raw materials and other, inputs from the domestic market, Increase in stocks, Domestic sales, Imports of raw materials, Exports, Depreciation, Salaries and wages, Interest payments, , (` in lakh), 600, 200, 1800, 100, 200, 75, 600, 450
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(ix), (x), (xi), (xii), (xiii), , Rent, Dividends, Undistributed profits, Corporate profit tax, Indirect taxes, , 75, 150, 80, 20, 50, , Solution: (a) Net value added at market prices, = (Domestic sales + Exports + Increase in, stocks), – (Purchase of raw materials and other inputs, from the domestic market, + Imports of raw materials) – Depreciation, = (1800 + 200 + 200) – (600 + 100) – 75 = `1425, lakh
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(b) Net value added at factor cost, = Net value added at market prices – Indirect, taxes, =, , 1425 – 50 = `1375 lakh, , Factor Incomes, = Salaries and wages + Interest + Rent + Dividends +, Undistributed profits + Corporate tax, = 600 + 450 + 75 + 150 + 80 + 20 = `1375 lakh, Hence, net value added at factor cost is equal to the sum of, factor incomes.
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Do it yourself 9, Calculate:, (a) Net value added at factor cost and, (b) Value of output at market price from the following, data., 6 marks, S. No., , Items, , (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), , Subsidies, Intermediate costs, Compensation of employees, Depreciation, Royalty, Interest, Indirect taxes, Rent, Profits, Net change in stocks, , (` in arab), 40, 200, 400, 50, 5, 25, 100, 10, 60, 20
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Solution of Do it yourself 9, (a) Net value added at factor cost (NVAfc), = Sum of factor incomes, = Compensation of employees + Rent +, Royalty + Interest + Profit, = 400 + 10 + 5 + 25+ 60 = `500 arab, (b) NVAfc = Value of output – Intermediate costs, – Depreciation – Indirect taxes + Subsidies, 500 = Value of output – 200 – 50 – 100 + 40, Value of output at market price = 500 + 200 + 50 + 100 –, 40 = `810 arab
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NUMERICAL 10, Calculate national income:, S. No., , Items, , (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), , Compensation of employees, Interest paid by production units, Rent, Profits, Employers’ contribution to social security schemes, Dividends, Consumption of fixed capital, Net indirect taxes, Net exports, Net factor income to abroad, Mixed income of self-employed, , (4 marks), (` in crore), 2,000, 500, 700, 800, 200, 300, 100, 250, 70, 150, 1,500
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Solution:, Particulars, , (` in crore), , Compensation of employees, (+) Interest paid by production units, (+) Rent, (+) Profits, (+) Mixed income of self employed, (–) Net factor income to abroad, , 2,000, 500, 700, 800, 1,500, (–)150, , National Income (NNPfc), , 5,350
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Do it yourself 10, Calculate national income from the following data.4 marks, S. No. Items, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), , Rent, Interest, Profits, Tax on profits, Employers’ contribution to social security schemes, Mixed income of self-employed, Net indirect taxes, Employees’ contribution to social security schemes, Compensation of employees, Net factor income from abroad, , [Ans. `1120 crore], , (` in arab), 80, 100, 210, 30, 25, 250, 60, 50, 500, (–)20
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Solution of Do it yourself 10, National Income = Compensation of employees, + Rent + Interest + Profits + Mixed income of self-employed, + Net factor income from abroad, = 500 + 80 + 100 + 210 + 250 + (– 20) = `1120 crore
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NUMERICAL 11, Calculate Domestic Income:, S. No., , Items, , (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), , Dividends, Social security contributions by employers, Corporate profit tax, Consumption of Fixed Capital, Retained earnings of private corporate sector, Interest paid by firms, Rent, Royalty, Wages and salaries, Interest paid by households, , (4 marks), (` in crore), 50, 40, 30, 60, 20, 150, 70, 30, 600, 10
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Solution:, \Particulars, , (` in crore), , Compensation of employees, (+) Interest paid by production units, (+) Rent, (+) Royalty, (+) Profits, , 640, 150, 70, 30, 100, , Domestic income (NDPfc), , 990, , Note: (i) Compensation of employees = Wages and salaries, + Social security contributions by employers, = 600 + 40 = `640 crore, (ii) Profits = Dividends + Corporate profit tax + Retained, earnings of private corporate sector, = 50 + 30 + 20 = `100 crore
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Do it yourself 11, Calculate Net national product at market price, S. No. Items, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), , Net current transfers from abroad, Wages and salaries, Net factor income to abroad, Social security contributions by employers, Net indirect tax, Rent, Consumption of fixed capital, Corporation tax, Dividend, Undistributed profits, Interest, , [Ans. `2,210 crore], , 4 marks, (` in arab), (–)10, 1,000, (–)20, 100, 80, 300, 120, 50, 200, 60, 400
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Solution of Do it yourself 11, Net national product at market price (NNPmp), = Wages and salaries + Social security contributions, by employers, + Rent + Interest + Corporation tax + Dividend, + Undistributed profits – Net factor income to, abroad + Net indirect tax, = 1,000 + 100 + 300 + 400 + 50 + 200 + 60 – (–20) +, 80 = `2,210 crore
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NUMERICAL 12, Calculate Net Domestic Product at market price:, (4 marks), S. No., , Items, , (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), , Interest received by households, Consumption of fixed capital, Rent and royalty, Net factor income from abroad, Net indirect tax, Profit, Social security contributions by employees, Mixed income of self-employed, Wages and salaries, Dividend, , (` in crore), 600, 800, 700, 100, 850, 1,200, 700, 8,000, 5,000, 400
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Solution:, \Particulars, , (` in crore), , Compensation of employees (wages and salaries), (+) Interest received by households, (+) Rent and royalty, (+) Profit, (+) Mixed income of self-employed, , 5,000, 600, 700, 1,200, 8,000, , Domestic factor income (NDPfc), (+) Net indirect tax, , 15,500, 850, , Net Domestic Product at market price (NDPmp), , 16,350
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Do it yourself 12, From the following data calculate the Gross National, Product at Market Price., 4 mark, S. No. Items, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), , Wages and Salaries, Rent, Current replacement cost, Net factor income from abroad, Mixed income, Subsidies, Profits, Indirect taxes, Employers’ contribution to social security schemes, Interest, , [Ans. `1,930 crore], , (` in arab), 700, 100, 50, (–)10, 400, 100, 400, 300, 50, 40
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Solution of Do it yourself 12, Gross National Product at Market Price, = Compensation of Employees (Wages and Salaries +, Employers’ contribution to social security schemes), + Operating Surplus (Rent + Profits + Interest) + Mixed, Income, + Current replacement cost + Indirect taxes – Subsidies +, NFIA, = (700 + 50) + (100 + 400 + 40) + 400 +50 + 300 – 100 +, (–10), = `1930 crore
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NUMERICAL 13, Calculate Gross National Product at market price:, (4 marks), S. No., , Items, , (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), (xiii), , Compensation of employees, Profits after tax, Mixed income of self-employed, Net addition to capital stock, Rent and royalty, Interest, Factor income from abroad, Goods and Services Tax, Gross investment, Net exports, Factor income paid to abroad, Subsidies, Corporation tax, , (` in crore), 2,500, 500, 7,500, 400, 400, 350, 150, 200, 470, 40, 100, 50, 200
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Solution:, Particulars, , (` in crore), , Compensation of employees, (+) Profit, (+) Rent and royalty, (+) Interest, (+) Mixed income of self-employed, , 2,500, 700, 400, 350, 7,500, , Domestic income (NDPfc), Adjustments:, (+) Depreciation (note 1), (+) Goods and Services Tax, (–) Subsidies, (+) Net factor income from abroad (NFIA) (note 2), , 11,450, , GNP at market price, , 11,720, , 70, 200, (–)50, 50, , Note: 1. Depreciation = Gross investment – Net investment, (or Net addition to capital stock), = 470 – 400, = `70 crore
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2. Net factor income from abroad (NFIA) = Factor income, from abroad – Factor income paid to abroad, = 150 – 100, = `50 crore, 3. Profits = Profits after tax + Corporation Tax, = 500 + 200, = `700 crore
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Do it yourself 13, Calculate Gross National Product at Market Price from the, following data., 4 mark, S. No. Items, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), , Wages and Salaries, Net Capital formation, Exports, Imports, Gross capital formation, Employers’ contribution to social security schemes, Net factor income from abroad, Rent and interest, Profits after tax, Goods and Services Tax, Subsidies, Corporate Tax, , [Ans. `1220 crore], , (` in arab), 500, 100, 50, 60, 120, 20, (–) 10, 250, 300, 50, 10, 100
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Solution of Do it yourself 13, GNPmp = Compensation of employees (Wages and, Salaries + Employers’ contribution to social security, schemes) + Operating surplus (Rent and interest +, Profits) + Depreciation + Goods and Services Tax –, Subsidies + NFIA, = (500 + 20) + (250 + 400) + 20 + 50 – 10 + (–10) =, `1220 crore, Note: (i) Depreciation = Gross capital formation – Net, capital formation, = 120 – 100 = 20, (ii) Profits = Profits after tax + Corporate Tax = 300 + 100, = 400
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NUMERICAL 14, Calculate compensation of employees:, S. No., , Items, , (i), (ii), (iii), (iv), (v), , Rent, Interest, Profits, Gross domestic product at factor cost, Consumption of fixed capital, , (3 marks), (` in crore), 20, 35, 15, 250, 60, , Solution:, Gross domestic product at factor cost, = Compensation of employees + Rent + Interest + Profits, + Consumption of fixed capital, 250 = Compensation of employees + 20 + 35 + 15 + 60, Compensation of employees = 250– 20 – 35 – 15–60 = `120 crore
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Do it yourself 14, Calculate Gross National Product at Market Price from the, following data., 4 mark, S. No. Items, (i), (ii), (iii), (iv), , Gross value added at market price, Wages and salaries, Net indirect taxes, Consumption of fixed capital, , [Ans. `9,000 crore], , (` in arab), 15,000, 5,000, 750, 250
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Solution of Do it yourself 14, Gross value added at market price, = Wages and salaries + Operating surplus + Consumption, of fixed capital, + Net indirect taxes, 15000 = 5000 + Operating surplus + 250 + 750, Operating surplus = 15000 – 5000 – 250 – 750 = `9000, crore
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NUMERICAL 15, From the following data, calculate:, (a) Gross domestic product at market price and, (b) Factor income from abroad, (6 marks), S. No., , Items, , (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), , Gross national product at factor cost, Net exports, Compensation of employees, Rent, Interest, Profit, Net indirect taxes, Net domestic capital formation, Gross fixed capital formation, Change in stocks, Dividend, Factor income to abroad, , (` in crore), 6,150, (–) 50, 3,000, 800, 900, 1,300, 300, 800, 850, 50, 300, 80
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Solution:, (a), Gross domestic product at market price (GDPmp), = Compensation of employees + Rent +, Interest + Profit + Depreciation + Net indirect taxes, = 3,000 + 800 + 900 + 1,300 + 100 + 300, = `6,400 crore, Note: Depreciation = Gross fixed capital formation +, Change in stocks – Net domestic capital formation, = 850 + 50 – 800 = `100 crore, (b) Gross national product at factor cost, = GDPmp + Factor income from abroad –, Factor income to abroad – Net indirect taxes, 6,150 = 6,400 + Factor income from abroad – 80 – 300, Factor income from abroad = 6,150 + 80 + 300 – 6,400, = `130 crore
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Do it yourself 15, Calculate: (a) Net national product at factor cost and (b), Gross Domestic product at market prices., 6 marks, S. No. Items, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), , Net indirect taxes, Consumption of fixed capital, Net factor income from abroad, Rent, Profits, Interest, Royalty, Wages and salaries, Employers’ contribution to social security schemes, , [Ans. (a) `257 crore (b) `332 crore], , (` in arab), 38, 34, (–)3, 10, 25, 20, 5, 170, 30
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Solution of Do it yourself 15, (a) Net National Product at Factor Cost (or National income), = Wages and salaries + Employers’ contribution to social security, schemes, + Rent + Interest + Profits + Royalty + Net factor income from, abroad, = 170 + 30 + 10 + 20 + 25 + 5 + (–3) = `257 crore, (b) Gross Domestic Product at Market Price = Net national, product at Factor Cost + Consumption of fixed capital + Net, indirect taxes, – Net factor income from abroad, = 257 + 34 + 38 – (–3) = `332 crore
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NUMERICAL 16, Calculate the value of “Rent” from the following data:, (CBSE 2019) (4 marks), S. No., (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), , Items, , (` in crore), , Gross Domestic Product at market Price, Mixed Income of Self-Employed, Subsidies, Interest, Rent, Profit, Compensation of Employees, Consumption of Fixed Capital, Indirect Tax, , 18,000, 7,000, 250, 800, ?, 975, 6,000, 1,000, 2,000, , Solution: GDPmp = NDPfc+ Depreciation + Net indirect tax, , (i) = (vii) + (ii)+ [(iv) + (vi) + Rent] + (viii) + [(ix)-(iii)]
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18,000 = (6,000 + 7,000 + (800 + 975 + Rent) + 1,000 +, (2,000 – 250), 18000 = 17525 + Rent ⇒ Rent = `475 crore
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Do it yourself 16, Calculate the value of “Interest” from the following data, (4 marks), S. No. Items, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), , Indirect tax, Subsidies, Profits, Consumption of fixed capital, Gross domestic product at market price, Compensation of employees, Interest, Mixed income of self-employed, Rent, , [Ans. 1,300 crore], , (` in arab), 1,500, 700, 1,100, 700, 17,500, 9,300, ?, 3,500, 800
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Solution of Do it yourself 16, GDPMP = NDPFC+ Depreciation + Net indirect tax, (v) = (vi) + (viii)+ [(iii)+(ix) + interest] + (iv) + [(i) – (ii)], 17,500 = (9,300+3,500+1,100+800+interest) + 700+ (1,500-700), 17,500 = 16,200 + Interest, Interest = 1,300 crore
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NUMERICAL 17, Calculate compensation of employees from the following, data:, (CBSE Sample Question Paper 2020) (3 marks), S. No., (i), (ii), (iii), (iv), (v), (vi), (vii), , Items, Profits after tax, Interest, Gross Domestic Product at Market Price, Goods and Services Tax, Consumption of Fixed Capital, Rent, Corporate Tax, , (` in crore), 20, 45, 200, 10, 50, 25, 5, , Solution: GDPmp = NDPfc + Consumption of Fixed Capital + Goods, and Services Tax, GDPmp = Compensation of employees + Profits (Profits after tax +, Corporate Tax) + Interest + Rent
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+ Consumption of Fixed Capital + Goods and Services Tax, 200 = Compensation of employees + (20 + 5) + 45 + 25 +, 50 + 10, Compensation of employees = 200 – 25 – 45 –25 – 50 – 10 =, `45 crore
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Do it yourself 17, Calculate the value of “Mixed Income of Self-Employed”, from the following data:, (CBSE 2019) (4 marks), S. No. Items, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), , Compensation of Employees, Interest, Consumption of Fixed Capital, Mixed Income of Self-Employed, Subsidies, Gross Domestic Product at Market price, Indirect Taxes, Profits, Rent, , [Ans. `2,750crore], , (` in arab), 17,300, 1,200, 1,100, ?, 750, 27,500, 2,100, 1,800, 2,000
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Solution of Do it yourself 17, GDPMP = (i) + [(ix) + (ii) + (viii)], + Mixed Income of Self employed + (iii) + (vii- v), 500 = 17,300 + (2000+ 1200 + 1800), + Mixed Income of Self employed +1100 +(2100-750), Mixed Income of Self employed =`2,750crore
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Question 1, Which of the following will be included in national, income?, (Choose the correct alternative), (a) Money receipt from sale of old car, (b) Scholarships received by students, (c) Remittances from abroad, (d) Free services of owner occupied building, , Objective Type Questions 1.5
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Answer 1, (d) Free services of owner occupied building, , Objective Type Questions 1.5
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Question 2, Which of the following transactions is not included in, national income?, (Choose the correct alternative), (a) Payment of interest by a private firm, (b) Payment of interest by banks on deposits, (c) Interest paid by an individual on a car loan taken, from a bank, (d) Interest on finance provided by the owners of the, production units, , Objective Type Questions 1.5
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Answer 2, (c), , Interest paid by an individual on a car loan taken, from a bank, , Objective Type Questions 1.5
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Question 3, Which one of the following is not included in, compensation of employees?, (Choose the correct alternative), (a) Payment of bonus by a firm to its employees, (b) House rent allowance by the employer, (c) Free medical facilities by the employer, (d) Festival gift from an employer, , Objective Type Questions 1.5
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Answer 3, (d) Festival gift from an employer, , Objective Type Questions 1.5
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Question 4, Which of the following is not included in compensation, of employees?, (Choose the correct alternative), (a) Wages and salaries in cash, (b) Wages and salaries in kind, (c) Employees’ contribution to social security schemes, (d) Employers’ contribution to social security schemes, , Objective Type Questions 1.5
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Answer 4, (c) Employees’ contribution to social security schemes, , Objective Type Questions 1.5
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Question 5, Broker’s commission on sale and purchase of second, hand goods is included in national income because:, (Choose the correct alternative), (a) It is a part of compensation of employees, (b) It is a part of gross domestic capital formation, (c) It is an income earned for rendering productive, services, (d) None of these, , Objective Type Questions 1.5
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Answer 5, (c) It is an income earned for rendering productive, services, , Objective Type Questions 1.5
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Question 6, Which of the following will be included in national, income?, (Choose the correct alternative), (a) Financial transactions, (b) Sale of old goods, (c) Illegal activities, (d) Production of goods and services, , Objective Type Questions 1.5
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Answer 6, (d) Production of goods and services, , Objective Type Questions 1.5
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Question 7, Which of the following transactions is not included in, national income?, (Choose the correct alternative), (a) Brokerage paid to broker for facilitating sale of, second hand goods, (b) Payment of corporation tax by a firm, (c) Interest on finance provided by the owners of the, production units, (d) Interest paid by banks on deposits by individuals, , Objective Type Questions 1.5
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Answer 7, (b) Payment of corporation tax by a firm, , Objective Type Questions 1.5
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Question 8, Wages, interest, profits and rents paid out by the firm, must add up to _________ of the firm.(Fill in the blank), , Objective Type Questions 1.5
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Answer 8, Net value added at factor cost (NVAfc), , Objective Type Questions 1.5
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Question 9, Prizes received by the household from government and, firms are included in National Income., True/ False? Give reason., , Objective Type Questions 1.5
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Answer 9, False : It is a transfer payment., , Objective Type Questions 1.5
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Question 10, Payment of interests by households to the firm and the, government as well, in case they hold borrowed money, from either, will be included in National Income., True/ False? Give reason., , Objective Type Questions 1.5
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Answer 10, False: It is not a factor payment because the, borrowings by households are assumed to be on, consumption expenditure., , Objective Type Questions 1.5
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Question 11, A part of profit which is distributed among the factors, of production is called _____________ ., (Fill in the blank), , Objective Type Questions 1.5
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Answer 11, dividend, , Objective Type Questions 1.5
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Question 12, _____________ is the income earned by the factors of, production in the form of wages, profits , rent interest,, etc, within the domestic territory of a country., (Fill in the blank), , Objective Type Questions 1.5
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Answer 12, Net Domestic Product at factor cost, , Objective Type Questions 1.5
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Question 1, State the various components of the Income Method that, are used to calculate national income., (CBSE Sample Question Paper 2015) (4 marks), , HOTs 1.5— Analysing, Evaluating & Creating Type Questions
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Answer 1, The various components that are used under the, income method to calculate national income are:, (i) Compensation of employees which includes wages, and salaries in cash and kind and employers’, contribution to social security benefits., (ii) Operating surplus which includes rent and royalties,, interest and profit earned by a firm., (iii) Mixed income of self-employed which includes any, income that has two or more factor income, which, cannot be accounted for separately., HOTs 1.5— Analysing, Evaluating & Creating Type Questions
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(iv) Net factor income from abroad, which is the, difference between factor income from abroad and, factor income to abroad., , HOTs 1.5— Analysing, Evaluating & Creating Type Questions
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Question 2, How will you treat the following in the calculation of Net, Domestic Product (NDP) of India? Give reasons for your, answer., (a) Factor income from abroad., (b) Remittances from non-resident Indians to their, families in India., (3 marks), , HOTs 1.5— Analysing, Evaluating & Creating Type Questions
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Answer 2, (a) No, it is not included in NDP of India because the, factor income is earned outside the domestic, territory of India., (b) No, it is not included in NDP of India because it is a, transfer income from abroad., , HOTs 1.5— Analysing, Evaluating & Creating Type Questions
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Question 3, Are the following items part of compensation of, employees? Give reasons for your answer., (i) Entertainment allowance to an employee to entertain, business guests., (ii) Employers’ contribution to gratuity fund of the, employees., (iii) Employees’ contribution to provident fund., (iv) Payment of insurance claim by LIC to the injured, worker., HOTs 1.5— Analysing, Evaluating & Creating Type Questions
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(v) Old age pension to an employee., (vi) Medical expenses of a firm on treatment of an, employee’s family., (6 marks), , HOTs 1.5— Analysing, Evaluating & Creating Type Questions
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Answer 3, (i), , It is not a part of compensation of employees, because it is paid for the benefit of business and, not for the employee. It is an intermediate, expenditure., (ii) It is a part of compensation of employees because, such contribution is for the benefit of the, employees and is paid for their productive, services., (iii) It is not a part of compensation of employees, because such contribution is made by an employee, from his wages/salary., HOTs 1.5— Analysing, Evaluating & Creating Type Questions
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(iv) It is not a part of compensation of employees, because it is not paid by the employer, but by LIC., (v) It is not a part of compensation of employees, because it is paid to the old employee without any, productive service by him in return. It is a transfer, payment., (vi) It is a part of compensation of employees because, such expenses are incurred by the firm in return of, productive services of the employee., , HOTs 1.5— Analysing, Evaluating & Creating Type Questions
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Question 4, Giving reason state whether the following will be included, in domestic product (or domestic factor income):, (i) Profits earned by branches of a country’s bank in, other countries, (ii) Profits earned by foreign companies of India, (iii) Salaries of Indian working in the Russian Embassy in, India, (3 marks), , HOTs 1.5— Analysing, Evaluating & Creating Type Questions
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Answer 4, (i) No, it is not included in domestic product because, this factor income is not generated in the domestic, territory of the country. It is factor income from, abroad., (ii) Yes, it is included in domestic factor income of, India because this factor income is earned within, domestic territory of India., (iii) No, it is not included in domestic factor income of, India because Russian Embassy in India is not a part, of the domestic territory of India. It is factor, income from abroad., HOTs 1.5— Analysing, Evaluating & Creating Type Questions
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Question 5, Giving reason state how the following are treated in, estimation of national income:, (i) Payment of interest by banks to its depositors., (ii) Expenditure on old age pensions by government., (iii) Profits earned by a company partly owned by, residents and party owned by non-residents and, located in India., (CBSE 2017) (3 marks), , HOTs 1.5— Analysing, Evaluating & Creating Type Questions
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Answer 5, (i), , Payment of interest by banks is included in national, income because it is factor income paid by a, production unit., (ii) Expenditure on old age pension is not included, because it is a transfer payment., (iii) Yes, it will be included in the domestic factor, income of India as profits are earned within the, domestic territory of India., , HOTs 1.5— Analysing, Evaluating & Creating Type Questions
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1.6, Expenditure Method of, Calculating National Income
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In this method, we take the sum of final expenditures, on consumption and investment. This sum equals, GDPmp. These final expenditures are on the final, goods and services (both consumption goods and, capital goods) produced within the domestic territory, of the country., , , , Top Tip, , Expenditure method includes only final expenditures, i.e., expenditure on consumption and investment. Intermediate, expenditure like that on raw materials, etc. is not included in, national income., Final Expenditure refers to the expenditure on final goods and, services produced within the domestic territory of the, country, which are meant for final consumption and
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investment. Examples:, (i) Expenditure on purchase of car/furniture/sewing, machine/refrigerator by a household is a final expenditure on, consumption, and thus included in national income., (ii) Expenditure on purchase of a car/furniture/machine/, refrigerator for use by a firm is a final investment, expenditure, and thus included in national income., Intermediate Expenditure /Intermediate Consumption/, Intermediate Cost refers to the expenditure incurred by a, production unit on purchasing those goods and services from, other production units, which are meant for resale or for using, up completely during the same year. Examples:, (i) Expenditure on fertilisers by a farmer, (ii) Payment of electricity bill by a school, (iii) Purchase of uniforms for nurses by a hospital, (iv) Expenditure on engine oil by a car service station
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(v) Expenditure by a firm on payment of fees to a chartered, accountant or a lawyer (Note that a chartered accountant, or a lawyer is an outsider to the firm. So, payment of fees, to them will not be a factor income, but an intermediate, expenditure), (vi) Expenditure on maintenance of factory building by a firm, (vii) Fees to a mechanic paid by a firm, (viii) Transport expenses by a firm, (ix) Expenditure on advertisement and scientific research by, a firm
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Main components of GDPmp or final, expenditures in the economy, 1. Private final consumption expenditure, (PFCE), It is the consumption expenditure of households on, the final goods and services produced in the economy., For example, purchase of car by a household,, expenditure on education of children by a family, (school fee or purchase of books), etc.
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2. Government final consumption, expenditure (GFCE), It is the consumption expenditure that the government, makes on the final goods and services produced in the, economy. For example, government expenditure on, free services provided such as education, health, police, service, defense services, etc.
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3. Gross domestic capital formation (GDCF), It is the final investment expenditure incurred by firms, and the government. For example, purchase of tractor, by a farmer, purchase of taxi by a taxi driver, purchase, of a truck to carry goods by a firm, purchase of a, machine or refrigerator installed in a production unit, by a firm., Note that GDCF is composed of the following:, GDCF = Gross domestic fixed capital, formation + Net change in stocks, or, GDCF = (Net fixed capital formation +, Depreciation) + (Closing Stock – Opening, Stock)
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4. Net exports (= Exports – Imports) (X–M), Net export refers to the excess of the value of exports, over the value of imports of a country in an accounting, year., Exports, though purchased by non-residents, are, produced within our domestic territory, and therefore,, a part of domestic product and thus, included in, GDPmp and hence national income., Imports, however, are deducted because goods and, services imported are not produced within the, domestic territory of the country., GDPmp, = Private final consumption expenditure, + Government final consumption, expenditure
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+ Gross domestic capital formation, + Net exports, , , , Top Tip, , Net imports is negative of net exports. For example, if net, imports = `30 crore, it means net exports = (–) `30 crore., GDPmp = PFCE + GFCE + GDCF – Net Imports, , By making the usual adjustments we can arrive at, national income.
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Precautions in making estimates of, national income by expenditure, method, 1. Avoid intermediate expenditure., By definition, the expenditure method includes only, final expenditures, i.e. expenditure on consumption, and investment. Like in the value added method,, inclusion of intermediate expenditure like that on raw, materials, etc. will mean double counting.
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2. Do not include expenditure on second, hand goods and financial assets., Buying second hand goods is not a fresh production, activity. Buying financial assets is not a production, activity because financial assets are neither goods nor, services. Therefore, they should not be included in, estimates of national income.
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3. Avoid transfer expenditures., A transfer payment is a payment against which no, services are rendered. Therefore, no production takes, place. Since no production takes place, it has no place in, national income. Charities, donations, gifts, scholarships, etc., are some examples.
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4. Include the self use of own produced final, products., For example, a house owner using the house for self., Although explicitly he does not incur any expenditure,, implicitly he is making payment of rent to himself., Since the house is producing a service, the imputed, value of the housing service must be included in, national income.
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Treatment of Items in the Estimation, of National Income by Expenditure, Method, S. No., , Items, , Treatment, , Reason, , 1., , Expenditure on education Yes, it is included in, of children by a family, e.g., national income., purchase of books etc., , 2., , Purchase of car by a, household, , Yes, it will be included Because it is a private, in the national income. final consumption, expenditure., , 3., , Fees received from, students, , Yes, it will be included Because it is a private, in the national income. final consumption, expenditure., , 4., , Expenditure on free, services provided by the, government, e.g., free, educational services, free, treatment of the poor in, government hospitals, etc., , Yes, it is included in, national income., , Because it is a private, final consumption, expenditure., , Because it is government, final consumption, expenditure.
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5., , 6., , 7., , 8., , 9., , Purchase of tractor by a, farmer/Purchase of taxi, by a taxi driver/Purchase of, a truck to carry goods by a, firm., Purchase of a machine, or refrigerator installed, in a production unit by a, firm., Construction of a house by, an individual/Expenditure, on adding a floor to the, building, Addition to the machinery,, factory buildings and, equipments by the firms, Net addition to capital, stock, , Yes, it is included in, national income., , Because it is gross, domestic capital, formation or final, investment expenditure., , Yes, it is included in, national income., , Because it is gross, domestic capital, formation or final, investment expenditure., Because it is a part of, gross fixed capital, formation, i.e. a final, investment expenditure., Because it is a part of, gross fixed capital, formation, i.e. a final, investment expenditure., Because it is net, investment or net capital, formation, which is an, item of final expenditure., , Yes, it is included in, national income by, expenditure method., Yes, it is included in, national income by, expenditure method., Yes, it is included in, national income by, expenditure method.
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10., , Purchase of goods by Yes, it is included in, foreign tourists, national income., , 11., , Purchase of second, hand machinery, from abroad, , No, it is not included in, national income., , 12., , Expenditure on, fertilizers by a farmer, , No, it is not included in, national income., , 13., , Payment of electricity No, it is not included in, bill by a school, national income., , 14., , Purchase of uniforms No, it is not included in, for nurses by a, national income., hospital, , Because these are exports,, i.e. demand for goods, produced in the domestic, territory, an item of final, expenditure., Because the value of, imports are deducted while, estimating the national, income of a country., Because it is an, intermediate expenditure for, the farmer and hence, deducted from value of, output while calculating, national income., Because it is an, intermediate cost for the, school., Because it is an, intermediate cost for the, hospital.
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15., , 16., , 17., 18., 19., , Expenditure on engine No, it is not included in, oil by car service station national income., , Because it is an, intermediate cost or, intermediate expenditure for, the car service station., Expenditure by a firm No, it is not included in Because it is intermediate, on payment of fees to a national income., cost or intermediate, chartered accountant or, expenditure of the firm., lawyer, (Note that a chartered, accountant or a lawyer is an, outsider to the firm. So,, payment of fees to them will, not be a factor income, but an, intermediate expenditure), Fees to a mechanic, No, it is not included in Because it is intermediate, paid by a firm., national income., cost or intermediate, expenditure of the firm., Expenditure on, No, it will not be included Because it is an, maintenance of factory in the national income., intermediate expenditure of, building by a firm, the firm., Transport expenses, No, it will not be, Because it is a part of, by a firm, included in national, intermediate, income., consumption.
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20., , 21., , Expenditure on, advertisement and, scientific research, by a firm, Purchase of bonds, by a domestic firm, , No, it will not be, included in national, income., , Because it is an, intermediate expenditure., , No, it will not be, included in the national, income., , Because buying financial, assets like bonds, shares,, etc. does not contribute to, any production of goods, and services.
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Key Terms, Final Expenditure — It refers to the expenditure on final goods, and services produced within the domestic territory of the, country, which are meant for final consumption and investment., Intermediate Expenditure (or Intermediate Consumption or, Intermediate Cost) — It refers to the expenditure incurred by a, production unit on purchasing those goods and services from, other production units, which are meant for resale or for using up, completely during the same year., Net Exports — It refers to the excess of the value of exports over, the value of imports of a country in an accounting year.
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RECAP, , Expenditure Method of Calculating National, Income, In this method, we take the sum of final expenditures on, consumption and investment. This sum equals GDPmp., These final expenditures are on the final goods produced, within the domestic territory of the country. Main, components of GDPmp or final expenditures in the economy, are:, (i) Private final consumption expenditure (PFCE), (ii) Government final consumption expenditure (GFCE), (iii) Gross domestic capital formation (GDCF) (= Gross, domestic fixed capital formation + Net change in stocks), (iv) Net exports (X–M) refers to the excess of the value of, exports over the value of imports of a country in an, accounting year. Exports, though purchased by non-
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residents, are produced within our domestic territory, so, included in GDPmp; whereas Imports are deducted because, imported goods are not produced within our domestic, territory., GDPmp = PFCE + GFCE + GDCF + Net Exports (or – Net, Imports), By making the usual adjustments we can arrive at national, income:, National Income (NNPfc) = GDPmp – Depreciation –, Indirect taxes + Subsidies + NFIA, Precautions in making estimates of national income by, expenditure method, 1. Avoid intermediate expenditure. National income, includes only final expenditures, i.e. expenditure on, consumption and investment.
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2. Do not include expenditure on second hand goods, and financial assets. Buying second hand goods is not, a fresh production activity. Buying financial assets is not, a production activity because financial assets are neither, goods nor services., 3. Avoid transfer expenditures, e.g. Charities, donations,, gifts, scholarships, etc. since no production takes place., 4. Include the self use of own produced final, products. For example, a house owner using the house, for self. Although explicitly he does not incur any, expenditure, implicitly he is making payment of rent to, himself. Since the house is producing a service, the, imputed value of the housing service must be included, in national income.
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NUMERICAL 18, Compute National Income., S. No., (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), , Particulars, , Private final consumption expenditure, Government final consumption expenditure, Net imports, Gross domestic capital formation, Change in stock, Net domestic fixed capital formation, Net indirect taxes, Net factor income from abroad, Profits, , (4 marks), (` in crore), 900, 400, 30, 250, 50, 180, 100, (–)40, 100
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Solution:, Particulars, , (` in crore), , Private final consumption expenditure, (+) Government final consumption expenditure, (+) Gross domestic capital formation, (–) Net imports, , 900, 400, 250, (–)30, , Gross Domestic Product at market price (GDPmp), (–) Depreciation, (–) Net indirect taxes, (+) Net factor income from abroad (NFIA), , 1520, (–)20, (–)100, (–)40, , National Income (NNPfc), , 1,360, , Note: Depreciation = Gross domestic capital formation, (iv) – Net domestic capital formation (vi + v), = 250 – (180 + 50) = 250 – 230 = `20, crore
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Do it yourself 18, Calculate National income from the following data., (4 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), , Private final consumption expenditure, Profit, Government final consumption expenditure, Net indirect taxes, Gross domestic capital formation, Change in stock, Net factor income from abroad, Consumption of fixed capital, Net imports, , [Ans. ` 1,360 crore], , (` in crore), 900, 100, 400, 100, 250, 50, (–)40, 20, 30
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Solution of Do it yourself 18, National income = Private final consumption expenditure, + Government final consumption expenditure, + Gross domestic capital formation – Net imports, – Consumption of fixed capital – Net indirect taxes, + Net factor income from abroad, = 900 + 400 + 250 – 30 – 20 – 100 + (– 40) = `1360 crore
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NUMERICAL 19, Find National Income from the following using, expenditure method., (4 marks), S. No., (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), , Particulars, , Current transfers from rest of the world, Net indirect taxes, Net exports, Rent, Private final consumption expenditure, Net domestic capital formation, Compensation of employees, Net factor income from abroad, Government final consumption expenditure, Profit, Mixed income of self-employed, Interest, , (` in crore), 50, 100, (–)25, 90, 900, 200, 500, (–)10, 400, 220, 400, 230
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Solution:, Particulars, , (` in crore), , Private final consumption expenditure, Government final consumption expenditure, Net domestic capital formation, Net exports, , 900, 400, 200, (–)25, , Net Domestic Product at market price (NDPmp), (–) Net indirect taxes, (+) Net factor income from abroad (NFIA), , 1,475, (–)100, (–)10, , National Income (NNPfc), , 1,365
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Do it yourself 19, Calculate Net National Product at factor cost by expenditure method from the data given below., (4 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), (xiii), , Private final consumption expenditure, Net fixed capital formation, Indirect taxes, Government current transfers to households, Government final consumption expenditure, Net factor income from abroad, Mixed income of the self-employed, Change in stocks, Current replacement cost, Rent, interest and profits, Subsidies, Exports, Imports, , [Ans. `1,170 crore], , (` in crore), 1,020, 180, 180, 25, 100, (–)10, 560, 60, 80, 190, 20, 100, 120
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Solution of Do it yourself 19, Net National Product at factor cost, = Private final consumption expenditure, + Government final consumption expenditure, + Net fixed capital formation + Change in stocks, + Exports – Imports – Indirect taxes + Subsidies + NFIA, = 1020 + 100 + 180 + 60 + 100 – 120 – 180 + 20 + (–10) =, `1170 crore
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NUMERICAL 20, Calculate Net National Product at market price., (4 marks), S. No., (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), , Particulars, , Gross domestic fixed capital formation, Private final consumption expenditure, Government final consumption expenditure, Value of output produced in the economy, Current replacement cost of fixed capital, Net exports, Net factor income from abroad, Sales by all firms in the economy, , (` in crore), 350, 8,000, 3,000, 150, 40, (–)60, 80, 100
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Solution:, Particulars, , (` in crore), , Private final consumption expenditure, Government final consumption expenditure, Gross domestic capital formation (note), Net exports, , 8,000, 3,000, 400, (–)60, , Gross Domestic Product at market price, (–) Depreciation, (+) Net factor income from abroad (NFIA), , 11,340, (–)40, 80, , Net National Product at market price, , 11,380, , Note: Gross domestic capital formation = Gross domestic, fixed capital formation (i) + Change in stock (iv – viii), = 350 + (150 – 100) = 350 + 50 = `400 crore
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Do it yourself 20, Calculate Gross National Product at factor cost from the, following data., (4 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), , Net domestic fixed capital formation, Closing stock, Government final consumption expenditure, Net indirect taxes, Opening stock, Consumption of fixed capital, Net exports, Private final consumption expenditure, Imports, Net factor income from abroad, , [Ans. `2,030 crore], , (` in crore), 310, 100, 200, 50, 60, 50, (–)10, 1,500, 20, (–)10
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Solution of Do it yourself 20, Gross National Produce at Factor Cost, = Private final consumption expenditure, + Government final consumption, expenditure, + Gross domestic capital formation, + Net exports – Net indirect taxes + NFIA, = 1500 + 200 + 400 + (–10) – 50 + (–10) =, `2030 crore, Note: Gross domestic capital formation, = Net domestic fixed capital formation, + Change in stock + Consumption of fixed capital, = 310 + (100 – 60) + 50 = `400 crore
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NUMERICAL 21, Calculate Net Domestic Product at factor cost., (4 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), , Private final consumption expenditure, Government final consumption expenditure, Exports, Imports, Annual allowance for wear and tear of capital, stock, Fixed business investment, Residential investment, Change in stock, Factor income to abroad, Factor income from abroad, Net product taxes, Net production taxes, , (` in crore), 8,000, 1,000, 70, 120, 60, 300, 200, 100, 40, 90, 400, 250
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Solution:, Particulars, , (` in crore), , Private final consumption expenditure, Government final consumption expenditure, Gross investment (note 1), Net exports (note 2), , 8,000, 1,000, 600, (–)50, , Gross Domestic Product at market price, (–) Depreciation (Annual allowance for wear and, tear of capital stock), (–) Net product taxes, (–) Net production taxes, , 9,550, (–)60, (–)400, (–)250, , Net National Product at market price, , 8,840, , Note: 1. Gross investment = Fixed business investment +, Residential investment + Change in stock, = 300 + 200 + 100 = `600 crore, 2. Net exports = Exports – Imports, = 70 – 120 = (–) `50 crore
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Do it yourself 21, Calculate Gross National Product at factor cost from the, following data., (4 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), , Consumption of fixed capital, Government final consumption expenditure, Net factor income received from abroad, Private final consumption expenditure, Exports, Opening stock, Imports, Closing stock, Gross domestic fixed capital formation, , [Ans. `1,200 crore], , (` in crore), 60, 200, (–) 10, 800, 50, 30, 60, 20, 230
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Solution of Do it yourself 21, Gross National Product at market price, = Government final consumption expenditure, + Private final consumption expenditure, + Gross domestic fixed capital formation, + Net exports (Exports – Imports), + Change in stock (closing stock – opening stock), + Net factor income from abroad, = 200 + 800 + 230 + (50 – 60) + (20 – 30) + (–10) =, `1200 crore
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NUMERICAL 22, Suppose there are only two firms, A and B in an, imaginary economy. Firm A uses no raw material and, produces cotton worth `50 lakh. Firm A gives ` 20, lakh to the workers as wages and keeps the remaining, ` 30 lakh as its profits. Firm A sells its cotton to firm, B, who uses it produce cloth. Firm B sells the cloth, produced to consumers for ` 200 lakh and gives ` 60, lakh as wages and keeps the remaining income, generated as profits., Assuming no depreciation and indirect taxes or, subsidies, calculate GDP by three methods., (NCERT) (6 marks)
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Solution:, (i) GDP by Value Added Method (Production phase), Value added (VA) = Value of output – Intermediate, consumption, VA by Firm A = 50 – 0 = `50 lakh, VA by Firm B = 200 – 50 (purchases of cotton by Firm B, from Firm A) = `150 lakh, Hence, GDP = VA by Firm A + VA by Firm B, = 50 + 150 = `200 lakh, Particulars, , Firm A, , Firm B, , Total, , Wages, , 20, , 60, , 80, , Profits, , 30, , 90, , 120, , Thus, GDP = Sum total of factor incomes paid by Firms A, and B
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+ Total profits of Firms A and B = 80 + 120 = `200 lakh, (iii) GDP by Expenditure Method (Disposition phase), GDP = Sum of final expenditures, i.e. expenditures on, goods and services for end use, In the given question, the final expenditure is expenditure, by consumers on cloth., Therefore, GDP = `200 lakh, Thus, all the three methods of estimating GDP give us the, same answer., , , , Top Tip, , In Numerical 22, we have left out factor payments in the form of rent, and interest. But this will not make any difference to the basic result,, because after paying wages the remainder of value added by a firm, will be distributed between rent, interest and profits (together called, operating surplus).
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Do it yourself 22, In an imaginary economy, suppose there are only two kinds, of producers — farmers and bakers (bread makers)., Farmers produced wheat worth `100 crore with no, intermediate costs. They sold `50 crore worth of wheat to, the bakers, who used this amount of wheat completely, during the year and produced `200 crore worth of bread., Value of capital consumption is `10 crore., Calculate GDP and NDP by (i) Value Added method, and, (ii) Expenditure method., (4 marks), [Ans. `240 crore]
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Solution of Do it yourself 22, (i) Value Added Method, Value Added (VA) =Value of output – Intermediate costs, VA by Farmer, = 100 – 0 = `100 crore, VA by Bakers, = 200 – 50 = `150 crore, Thus, GDP, = VA by Farmers + VA by Bakers = 100 +, 150, = `250 crore, NDP, = GDP – Depreciation (value of capital, consumption), = 250 – 10 = `240 crore, (ii) Expenditure Method, GDP = Sum of final expenditures, i.e. expenditures on, Goods and services for end use
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= Final consumption expenditures by consumers, = Purchases of wheat by consumers from Farmers +, Purchases of Bread from Bakers = 50 + 200 = `250 crore, NDP = GDP – Depreciation = 250 – 10 = `240 crore
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NUMERICAL 23, Calculate Net domestic product at market price by (a), Income method and (b) expenditure method., (6 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), , Net Indirect taxes, Net exports, Social security contribution by employers, Operating surplus, Net purchases of goods and services by, general government, Net domestic capital formation, Government final consumption expenditure, Change in stocks, Sales by general government, Compensation of employees, Private final consumption expenditure, , (` in crore), 40, 10, 50, 110, 30, 60, 130, 10, 10, 500, 450
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Solution:, (a) Net domestic product at market price (Income, method) = Compensation of employees + Operating, surplus + Net indirect taxes = 500 + 110 + 40, = `650 crore, (b) Net domestic product at market price (Expenditure, method) = Private final consumption expenditure +, Government final consumption expenditure + Net, domestic capital formation + Net exports, = 450 + 130 + 60 + 10 = `650 crore
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Do it yourself 23, From the data given below, calculate: (a) Gross National, Product at market price by expenditure method (b) Gross, Domestic Product at market price by income method, (6), S. No. Pariculars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), (xiii), , Private final consumption expenditure, Government final consumption expenditure, Gross domestic capital formation, Net exports, Wages and salaries, Employers’ contribution to social security schemes, Profits, Interest, Indirect taxes, Subsidies, Rent, Net factor income from abroad, Consumption of fixed capital, , (` in crore), 200, 20, 40, (–) 5, 165, 10, 15, 20, 30, 5, 15, 5, 5
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Solution of Do it yourself 23, (a) Gross National Product at market price (Expenditure, method), = Private final consumption expenditure, + Government final consumption expenditure, + Gross domestic capital formation + Net exports, + Net factor income from abroad, = 200 + 20 + 40 + (–5) + 5 = `260 crore, (b) Gross Domestic Product at market price (Income method), = Wages and salaries + Employers’ contribution to social, security schemes, + Profits + Interest + Rent + Indirect taxes – Subsidies, + Consumption of fixed capital, = 165 + 10 + 15 + 20 + 15 + 30 – 5 + 5 = `255 crore
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NUMERICAL 24, From the data given below, calculate :, (a) National income by income method., (b) Gross Domestic Product at factor cost by, expenditure method., (6 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), , Private final consumption expenditure, Net domestic fixed capital formation, Consumption of fixed capital, Closing stock, Opening stock, Government final consumption expenditure, Net exports, Wages and salaries, Contribution of employers towards social, security, Operating surplus, , (` in crore), 85, 25, 2, 10, 5, 10, (–)5, 80, 10, 20
Page 564 :
(xi), (xii), , Net factor income received from abroad, Net indirect taxes, , (–)5, 10, , (a) National income (Income method) = Wages and, salaries + Contribution of employers towards social, security + Operating surplus + Net factor income, received from abroad, = 80 + 10 + 20 + (–) 5 = `105 crore, (b) Gross Domestic Product at factor cost (Expenditure, method) = Private final consumption expenditure +, Government final consumption expenditure + Net, domestic fixed capital formation + Consumption of, fixed capital + Change in stock (Closing stock –, opening stock) + Net exports – Net indirect taxes, = 85 + 10 + 25 + 2 + (10 – 5) + (– 5) – 10 = `112 crore
Page 565 :
Do it yourself 24, Calculate national income by (a) Income method and (b), Expenditure method., (6 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), (xiii), (xiv), , Rent, Net factor income from abroad, Compensation of employees, Indirect taxes, Government final consumption expenditure, Subsidies, Royalty, Net exports, Interest, Corporate tax, Profit after tax, Private final consumption expenditure, Change in stocks, Net domestic fixed capital formation, , [Ans. `735 crore], , (` in crore), 50, 5, 500, 100, 120, 30, 20, (–)20, 40, 20, 100, 630, 10, 60
Page 566 :
Solution of Do it yourself 24, (a) National income (Income method), = Compensation of employees + Rent + Royalty + Interest, + Profit after tax + Corporate tax + NFIA, = 500 + 50 + 20 + 40 + 100 + 20 + 5 = `735 crore, (b) National income (Expenditure method), = Private final consumption expenditure, + Government final consumption expenditure, + Net domestic fixed capital formation, + Change in stocks + Net exports, – Indirect tax + Subsidies + Net factor income from, abroad, = 630 + 120 + 60 + 10 + (–20) – 100 + 30 + 5 = `735 crore
Page 567 :
NUMERICAL 25, Calculate from the following data, net national, product at market price by (a) income method and, (b) expenditure method., (6 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), , Compensation of employees, Mixed income of the self-employed, Gross fixed capital formation, Consumption of fixed capital, Employers’ contribution to social security, schemes, Operating surplus, Net capital formation, Exports, Imports, Indirect taxes, , (` in crore), 1,200, 800, 430, 30, 100, 1,000, 450, 10, 40, 140
Page 568 :
(xi), (xii), (xiii), (xiv), (xv), , Subsidies, Private final consumption expenditure, Government final consumption expenditure, Purchase by non-residential households in the, domestic market, Net factor income to abroad, , 20, 2,100, 600, 50, 20, , Solution:, (a) Net National Product at market price (Income, method) = Compensation of employees + Operating, surplus + Mixed income of the self-employed – Net, factor income to abroad + Indirect taxes – Subsidies, = 1,200 + 1,000 + 800 – 20 + 140 – 20 = `3,100 crore, (b) Net National Product at market price, (Expenditure method) = Private final consumption, expenditure + Government final consumption, expenditure + Net capital formation + Export –, Imports – Net factor income to abroad, = 2,100 + 600 + 450 + 10 – 40 – 20 = `3,100 crore
Page 569 :
Do it yourself 25, Calculate national income by expenditure and income, methods., (6 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), , Operating surplus, Private final consumption expenditure, Net factor payment made abroad, Social security contribution by employees, Compensation of employees, Change in stocks, Government final consumption expenditure, Net exports, Net domestic capital formation, Consumption of fixed capital, Net indirect taxes, , [Ans. `320 crore], , (` in crore), 110, 300, 20, 20, 230, 10, 60, (–)10, 40, 30, 50
Page 570 :
Solution of Do it yourself 25, National income (Expenditure method), = Private final consumption expenditure, + Government final consumption expenditure, + Net domestic capital formation + Net exports, – Net factor payment made abroad – Net indirect, taxes, = 300 + 60 + 40 + (–10) – 20 – 50 = `320 crore, National income (Income method) = Compensation, of employees, + Operating surplus – Net factor payment made, abroad, = 230 + 110 – 20 = ` 320 crore
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NUMERICAL 26, Calculate from the following data, Net National, Product at market price by (a) income method and, (b) expenditure method., (6 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), , Compensation of employees paid by the, Government, Mixed income of the self-employed, Wages and salaries, Employers’ contribution to social security, schemes, Operating surplus, Indirect taxes, Subsidies, Net capital formation, Net factor income to abroad, Government final consumption expenditure, , (` in crore), 40, 50, 400, 80, 300, 30, 10, 150, 10, 230
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(xi), (xii), (xiii), (xiv), (xv), , Private final consumption expenditure, Exports, Imports, Consumption of fixed capital, Profits, , 500, 15, 45, 20, 130, , Solution:, (a) Net National Product at market price (Income, method) = Wages and salaries + Employers’ contribution, to social security schemes + Operating surplus + Mixed, income – Net factor income to abroad + Indirect taxes –, Subsidies, = 400 + 80 + 300 + 50 – 10 + 30 – 10 = `840 crore, (b) Net National Product at market price, (Expenditure Method) = Private final consumption, expenditure + Government final consumption expenditure +, Net capital formation + Exports – Imports – Net factor, incometoabroad = 500 + 230 + 150 + 15 – 45 – 10 = `840crore
Page 573 :
Do it yourself 26, Calculate gross national product at market price from the, following data by (a) income method and (b) expenditure, method., (6 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), (xiii), (xiv), , Mixed income of self-employed, Corporation tax, Interest, Rent, Undistributed profits, Dividends, Employers’ contribution to social security schemes, Compensation of employees, Government final consumption expenditure, Private final consumption expenditure, Net factor income to abroad, Gross capital formation, Change in stocks, Net indirect taxes, , (` in crore), 800, 50, 100, 80, 150, 70, 120, 1,200, 730, 1,580, 20, 300, 40, 100
Page 574 :
(xv), (xvi), , Current replacement cost, Net exports, , [Ans. `2,580 crore], , 50, (–)10
Page 575 :
Solution of Do it yourself 26, (a) Gross National Product at Market price (Income Method), = Compensation of employees+ Mixed income of, self-employed, + Interest + Rent + Corporation tax + Undistributed, profits, + Dividends – Net factor income to abroad, + Current replacement cost + Net indirect taxes, = 1200 + 800 + 100 + 80 + 50 + 150 + 70 – 20 + 50, + 100, = `2580 crore, (b) Gross National Product at market price (Expenditure, Method), = Private final consumption expenditure
Page 576 :
+ Government final consumption expenditure, + Gross capital formation + Net exports – Net factor, income to abroad, = 1580 + 730 + 300 + (–10) – 20 = `2580 crore
Page 577 :
NUMERICAL 27, Calculate gross national product at market price by, income method and expenditure method from the, following data., (6 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), , Rent, Private final consumption expenditure, Net exports, Interest, Profit, Government final consumption expenditure, Net domestic capital formation, Compensation of employees, Consumption of fixed capital, Net indirect taxes, Net factor income from abroad, , (` in crore), 40, 800, 20, 60, 120, 200, 100, 800, 20, 100, (–)20
Page 578 :
Solution : GNPmp (Income method) = Compensation, of employees + Rent + Interest + Profit + Consumption of, fixed capital + Net factor income from abroad + Net indirect, taxes, = 800 + 40 + 60 + 120 + 20 + (–20) + 100 = `1,120 crore, GNPmp (Expenditure method) = Private final consumption, expenditure + Government final consumption expenditure +, Net domestic capital formation + Consumption of fixed capital, + Net exports + Net factor income from abroad = 800 + 200 +, 100 + 20 + 20 + (–20) = ` 1,120 crore
Page 579 :
Do it yourself 27, Calculate gross national product at factor cost by income, method and expenditure method from th following data., (6 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), (xiii), (xiv), , Factor income from abroad, Compensation of employees, Net domestic capital formation, Private final consumption expenditure, Factor income to abroad, Change in stock, Employers’ contribution to social security schemes, Consumption of fixed capital, Interest, Exports, Imports, Indirect taxes, Subsidies, Rent, , (` in crore), 10, 150, 50, 220, 15, 15, 10, 15, 40, 20, 25, 30, 10, 40
Page 580 :
(xv), (xvi), (xvii), (xviii), , Government final consumption expenditure, Net current transfers from abroad, Profit, Dividend, , [Ans. `340 crore], , 85, (–)80, 100, 40
Page 581 :
Solution of Do it yourself 27, GNPfc (Income method) = Compensation of employees, + Interest + Rent + Profit + Consumption of fixed, capital, + Factor income from abroad – Factor income to, abroad, = 150 + 40 + 40 + 100 + 15 + 10 – 15 = `340 crore, GNPfc (Expenditure method) = Private final consumption, expenditure, + Government final consumption expenditure, + Net domestic capital formation, + Consumption of fixed capital + Exports, – Imports – Indirect taxes + Subsidies
Page 582 :
+ Factor income from abroad – Factor income to, abroad, = 220 + 85 + 50 + 15 + 20 – 25 – 30 + 10 + 10 – 15 =, `340 crore
Page 583 :
NUMERICAL 28, Given the following data, find the missing value of, ‘Government Final Consumption Expenditure’ and, ‘Mixed Income of Self Employed’., (CBSE 2019) (6), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), , National Income, Gross Domestic Capital Formation, Government Final consumption Expenditure, Mixed Income of self-Employed, Net Factor Income from abroad, Net Indirect Taxes, Profits, Wages and Salaries, Net Exports, Private Final Consumption Expenditure, Consumption of fixed Capital, Operating Surplus, , (` in crore), 71,000, 10,000, ?, ?, 1,000, 2,000, 1,200, 15,000, 5,000, 40,000, 3,000, 30,000
Page 584 :
Solution :, Mixed income of self-employed = (i)–[(viii)+(xii)+(v)], = 71,000 – (15,000 + 30,000, + 1,000), Mixed income of self-employed = `25,000 crore, Government Final consumption expenditure, = (i)–[(x)+(ii)+(v)+(ix)]+(vi)+(xi), = 71,000 –(40,000 + 10,000 + 1,000 + 5,000) + 2,000 + 3,000, = `20,000 crore
Page 585 :
Do it yourself 28, Calculate gross national product at factor cost by income, method and expenditure method from th following data.(6), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), , National Income, Net Indirect Taxes, Private Final Consumption Expenditure, Gross Domestic Capital Formation, Profits, Government Final Consumption Expenditure, Wages & Salaries, Consumption of Fixed Capital, Mixed Income of Self Employed, Operating Surplus, Net Factor Income from Abroad, Net Exports, , (` in crore), 50,000, 1,000, ?, 17,000, 1,000, 12,500, 20,000, 700, 13,000, ?, 500, 2,000, , [Ans Private final Consumption expenditure ` 19,700 crore;, Operating surplus `16,500 crore]
Page 586 :
Solution of Do it yourself 28, Operating surplus = (i) – [(vii) + (ix) + (xi)] = 50,000 –, (20,000 + 13,000 + 500) = `16,500 crore, Private final Consumption expenditure = (i)–, [(iv)+(vi)+(xi)+(xii)]+(vii)+(ii), = 50000 – (17000 + 12500 + 2000 + 500) + 700 + 1000 =, `19,700 crore
Page 587 :
NUMERICAL 29, Given the following data, find the missing values of, ‘Gross Domestic Capital Formation’ and ‘Wages and, Salaries’., (CBSE 2019) (6 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), , Mixed Income of Self Employed, Net Indirect Taxes, Wages & Salaries, Government Final Consumption Expenditure, Net Exports, Consumption of Fixed Capital, Net Factor Income from Abroad, Operating Surplus, National Income, Profits, Gross Domestic Capital Formation, Private Final Consumption Expenditure, , (` in crore), 3,500, 300, ?, 14,000, 3,000, 300, 700, 12,000, 30,000, 500, ?, 11,000
Page 588 :
Solution :, Wages and salaries = ix–[(i)+(viii)+(vii)], = 30,000 – (3,500 + 12,000 + 700), = `13,800 crore, Gross domestic Capital formation, = (ix)– [(iv)+(v)+(vii)+(xii)]+(ii)+(vi), = 30,000 – (14,000 + 3000 + 700 + 11,000) + 300 + 300, = `1,900 crore
Page 589 :
Do it yourself 29, Given the following data, find the values of “Gross, Domestic Capital Formation” and “Operating Surplus. (6), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), , National Income, Wages and Salaries, Private Final Consumption Expenditure, Net Indirect Taxes, Gross Domestic Capital Formation, Depreciation, Government Final Consumption Expenditure, Mixed Income of Self-Employed, Operating Surplus, Net Exports, Rent, Net Factor Income From Abroad, , (` in crore), 22,100, 12,000, 7,200, 700, ?, 500, 6,100, 4,800, ?, 3,400, 1,200, (–) 150, , [Ans. Gross Domestic Capital Formation `6,750 crore; Operating, surplus `5,450 crore]
Page 590 :
Solution of Do it yourself 29, Gross Domestic Capital Formation, = (i) – {iii+vii+x} + vi – xii + iv, GDCF = 22,100 – {7,200 + 6,100 + 3,400} + 500 – (–150) +, 700, GDCF = 6,750 crore, Operating surplus = National Income – wages and, salaries, – Mixed Income of Self Employed – Net Factor Income, from Abroad, = (i) – (ii) – (viii) – (xii) = 22,100 – 12,000 – 4,800 – (–, 150) = 5,450 crore
Page 591 :
NUMERICAL 30, Given the following data, find the missing values of, ‘Gross Domestic Capital Formation’ and ‘Wages and, Salaries’., (CBSE 2019) (6 marks), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), , Mixed Income of Self-Employed, Net Factor Income from Abroad, Private Final Consumption Expenditure, Profits, Net Indirect Taxes, National Income, Gross Domestic Capital Formation, Wages and Salaries, Net Exports, Government Final Consumption Expenditure, Consumption of Fixed Capital, Operating Surplus, , (` in crore), 700, 150, 2,200, 200, 150, 5,000, 1,100, 2,200, ?, 1,300, 200, ?
Page 592 :
Solution :, National Income (vi) = Wages and Salaries (viii) + Operating, Surplus + Mixed Income (i) + NFIA (ii), Operating Surplus = (vi) – (viii) – (i) – (ii) = 5,000 – 2200, – 700 – 150 = `1,950 crore, National Income (vi) = PFCE (iii) + GFCE (x) + GDCF (vii), + Net Exports (ix) – Consumption of Fixed, Capital (xi) – Net Indirect Taxes (v) + NFIA (ii), Net exports = (vi) – (iii) – (x) – (vii) + (xi) + (v) – (ii), = 5,000 – 2,200 – 1,300 – 1,100 + 200 + 150 – 150 = `600, crore
Page 593 :
Do it yourself 30, Given the following data, find the values of “Gross, Domestic Capital Formation” and “Operating Surplus. (6), S. No. Particulars, (i), (ii), (iii), (iv), (v), (vi), (vii), (viii), (ix), (x), (xi), (xii), , Wages and Salaries, National Income, Net Exports, Net Factor Income from Abroad, Gross Domestic Capital Formation, Mixed Income of Self-Employed, Private Final Consumption Expenditure, Net Indirect Taxes, Operating Surplus, Government Final Consumption Expenditure, Consumption of Fixed Capital, Profits, , (` in crore), 2,400, 4,200, ?, 200, 1,100, 400, 2,000, 150, ?, 1,000, 100, 500, , [Ans. Operating surplus `1,200 crore; Net exports `150 crore]
Page 594 :
Solution of Do it yourself 30, Operating surplus = (ii) – (iv) – (vi) – (i), = 4200 – 200 – 400 – 2400 = 1200 crore, Net exports = (ii) – (vii) – (x) – (v) + (xi) + (viii) – (iv), = 4200 – 2000 – 1000 – 1100 + 100 + 150 – 200 = 150, crore
Page 595 :
Question 1, Which one of the following is an intermediate expenditure?, (Choose the correct alternative), (a) Expenditure on purchase of furniture by a firm for its, own use, (b) Expenditure on maintenance by a firm, (c) Expenditure on purchase of tractor by a firm for its, own use, (d) Machine bought by a household, Objective Type Questions 1.6
Page 596 :
Answer 1, (b) Expenditure on maintenance by a firm, , Objective Type Questions 1.6
Page 597 :
Question 2, Which one of the following is not included in national, income?, (Choose the correct alternative), (a) Payment of indirect tax by a firm, (b) Bonus paid to employees, (c) Addition to stocks during a year, (d) Purchase of taxi by a taxi driver, , Objective Type Questions 1.6
Page 598 :
Answer 2, (a), , Payment of indirect tax by a firm, , Objective Type Questions 1.6
Page 599 :
Question 3, Purchase of car by a household is a part of gross, domestic capital formation., True/False? Give reason., , Objective Type Questions 1.6
Page 600 :
Answer 3, 3. False: It is a private final consumption expenditure., , Objective Type Questions 1.6
Page 601 :
Question 4, Free services provided by the government will not be, included in national income., True/False? Give reason., , Objective Type Questions 1.6
Page 602 :
Answer 4, False: It will be included in national income as it is, government final consumption expenditure., , Objective Type Questions 1.6
Page 603 :
Question 5, Gross domestic capital formation is always greater than, gross fixed capital formation., True/False? Give reason., , Objective Type Questions 1.6
Page 604 :
Answer 5, False: Gross domestic capital formation can be less, than gross fixed capital formation if change in stock is, negative, i.e., when opening stock exceeds closing, stock., , Objective Type Questions 1.6
Page 605 :
Question 6, Match the following:, Column I, (i) Addition to the, machinery, , (ii) Addition of housing, facilities, (iii) Addition to the stock of, capital of the firms, , Column II, (a) Change in inventories, factory buildings and, equipment employed by, the firms., (b) Residential investment, (c) Fixed business, investment, Objective Type Questions 1.6
Page 606 :
Answer 6, (i) – (c) , (ii) – (b) , (iii) – (a), , Objective Type Questions 1.6
Page 607 :
Question 7, It is only the households which undertake the final, consumption expenditure on the goods and services, produced by the firms., True/False? Give reason., , Objective Type Questions 1.6
Page 608 :
Answer 7, False: Final consumption expenditure is also incurred, by the government. Firms may also buy consumption, goods to treat their guests or for their employees., , Objective Type Questions 1.6
Page 609 :
Question 8, The expenditure on intermediate goods is not included, in the calculation of GDP, whereas the expenditure on, investment goods is included., True/False? Give reason., , Objective Type Questions 1.6
Page 610 :
Answer 8, True: The reason is that investment goods remain with, the firm, whereas intermediate goods are consumed in, the process of production., , Objective Type Questions 1.6
Page 611 :
Question 9, The final expenditure incurred by the government, includes the consumption expenditure only., True/False? Give reason., , Objective Type Questions 1.6
Page 612 :
Answer 9, False: The expenditure that the government makes on, the final goods and services, includes both final, consumption expenditure and final investment expenditure., , Objective Type Questions 1.6
Page 613 :
Question 10, Aggregate imports expenditure incurred by the, economy includes expenditure on the imports of, consumption goods by households, expenditure on, imports of foreign investment goods by firms and, _______________., (Fill in the blank), , Objective Type Questions 1.6
Page 614 :
Answer 10, Government expenditure incurred on imports, , Objective Type Questions 1.6
Page 615 :
Question 11, ____________ (Exports / Imports), which denotes, aggregate expenditure incurred by the foreigners on the, final goods and services produced in the domestic, territory of the country is ____________, (included / not included) in national income., (Fill in the blanks with the correct options), , Objective Type Questions 1.6
Page 616 :
Answer 11, Exports , included, , Objective Type Questions 1.6
Page 617 :
Question 12, Final expenditure is the spending on (i), ______________; it does not include spending on (ii), _____________(Intermediate goods / Final goods)., (Fill in the blanks with the correct options), , Objective Type Questions 1.6
Page 618 :
Answer 12, (i) Final goods (ii) Intermediate goods, , Objective Type Questions 1.6
Page 619 :
Question 13, Which one of the following is not a part of a country’s, Net Domestic Product at market price’?, (Choose the correct alternative), (a) Depreciation, (b) Indirect tax, (c) Net exports, (d) Net change in stocks, , Objective Type Questions 1.6
Page 620 :
Answer 13, (a), , Depreciation, , Objective Type Questions 1.6
Page 621 :
Question 1, Should the following be treated as final expenditure or, intermediate expenditure? Give reason., (i) Purchase of furniture by a firm, (ii) Expenditure on maintenance by a firm, (3 marks), , HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 622 :
Answer 1, (i) It is a final expenditure if it is purchased by the firm, for its own use because it is an investment, expenditure. However, if it is purchased by the firm, for re-sale, then it is an intermediate expenditure., (ii) It is an intermediate expenditure because it is an, expenditure on single use producer goods., , HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 623 :
Question 2, State the various components of the Expenditure Method, that are used to calculate national income., (CBSE Sample Question Paper 2016) (4 marks), , HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 624 :
Answer 2, The components of the Expenditure Method that are, used to calculate national income are:, (a) Private Final Consumption Expenditure: The final, consumption expenditure of households on the, goods and services produced by all the firms in the, economy., (b) Government Final Consumption Expenditure: The, expenditure that the government makes on the final, goods and services produced by all the firms in the, economy., (c) Investment Expenditure: The final investment, HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 625 :
expenditure incurred by firms on the capital goods, produced by other firms in the economy., (d) Net Exports: Exports minus imports. (Net exports, = Exports – Imports), , HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 626 :
Question 3, Write down the three identities of calculating GDP of a, country by the three methods. Also briefly explain why, each of these give us the same value of GDP., (NCERT) (6 marks), , HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 627 :
Answer 3, GDPmp (by Product Method), = Value of output produced by all firms in the, economy during the year – Value of intermediate, goods used by all firms in the economy during the, year, GDPmp (by Income method), = Compensation of employees + Interest + Rent, and royalty + Profits + Mixed income of selfemployed + Depreciation + Net indirect taxes, (Indirect taxes – Subsidies), HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 628 :
GDPmp (by Expenditure Method), = Private, final, consumption, expenditure, + Government final consumption expenditure, + Gross domestic capital formation + Net Exports, (Exports – Imports), All the three methods give equal value of GDP because, the same amount of money, representing the aggregate, value of final goods and services moves in the economy, in a circular way. Income generated in production units, in the form of aggregate value of final goods and, services produced in the economy is distributed among, HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 629 :
owners as factors payments, which in turn spent on, consumption and investment expenditure on final foods, and services produced by all the firms in the economy., , HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 630 :
Question 4, Why are (a) net exports and (b) net change is stocks, included in national income? Explain., (4 marks), , HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 631 :
Answer 4, (a) National income by expenditure method includes, net exports (= exports – imports) because it is an, item of final expenditure. Exports, though, purchased by non-residents, are produced within, our domestic territory, and therefore, a part of, domestic product and hence included in national, income. Imports are deducted because goods and, services imported are not produced within the, domestic territory of the country., , HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 632 :
(b) Net change in stocks, i.e., net addition to stocks, during a year is included in national income, because it is a component of final investment, expenditure since Gross investment = Net change, in stocks + Fixed business investment + Residential, investment., , HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 633 :
Question 5, Are the following a part of a country’s Net Domestic, Product at market price? Explain giving reasons., (i) Indirect tax, (ii) Net exports, (iii) Net factor income from abroad, (iv) Consumption of fixed capital, (6 marks), , HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 634 :
Answer 5, NDPmp (by production method) = Value of output –, Intermediate consumption – Depreciation, NDPmp (by expenditure method) = Private final, consumption expenditure + Government final, consumption expenditure + Gross domestic capital, formation + Net exports – Depreciation, (i) Yes, Indirect tax is a part of NDPmp because, indirect taxes have not been paid yet to the, government., (ii) Yes, Net exports is a part of NDPmp because it is, an item of final expenditure., HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 635 :
(iii) No, NFIA is not a part of NDPmp because this is, the net income earned outside the domestic, territory of the country., (iv) No, consumption of fixed capital (or depreciation), is not a part of NDPmp because provision for, depreciation has been made while arriving at, NDPmp., , HOTs 1.6— Analysing, Evaluating & Creating Type Questions
Page 636 :
1.7, Real and Nominal GDP
Page 637 :
Nominal GDP, Real GDP and GDP, Deflator, Nominal GDP, It is the market value of the final goods and services, produced within domestic territory of a country during, an accounting year, as estimated at the current year’s, prices. In other words, Nominal GDP (or GDP at, current prices) is measured as the product of current, year’s output (Q1) of final goods and services and their, current year’s price (P1)., Change in nominal GDP may include both change in, prices and change in flow of goods and services. Thus,, nominal GDP may increase even if there is no increase, in the output of goods and services produced in the
Page 638 :
economy, due to rise in general price level during the, current year.
Page 639 :
Real GDP, It is the market value of the final goods and services, produced within the domestic territory of a country, during an accounting year, as estimated at the base, year’s* prices/constant prices. In other words, Real, GDP (or GDP at constant prices) is measured as, product of current year output (Q1) and their base, year’s price (P0)., Since base year’s prices remaining constant, real GDP, will increase only if the output of goods and services, produced in the economy is increasing., * Base year is the year whose prices are used to calculate the real GDP.
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, , Top Tip, , Real GDP is a better indicator of economic growth and welfare, of people of the country than Nominal GDP as it is not, affected by changes in general price level. Secondly, because, increase in real GDP means more goods and services are, available to the society during the year. Thus, welfare, increases., , Numerical Example:, Nominal, Quantity of, GDP, Current, (P1Q1), Year (Q1) (in units), , Real GDP, (P0Q1), , Goo, ds, , Price of, Current Year, (P1) (in `), , Price of, Base Year, (P0) (in `), , A, , 20, , 10, , 100, , 2,000, , 1,000, , B, , 10, , 5, , 200, , 2,000, , 1,000, , C, , 30, , 20, , 50, , 1,500, , 1,000, , 5,500, , 3,000
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In the above example, Nominal GDP = ΣP1Q1 = ` 5,500, and Real GDP = ΣP0Q1 = `3,000, The difference between Nominal GDP and Real GDP is, 5,500 – 3,000 = ` 2,500. This is only the monetary difference, as the quantity sold in the market remains unchanged, and the variation in the value of nominal and real GDP, is merely due to the change in the prices in the, economy between the base year and current year.
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GDP Deflator, The ratio of Nominal GDP to Real GDP of current year, is a well known price index, called GDP Deflator., , Sometimes GDP deflator is also denoted in percentage, terms. In such a case,, , It gives the change in price level between the base year, and current year. This is because in the calculation of, real and nominal GDP of the current year, the volume
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of production is fixed. Therefore, if these measures, differ it is only due to change in the price level between, the base year and the current year., In our numerical example, Nominal GDP = ΣP1Q1 =, `5,500 and Real GDP = ΣP0Q1 = ` 3,000, Therefore,, This implies that the prices have risen by 83.33%, between the base year and the current year.
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Given the Nominal GDP, how to find out, Real GDP?, Given the Nominal GDP, we can find out Real GDP by, eliminating the effect of change in prices between the, base year and the current year., The effect of change in prices on the nominal GDP can, be eliminated in the following way:, , Example: Suppose Nominal GDP = `288 and Price, index = 120, then Real GDP can be calculated as:
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, , Top Tip, , Nominal GNP, Real GNP and GNP Deflator, • Nominal GNP is the value of GNP at the current year’s, prices., • Real GNP is the value of GNP at the base year’s prices., • The ratio of nominal GNP to real GNP of the current year is, called GNP Deflator.
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Nominal and Real Income, Nominal National Income (or National, Income at current prices), When national income (product) of the current year is, estimated on the basis of prices prevailing in the, current year, it is called nominal national income (or, national income at current prices)., In other words, nominal national income is measured, as the product of current year’s output (Q1) of final, goods and services and their current year’s price (P1)., Change in nominal national income may include both, change in prices and change in flow of goods and, services. Thus, nominal national income may increase, due to increase in prices of goods and services during
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the current year without increase in the flow of goods, and services in the economy, due to rise in general, price level during the current year.
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Real National Income (or National Income at, constant prices), When national income (product) of the current year is, estimated on the basis of prices prevailing in the base, year, it is called real national income (or national, income at constant prices)., In other words, real national income is measured as, product of current year output (Q1) and their base, year’s price (P0)., Since base year’s prices remaining constant, real national income will increase only if the output of goods, and services produced in the economy is increasing., Thus, real national income reflects the real growth of
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an economy because it increases only when there is an, increase in real national output over a period of time.
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Numerical Example:, Goods, , Price of, Price of, Quantity, Current Year Base Year of Current, (P1) (in `) (P0) (in `) Year (Q1), (in units), , Nominal, NI, (P1Q1), , Real NI, (P0Q1), , A, , 20, , 10, , 100, , 2,000, , 1,000, , B, , 10, , 5, , 200, , 2,000, , 1,000, , C, , 30, , 20, , 50, , 1,500, , 1,000, , 5,500, , 3,000, , Nominal National Income = ΣP1Q1 = `5,500; Real, National Income = ΣP0Q1 = ` 3,000, The difference between Nominal National Income and, Real National Income is 5,500 – 3,000 = `2,500.
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This is only the monetary difference as the quantity sold in the market remains unchanged and the variation, in the value of nominal and real national income is, merely due to the change in the prices in the economy, between the base year and current year.
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Given the Nominal National Income, how to, find out Real National Income?, Given the Nominal national income, we can find out Real, national income by eliminating the effect of change in, prices between the base year and the current year., The effect of change in prices on the nominal national, income can be eliminated in the following way:, , Example: Suppose Nominal national income = `288, and Price index = 120, then Real national income can, be calculated as:
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RECAP, , Nominal GDP, Nominal GDP is measured as the product of current year’s output, (Q1) of final goods and services and their current year’s price (P1)., Nominal GDP may increase even if there is no increase in the, output of goods and services produced in the economy, due to, rise in general price level during the current year., , Real GDP, Real GDP is measured as product of current year output (Q1), and their base year’s price (P0). Real GDP will increase only if, the output of goods and services produced in the economy is, increasing. Thus, Real GDP is a better indicator of economic, growth and welfare of people of the country than Nominal, GDP as it is not affected by changes in general price level., Given Nominal GDP, we can find Real GDP by eliminating the effect, of change in prices between the base year and the current
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year in the following way:, , GDP Deflator, The ratio of Nominal GDP to Real GDP of current year is a well, known price index, called GDP Deflator. It gives the change in price, level between the base year and current year., , Nominal and Real National Income, , •, , When national income (product) of the current year is, estimated on the basis of prices prevailing in the current, year, nominal national income (or national income at, current prices) whereas when national product of the, current year is estimated on the basis of prices prevailing
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•, , in the base year, it is called real national income (or, national income at constant prices)., Nominal national income may increase due to increase, in prices of goods and services during the current year, without increase in the flow of goods and services in the, economy. Real national income reflects the real growth, of an economy because it increases only when there is an, increase in real national output over a period of time., Given Nominal Income, we can find Real Income by, eliminating the effect of change in prices between the, base year and the current year in the following way:
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Key Terms, Nominal GDP — It is the market value of the final goods and, services produced within domestic territory of a country during an, accounting year, as estimated at the current year’s prices., Real GDP — It is the market value of the final goods and services, produced within the domestic territory of a country during an, accounting year, as estimated at the base year’s* prices/constant, prices., GDP Deflator — The ratio of Nominal GDP to Real GDP of current, year is a well known price index, called GDP Deflator., Nominal National Income — When national income (product) of, the current year is estimated on the basis of prices prevailing in, the current year, it is called nominal national income., Real National Income — When national income (product) of the, current year is estimated on the basis of prices prevailing in the, base year, it is called real national income.
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NUMERICAL 31, Calculate real national income, nominal national, income and price index. Also, interpret the result., (6 marks), Goods, , Price of Current, Year, (in `), , Price of Base, Year, (in `), , Quantity of, Current, Year (in units), , Quantity of, Base, Year (in units), , A, , 20, , 10, , 10, , 5, , B, , 30, , 20, , 20, , 10, , C, , 50, , 40, , 5, , 2
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Solution:, Goods, , Price of, Current, Year (P1), (in `), , Price of Quantity Quantity, Base Year, of, of Base, (P0) (in `) Current Year (Q0), Year (Q1) (in units), (in units), , A, , 20, , 10, , 10, , B, , 30, , 20, , C, , 50, , 40, , Nominal, NI, (P1Q1), , Real NI, (P0Q1), , 5, , 200, , 100, , 20, , 10, , 600, , 400, , 5, , 2, , 250, , 200, , ΣP1Q1 =, 1,050, , ΣP0Q1 =, 700, , Nominal National Income = `P1Q1 = `1,050; Real National, Income = ` P0Q1 = ` 700, Interpretation: The difference between Nominal, National Income and Real National Income is 1,050 – 700
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= `350., difference between Nominal National Income and Real, National Income is 1,050 – 700 = `350., This is only the monetary difference as the quantity sold, in the market remains unchanged and the variation in the, value of nominal and real national income is merely due, to the change in the prices in the economy between the, base year and current year., Price index of 150% signifies that price level has increased, by 50% between the base year and the current year.
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Do it yourself 31, Calculate real GNP, nominal GNP and GNP Deflator. Also,, interpret the result., (6 marks), Goods, , Price of Current Price of Base, Year (in `), Year (in `), , Quantity of Current, Year (in units), , A, , 20, , 10, , 100, , B, , 10, , 5, , 200, , C, , 30, , 20, , 50
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Solution of Do it yourself 31, Goods, , Price of, Current Year, (P1) (in `), , Price of, Base Year, (P0) (in `), , Quantity of, Current, Year (Q1), (in units), , Nominal, GNP, (P1Q1), , Real GNP, (P0Q1), , A, , 20, , 10, , 100, , 2,000, , 1,000, , ΣP1Q1 =, 5,500, , ΣP0Q1 =, 3,000, , B, C, , 10, , 30, , 5, , 20, , 200, 50, , 2,000, 1,500, , 1,000, 1,000, , Nominal GNP= ΣP1Q1 = ` 5,500; Real GNP = ΣP0Q1 =, `3,000, Price index = Nominal GNP/Real GNP × 100 =, 5,500/3,000 × 100 = 183.33%
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Interpretation: Price index of 183.33% signifies that price, level has increased by 83.33% between the base year and, the current year.
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NUMERICAL 32, If the Nominal Gross Domestic Product = `4400 crore, and the Price Index (base = 100) = 110, calculate the, Real Gross Domestic Product., (3 marks), Solution:
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Do it yourself 32, If the Real GNP is `500 crore and Price Index (base = 100) is, 125, calculate the Nominal GNP., (3 marks), [Ans. Nominal GNP= ` 625 crore]
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Solution of Do it yourself 32, Real GNP = Nominal GNP/Price index × 100, ⇒ 500 = Nominal GNP/125 × 100, ⇒ Nominal GNP = (500 × 125)/100 = `625 crore
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NUMERICAL 33, Suppose only one Product X is produced in the, country. Its output during the year 2019 and 2020 was, 100 units and 110 units respectively. The market price, of X during the years 2019 and 2020 were `50 and ` 55, per unit respectively., (i) Calculate the percentage change in real GDP and, nominal GDP in year 2020 using 2019 as the base, year., (ii) Calculate GDP deflator for the years 2019 and, 2020 (in percentage terms) and comment on the, results., (6 marks)
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Solution: Substituting L = 100 and K = 9 in the given, production function,, Year, , Output, (units), , Market Price, (`per unit), , Real GDP using, base year price, , Nominal GDP using, current year price, , 2019, , 100, , 50, , 100 × `50 = `5,000, , 100 × `50 = `5,000, , 2020, , 110, , 55, , 110 × `50 = `5,500, , 110 × `55 = `6,050, , (i), , (ii), For the year 2019:, Since real and nominal GDP in 2019 are same, GDP deflator is, 100. This is because 2019 is the base year., For the year 2020:
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It means prices have risen by 10% between the two, periods. Which is true because price of product X has, indeed gone up from `50 to `55.
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Do it yourself 33, Use the following information of an imaginary country:, (CBSE Sample Question Paper 2018) (4 marks), Year, , 2017-2018, , 2018-2019, , 2019-2020, , Nominal GDP, , 6.5, , 8.4, , 9, , GDP deflator, , 100, , 140, , 125, , (i) For which year is real GDP and nominal GDP same and, why?, (ii) Calculate real GDP for the given years. Is there any year, for which real GDP falls?, [Ans. (a) 2017-18 because it is the base year (b) GDP, declined in the year 2018-2019]
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Solution of Do it yourself 33, (i) For the year 2017-2018, real GDP and nominal GDP, are same as it is the base year and thus, GDP deflator is, 100., (ii), Year, , Nominal GDP, , GDP deflator, Real GDP*, , 2017-2018, , 2018-2019, , 2019-2020, , 6.5, , 8.4, , 9, , 100, 6.5, , 140, 6, , 125, 7.2, , *Real GDP = Nominal GDP/GDP Deflator × 100, The real GDP declined in the year 2018-2019. It is due to, high rate of inflation or price level. (Price level has risen, by 40% between the base year and the year 2018-2019.)
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Question 1, If the nominal GDP of the current year is double the, nominal GDP of the base year, the volume of production, of the country must have doubled., True/False? Given reason., , Objective Type Questions 1.7
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Answer 1, False: It is possible that only prices of all goods and, services (i.e. price level) have doubled between the, base year and the current year whereas the, production has remained constant., , Objective Type Questions 1.7
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Question 2, In order to compare the GDP figures of different, countries , we cannot rely on (i) ____________. For, comparison we take help of (ii) ____________. (Real, GDP/ Nominal GDP), (Fill in the blanks with correct options), , Objective Type Questions 1.7
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Answer 2, (i) Nominal GDP (ii)Real GDP, , Objective Type Questions 1.7
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Question 3, Nominal GDP can never be less than Real GDP., True/False? Given reason., , Objective Type Questions 1.7
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Answer 3, False: Nominal GDP can be less than real GDP, if prices, in the current year are less than the prices in the, base year., , Objective Type Questions 1.7
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Question 4, Real gross domestic product can be equal to nominal, gross domestic product., True/False? Given reason., , Objective Type Questions 1.7
Page 678 :
Answer 4, True: Real GDP can be equal to nominal GDP if prices, in the current year are equal to the base year’s, prices., , Objective Type Questions 1.7
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Question 5, National income at current prices is higher than national, income at constant prices during a period of:, (Choose the correct alternative), (a) Rising prices, (b) Falling prices, (c) Constant prices, (d) Both (a) and (b), , Objective Type Questions 1.7
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Answer 5, (a) Rising prices, , Objective Type Questions 1.7
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Question 6, Suppose a country produces bread only. In the year, 2018 - 19 it had produced 1,000 units of bread, price, was ` 10 per bread . In 2019 - 20, it produced 1,100, units of bread at price of ` 12 per bread. In 2019 - 20,, the nominal and real GDP are:, (a) `10,000 and `10,000, (b) `10,000 and `11,000, (c) `13, 200 and `10,000, (d) `13,200 and `11,000, Objective Type Questions 1.7
Page 682 :
Answer 6, (d) `13,200 and ` 11,000, , Objective Type Questions 1.7
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Question 7, The ratio of nominal GDP to real GDP is a well-known, index of prices, called ______________., (Fill in the blank), , Objective Type Questions 1.7
Page 684 :
Answer 7, GDP deflator, , Objective Type Questions 1.7
Page 685 :
Question 8, Which of the following formula is correct?, (Choose the correct alternative), , Objective Type Questions 1.7
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Answer 8, , Objective Type Questions 1.7
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Question 9, In the calculation of real and nominal GDP of the, current year, the difference between the two is due to, ________________. (Change in volume of production, / Change in the price level between the base year and, the current year), (Fill in the blank with correct options), , Objective Type Questions 1.7
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Answer 9, Change in the price level between the base year and, the current year., , Objective Type Questions 1.7
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Question 10, Cost of purchase of a given basket of commodities by a, representative consumer in the current year is, expressed as a percentage of the cost of purchase of the, same basket in the base year, this gives us, ___________ ., (Fill in the blank), , Objective Type Questions 1.7
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Answer 10, the consumer price index (CPI) of the current year, , Objective Type Questions 1.7
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Question 11, If the GDP deflator is 150 % and real GDP is `1,100 the, nominal GDP will be :, (Choose the correct alternative), (a) `733, (b) `1,650, (c) `1,100, (d) `2,750, , Objective Type Questions 1.7
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Answer 11, (b) `1,650, , Objective Type Questions 1.7
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Question 12, A representative consumer had to spend `1,400 on, purchase of a given basket of commodities in the year, 2015-16. Due to inflation, CPI of the year 2019-20, (taking 2015-16 as base year) was 120. How much, amount the consumer had to spend on purchase of the, same basket of commodities in the year 2019-20?, (Choose the correct alternative), (a) ` 1,167, (b) ` 1,680, (c) ` 1,520, (d) ` 1,280, , Objective Type Questions 1.7
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Answer 12, (b) `1,680, , Objective Type Questions 1.7
Page 695 :
Question 13, Like Consumer Price Index (CPI), the index for wholesale, prices is called _____________., (Fill in the blank), , Objective Type Questions 1.7
Page 696 :
Answer 13, Wholesale Price Index (WPI), , Objective Type Questions 1.7
Page 697 :
Question 14, ___________ takes into account all the goods and, services produced in a country., (Choose the correct alternative), (a) GDP deflator, (b) Consumer Price Index, (c) Producer Price Index, (d) Wholesale Price Index, , Objective Type Questions 1.7
Page 698 :
Answer 14, (a), , GDP deflator, , Objective Type Questions 1.7
Page 699 :
Question 15, CPI includes prices of imported goods also but GDP, deflator does not include price of imported goods., True/False? Given reason., , Objective Type Questions 1.7
Page 700 :
Answer 15, True: CPI includes prices of goods consumed by the, representative consumer, hence it includes, prices of imported goods. But GDP Deflator, calculated on the basis of nominal and real GDP, includes domestically produced goods only., , Objective Type Questions 1.7
Page 701 :
Question 16, The weights are constant in (i) _______________ but, they differ according to production level of each good in, (ii) _______________. (GDP deflator/ CPI), (Fill in the blank with correct options), , Objective Type Questions 1.7
Page 702 :
Answer 16, (i) CPI (ii) GDP deflator, , Objective Type Questions 1.7
Page 703 :
Question 1, When can Real GDP be greater than Nominal GDP?, (1 mark), , HOTs 1.7— Analysing, Evaluating & Creating Type Questions
Page 704 :
Answer 1, When base year’s prices are higher than the current, year’s prices., , HOTs 1.7— Analysing, Evaluating & Creating Type Questions
Page 705 :
Question 2, Discuss any two differences between GDP at constant, prices and GDP at current Prices., (CBSE Sample Question Paper 2016) (4 marks), , HOTs 1.7— Analysing, Evaluating & Creating Type Questions
Page 706 :
Answer 2, Two main difference between GDP at current prices, and at constant price are:, (i) GDP at current prices are measured at current, year’s prices whereas GDP at constant prices are, measured at base year’s prices., (ii) GDP at current prices may increase due to rise in, prices even if there is no flow of goods and services, whereas GDP at constant prices will only increase, when there is an increase in the flow of goods and, services., HOTs 1.7— Analysing, Evaluating & Creating Type Questions
Page 707 :
1.8, GDP and Welfare
Page 708 :
Is GDP a perfect index of economic, welfare?, Generally it is considered that an increase in the Gross, Domestic Product (GDP) of any economy ensures, increase in welfare of the people of the country., However, this may not always be correct. Following are, some of the limitations of using GDP as an index of, welfare of a country:, , 1. Distribution of GDP, If the GDP of the country is rising, the welfare of, people may not increase if there is inequalities in the, distribution of GDP. Increase in inequalities means, that rich become richer and poor become poorer. Since, utility of money is higher among poor and lower Amo-
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ng the rich, therefore, if the distribution of GDP is not, uniform, inequalities may not lead to increase in, welfare of the entire country people.
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2. Non-monetary exchanges (or non-monetary, production), Non-monetary exchanges are those activities in an, economy which cannot be evaluated in terms of money, due to non-availability of data., For example, domestic services of a housewife/family, members, hobbies like painting, gardening, etc. are not, paid for. Similarly, barter exchanges take place without, the help of money. But these activities do contribute to, welfare of the people., Since GDP does not account for such activities, it is a major, cause of underestimation of GDP in the economy. As a, result, welfare of the people is also underestimated., Thus, GDP may not give us a clear indication of the
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production activity and welfare of people of the country.
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3. Externalities, Externalities refer to the harms (or benefits) a firm or, an individual causes to another for which they are not, penalised (or not paid)., Examples of negative externalities:, (i) Pollution caused by vehicles and smoke out of, chimneys of factories, (ii) Traffic jams, Such externalities may cause harm to the people., Hence, their welfare will fall. However, GDP does not, account for such negative externalities. Thus, GDP, overestimates the actual welfare., Examples of positive externalities:, (i), Introduction of metro rail has saved the time and
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money of general public and has provided safe, means of transport., (ii) Saving of commuting time due to construction of a, fly-over, Positive externalities increase welfare of people or, general public. However, GDP does not account for such positive externalities. Thus, GDP as an index underestimates welfare.
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4. Composition of GDP, • If the production of tobacco products, liquor, etc., increases in the country, GDP will increase since it is, counted in GDP. However, these harmful goods, adversely affect the health of people., • If the government imposes a ban on consumption of, tobacco products, liquor, etc., it will bring the, production of tobacco products, liqour, etc. Since it, is counted in GDP, GDP will fall. However, the ban, will improve the health in general. It will thus, increase welfare.
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Key Terms, Non-monetary exchanges—Those activities in an economy which, cannot be evaluated in terms of money due to non-availability of, data, e.g. domestic services of a housewife/family members., Externalities—Harms (or benefits) a firm or an individual causes, to another for which they are not penalised (or not paid).
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RECAP, , Limitations of using GDP as an index of welfare of, a country:, 1. Distribution of GDP: If the GDP of the country is rising, the, welfare of people may not increase if there is inequalities in, the distribution of GDP, i.e. rich become richer and poor, become poorer., 2.Non-monetary exchanges: Non-monetary exchanges refer to, the goods and services produced but not exchanged for any, monetary value. For example, value of household chores, (cooking, washing, cleaning etc.) by a millions of home-makers is, not included in the GDP of the economy. It is major cause of, undervaluation of GDP in the economy. As result, welfare of the, people is also underestimated., 3. Externalities: Externalities refer to the harms (or benefits) a, firm or an individual causes to another for which they are not
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penalised (or not paid). Negative externalities: (i) Air pollution, caused by vehicles (ii) Traffic jams. Such externalities reduce, welfare. However, GDP does not account for such negative, externalities. Thus, GDP overestimates the actual welfare. Positive, externalities: (i) Introduction of metro rail has saved the time, and money of general public (ii) Saving of commuting time, due to construction of a fly-over. Positive externalities, increase welfare of people. However, GDP does not account, for such positive externalities. Thus, GDP as an index, underestimates welfare.
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Question 1, If the real GDP of a country is rising, the welfare of, people always rise., True/False? Given reason., , Objective Type Questions 1.8
Page 719 :
Answer 1, False: With rise in real GDP, welfare may not rise if there, is inequality in the distribution of GDP, or due to, externalities and non - monetary exchanges., , Objective Type Questions 1.8
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Question 2, The exchanges which take place in the informal sector, without the help of money are called________. They, are generally not counted in the GDP of a country. This, is a case of _________ of GDP., (Fill in the blanks), , Objective Type Questions 1.8
Page 721 :
Answer 2, barter exchanges , under-estimation, , Objective Type Questions 1.8
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Question 3, GDP calculated in the standard manner may not give us, a clear indication of the productive activity and wellbeing of a country because of :, (Choose the correct alternative), (a) Unequal distribution of GDP, (b) Non-monetary exchanges, (c) Externalities, (d) All of the above, , Objective Type Questions 1.8
Page 723 :
Answer 3, (b) Non-monetary exchanges, , Objective Type Questions 1.8
Page 724 :
Question 1, Give one example of ‘externality’ which reduces welfare, of the people., (CBSE 2013) (1 mark), , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 725 :
Answer 1, Smoke of a factory polluting the air or release of, contaminated water into river or traffic jams, etc. (any, one), , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 726 :
Question 2, Define externalities. Give an example of negative externality.What is its impact on welfare?, (CBSE 2014) (3 marks), , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 727 :
Answer 2, Externalities refer to the benefits (or harms) a firm or, an individual causes to another for which it is not paid, (or penalised), Example of negative externality: Smoke of a factory, polluting the air., Impact: Reduces welfare through negative effect on, health., , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 728 :
Question 3, ‘GDP as an index of welfare may understate or overstate, welfare.’ Explain the statement using examples of a, positive and a negative externality., (CBSE Sample Question Paper 2017) (3 marks), , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 729 :
Answer 3, GDP doesn’t account for externalities, Positive Externality: e.g. saving commuting time due to, construction of a fly-over, increases welfare. GDP as an, index understates welfare., Negative Externality: e.g. pollution from factories,, decreases welfare. GDP overstates welfare., , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 730 :
Question 4, How do the negative externalities affect the welfare of the, people ? Explain by taking an example., (CBSE 2017) (3 marks), , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 731 :
Answer 4, Pollution by factories, vehicles, etc is an example of, negative externalities, i.e. harm caused by a firm or a, person to others for which they are not paid for. Gross, domestic product does not take into account such, harms caused., , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 732 :
Question 5, Suppose a ban is imposed on consumption of tobacco., Examine its likely effects on (a) gross domestic product, and (b) welfare., (CBSE 2017) (3 marks), , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 733 :
Answer 5, (a) Ban on consumption of tobacco will bring down, production of tobacco. Since it is counted in GDP,, GDP will fall., (b) The ban will improve the health in general. It will, thus increase welfare., , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 734 :
Question 6, How does increase in inequalities in distribution of, income affect welfare of the society ? Explain., (CBSE 2017) (3 marks), , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 735 :
Answer 6, Increase in inequalities means that rich become richer, and poor become poorer. Since utility of money is, higher among poor and lower among the rich, any, increase in inequalities may not lead to increase in, welfare., , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 736 :
Question 7, Government incurs expenditure to popularise yoga, among the masses. Analyse its impact on gross domestic, product and welfare of the people., (CBSE 2016) (3 marks), , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 737 :
Answer 7, Government expenditure on popularising yoga raises, GDP because it is government’s final consumption, expenditure. It also raises welfare of the people because, yogic exercises improve health and thus, raise efficiency, of the people., , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 738 :
Question 8, Sale of petrol and diesel cars is rising particularly in big, cities. Analyse its impact on gross domestic product and, welfare., (CBSE 2016) (3 marks), , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 739 :
Answer 8, Sale of cars raises GDP, because sales are of final, products. Cars provide convenience in transportation, but at the same time, it causes traffic jams, air pollution, and noise pollution, which reduces the welfare of the, people. Pollution has bad effects on the health of the, people., , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 740 :
Question 9, State, giving reasons, whether the following will be, included in national income:, (3 marks), (i) Growing vegetables in a kitchen garden of the, house/Services rendered by family members to each, other., (ii) Production of tobacco products, liquor, etc., (iii) Harmful effects of air pollution caused by factories or, vehicles., , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 741 :
Answer 9, (i) No, it will not be included in the national income as, it is difficult to estimate the market value of, production. It is a non-monetary production or, non-monetary exchange., (ii) Yes, it is included in the national income since, output is produced., (iii) No, national income does not include negative, e0xternalities though they reduce welfare of people., , HOTs 1.8— Analysing, Evaluating & Creating Type Questions
Page 742 :
Self-Assessment Test 1, , National Income and Related Aggregates, Time Allowed: 1 hour, , Maximum Marks: 25
Page 743 :
Question 1, What is Macroeconomics ?, , (1 mark)
Page 744 :
Question 2, Give any two examples of flow concept., , (1 mark)
Page 745 :
Answer 2, National income, Investment
Page 746 :
Question 3, According to a report forwarded by the Reserve Bank of, India, there was a fall in rate of inflation as measured by, Consumer Price Index (CPI) on year-on-year basis to 5%, from 8% in the precious year. Which of the following, statements represents the situation?, (1 mark), (a) CPI has fallen, (b) CPI has risen at a rate lower than the preceding, year, (c) CPI is constant, (d) None of the above
Page 747 :
Answer 3, (b) CPI has risen at a rate lower than the preceding, year
Page 748 :
Question 4, Depreciation is also known as:, (a) Capital loss, (b) Unforeseen obsolescence, (c) Capital allowance, (d) Both (a) and (b), , (1 mark)
Page 749 :
Answer 4, (c) Capital allowance
Page 750 :
Question 5, Calculate “Intermediate Consumption” from the following, data:, (3 marks), S. No., , Items, , (` in crore), , (i), , Gross value of output, , 300, , (ii), , Net value added at factor cost (NVAfc), , 100, , (iii), , Subsidies, , 15, , (iv), , Depreciation, , 30
Page 751 :
Answer 5, Intermediate consumption = (i)- (iv)-(Indirect tax – iii), – (ii), = 300 – 30 – (0-15) – 100 = 300 – 30 + 15 – 100, = `185 crore
Page 752 :
Question 6, Which of the following items will be included/not, included while estimating Gross Domestic Product? Give, valid reasons in support of your answer., (a) Wages received by an Indian working in the British, Embassy in India., (b) Financial aids received from abroad after “Fani, cyclone”., (c) Purchase of second hand machinery from abroad., (3 marks)
Page 753 :
Answer 6, (a) Wages received by an Indian working in British, embassy in India is not a part of economic, territory of India, as British Embassy is a part of, Economic territory of Britain., (b) Financial aid is a transfer income as no factor, service is provided in return. Hence, it is not, included while estimating the value of GDP., (c) Purchase of second hand machinery from abroad, is not included as the value of imports are, deducted while estimation GDP of a country.
Page 754 :
Question 7, What is meant by the problem of double counting?, Discuss briefly the two approaches to avoid this problem., (3 marks)
Page 755 :
Question 8, (a)Distinguish between Real Gross Domestic Product, and Nominal Gross Domestic Product., (2 marks), (b)"Real Gross Domestic Product is a better indicator of, economic growth than Nominal Gross Domestic, Product.", Do you agree with the given statement? Support your, answer with a suitable numerical example. (4 marks)
Page 756 :
Answer 8, (b) The given statement is correct. Real Gross Domestic, Product (GDP) is a better indicator of economic growth, than Nominal Gross Domestic Product (GDP) as it is not, affected by changes in general price level., Numerical Example:, Goods, , P1, , P0, , Q1, , P1Q1, , P0Q1, , A, , 20, , 10, , 100, , 2,000, , 1,000, , B, , 10, , 5, , 200, , 2,000, , 1,000, , C, , 30, , 20, , 50, , 1,500, , 1,000, , ΣP1Q1 =, 5,500, , ΣP0Q1 =, 3,000
Page 757 :
In the above example the difference between Real, GDP (ΣP0Q1) and Nominal GDP (ΣP1Q1) is 5,500 –, 3,000 = `2,500. This is only the monetary difference, as the quantity sold in the market remains unchanged, and the variation in the value of GDP is merely due to, the change in the prices in the economy.
Page 758 :
Question 9, (a) The value of the nominal GNP of an economy was `, 2500 crore in a particular year. The value of GNP, of that country during the same year, evaluated at, the prices of base year, was `3000 crore. Calculate, the value of the GNP deflator of the year in, percentage terms. Has the price level risen between, the base year and the year under consideration?, (3 marks), (b) Calculate compensation of employees from the, following data:, (3 marks)
Page 759 :
S. No, , Particulars, , Amount (in ` crore), , i., , Profits after tax, , 20, , ii., , Interest, , 45, , iii., , Gross Domestic Product at Market Price, , 200, , iv., , Goods and Services Tax, , 10, , v., , Consumption of Fixed Capital, , 50, , vi., , Rent, , 25, , vii., , Corporate Tax, , 5
Page 760 :
Answer 9, (a) GNP Deflator = (Nominal GNP/Real GNP) × 100, = 2500/3000 × 100 = 83.33%, Thus, the price level has fallen by 16.67% between, the base year and the year under consideration., (b) Compensation of Employees = (iii) – (v) – (iv) – (vi, + ii + i + vii), = 200 – 50 -10 – (25 + 45 + 20 + 5) = `45 crore
Page 761 :
Self-Assessment Test 2, , National Income and Related Aggregates, Time Allowed: 1 hour, , Maximum Marks: 25
Page 762 :
Question 1, Define an intermediate good., , (1 mark)
Page 763 :
Question 2, Wages received by an Indian working in the British, Embassy in India will be included in Gross Domestic, Product (GDP) of India. True/False? Give reason., (1 mark)
Page 764 :
Answer 2, False: Not included in GDP of India as it is factor income, from abroad.
Page 765 :
Question 3, If the national income is ` 2,800 crore and NDPfc is, `3,000 crore, which of the following option will be, correct?, (1 mark), (a) Factor income from abroad ` 500 and factor, income to abroad is `200, (b) Factor income from abroad ` 400 and factor, income to abroad is ` 600, (c) Factor income from abroad `600 and factor, income to abroad is ` 400, (d) Factor income from abroad ` 700 and factor, income to abroad is ` 700
Page 766 :
Answer 3, (b) Factor income from abroad `400 and factor income, to abroad is ` 600
Page 767 :
Question 4, Which of the following would be the normal resident of, India?, (1 mark), (a) An Indian working in an American embassy in India, (b) An Indian working in Singapore branch of an, Indian bank., (c) A team of German engineers in India on official, job for six months., (d) Five Afghan student pursing law in India for the, last four years
Page 768 :
Answer 4, (a) An Indian working in an American embassy in India
Page 769 :
Question 5, "Circular flow of income in a two sector economy is, based on the axiom that one’s expenditure is other’s, income.", Do you agree with the given statement? Support your, answer with valid reasons., (3 marks)
Page 770 :
Answer 5, Yes, the given statement is correct. In a two sector, economy, the firms produce goods and services and, make factors payments to the households. The factor, income earned by the households will be used to buy the, goods and services which would be equal to income of, firms. The aggregate consumption expenditure by the, households in the economy is equal to the aggregate, expenditure on goods and services produced by the, firms in the economy (Income of the producers).
Page 771 :
Question 6, “India’s GDP is expected to expand 7.5% in 2019-20:, World Bank” — The Economic Times., Does the given statement mean that welfare of people, of India increase at the same rate? Comment with, reason., (3 marks)
Page 772 :
Answer 6, Generally it is considered that an increase in the Gross, Domestic Product (GDP) of any economy (India in this, case) ensures increase in welfare of the people of the, country. However, this may not always be correct. Some, of the prime reasons for the same are:, (a) unequal distribution and composition of GDP,, (b) non-monetary transactions in the economy which are, not accounted for in GDP, and, (c) occurrence of externalities in the economy (both, positive and negative).
Page 773 :
Question 7, Calculate “Depreciation” from the following data:, (3 marks), S. No., , Items, , (` in crore), , (i), , Gross value of output, , 300, , (ii), , Net value added at factor cost (NVAfc), , 100, , (iii), , Subsidies, , 15, , (iv), , Intermediate Consumption, , 185
Page 774 :
Answer 7, Depreciation = (i) – (iv) – ( iii) – (ii) = 300 – 185 – (–15), – 100, = 200 – 185 + 15 = 215 – 185 = `30, crore.
Page 775 :
Question 8, Using numerical example, distinguish between Real, National Income and Nominal National Income., OR, Explain any three precautions while calculating GDP, by Value Added Method., (6 marks)
Page 776 :
Question 9, (a) Distinguish between net factor from abroad and, net exports., (2 marks), (b) Calculate the value of “Mixed Income of SelfEmployed” from the following data : (4 marks), S. No., , Items, , (` in crore), , (i), , Compensation of Employees, , 17,300, , (ii), , Interest, , 1,200, , (iii), , Consumption of Fixed Capital, , 1,100, , (iv), , Mixed Income of Self-Employed, , (v), , Subsidies, , (vi), , Gross Domestic Product at Market price, , ?, 750, 27,500
Page 777 :
(vii), , Indirect Taxes, , 2,100, , (viii), , Profits, , 1,800, , (ix), , Rent, , 2,000
Page 778 :
Answer 9, (b) GDPMP = (i) + [(ix) + (ii) + (viii)], + Mixed Income of Self employed + (iii) + (vii – v), 500 = 17,300 + (2000 + 1200 + 1800) + Mixed, Income +1100 + (2100 – 750), Mixed Income =`2,750crore
Page 779 :
Self-Assessment Test 3, , National Income and Related Aggregates, Time Allowed: 1 hour, , Maximum Marks: 25
Page 780 :
Question 1, What are 'non-monetary exchanges'?, , (1 mark)
Page 781 :
Question 2, Define 'Value Addition'?, , (1 mark)
Page 782 :
Question 3, When national income (product) of the current year is, estimated on the basis of prices prevailing in the, current year, it is called (i)_________ whereas when it, is estimated on the basis of prices prevailing in the, base year, it is called (ii)__________. (real national, income/nominal national income) (Fill in the blanks with, the correct options), (1 mark)
Page 783 :
Answer 3, (i) nominal national income (ii) real national income
Page 784 :
Question 4, If Real GDP = `240 crore and Price Index = 120,, Nominal GDP = __________?, (1 mark)
Page 785 :
Answer 4, `288 crore. Explanation : Real GDP = Nominal, GDP/Price index × 100, Nominal GDP = (Real GDP × Price index)/100 × (240, × 120)/100 – 266
Page 786 :
Question 5, Calculate “Gross value of output” from the following, data:, (3 marks), S. No., , Items, , (` in crore), , (i), , Net value added at factor cost (NVAfc), , 100, , (ii), , Depreciation, , 30, , (iii), , Subsidies, , 15, , (iv), , Intermediate Consumption, , 185
Page 788 :
Question 6, If in a locality, a new park is developed by the, municipal corporation, it will have externalities, both, positive and negative. State on example each of both, types of externalities with reason., (3 marks)
Page 789 :
Answer 6, The park in neighbourhood can be a source of positive, externality as it helps in reducing pollution and thereby, improving health and efficiency., The park in neighbourhood can be a source of negative, externality if it is used by anti-social elements. This can, increase crime and lead to insecurity.
Page 790 :
Question 7, Define the problem of double counting in the, computation of national income. State any two, approaches to correct the problem of double counting., (3 marks)
Page 791 :
Question 8, Explain any three precautions while calculating, national income by Income Distributed Method., (6), OR, Will the following be included in domestic factor income, of India? Give reasons in support of your answer. (6), (i) Compensation of employees paid by a foreign, company located in India., (ii) Compensation of employees paid by American, embassy in India to resident Indians., (iii) Expenditure on engine oil by car service station.
Page 792 :
Answer 8, II Part:, (i) Yes, it will included in the domestic factor income of, India as foreign company is located within the, domestic territory of India., (ii) No, it will not be included in the domestic factor, income of India as American embassy is not a part, of the domestic territory of India., (iii) Expenditure on engine oil by a car service station is, not included because it is an intermediate cost.
Page 793 :
Question 9, Given the following data, find the values of, ‘Operating Surplus’ and ‘Gross Domestic Capital, Formation’:, (6 marks), S. No., , Items, , (` in crore), , (i), , Government Final Consumption Expenditure, , 2,000, , (ii), , Mixed Income of Self-Employed, , 1,500, , (iii), , National Income, , 12,000, , (iv), , Net Factor Income from Abroad, , (v), , Operating Surplus, , (vi), , Profits, , (vii), , Private Final Consumption Expenditure, , 200, ?, 500, 6,000
Page 794 :
(vii), , Private Final Consumption Expenditure, , 2,100, , (viii), , Net Indirect Taxes, , 1,800, , (ix), , Net Exports, , 2,000, , (x), , Consumption of Fixed Capital, , (xi), , Gross Domestic Capital Formation, , (xii), , Wages and Salaries, , 600, ?, 6,000
Page 795 :
Answer 9, Operating surplus = iii – xii – ii – iv, = 12000 – 6000 – 1500 – 200 =, 4300 Crore., GDCF = iii+ x + viii – iv – i – vii – ix, = 12000+ 600 + 700– 200 -2000-6000 –, 1800 = `3300 crore.
Page 796 :
Self-Assessment Test 4, , National Income and Related Aggregates, Time Allowed: 1 hour, , Maximum Marks: 25
Page 797 :
Question 1, The problem of _________ arises when the value of, some goods and service are counted more than once, while estimating national income., (1 mark)
Page 798 :
Answer 1, Double counting
Page 799 :
Question 2, Higher GDP always means greater per capital, availability of goods in the economy., True/False? (1 mark)
Page 800 :
Answer 2, False: GDP does not account for inequalities in, distribution of income. If the rising GDP is, concentrated in a few hands, per capital, availability of goods in the economy might not, increase.
Page 801 :
Question 3, Which of the following is used for calculating National, Income by income method?, (1 mark), (a) Income Tax, (b) Corporation Tax, (c) Sales Tax, (d) Net Indirect Tax
Page 802 :
Answer 3, (b) Corporation Tax
Page 803 :
Question 4, If GDPmp is `5,000 crore, intermediate consumption is, ` 2,500 crore and the ratio of sales to change in stock, is 2 : 1, then sales will be:, (1 mark), (a) ` 4,000, (b) ` 5,000, (c) ` 3,000, (d) ` 2,000
Page 804 :
Answer 4, (b) `5,000
Page 805 :
Question 5, How is Real Gross domestic Product (GDP) different from, Nominal Gross Domestic Product (GDP)? Given the, Nominal GDP, how is Real GDP computed? Explain using, a numerical example., (3 marks)
Page 806 :
Question 6, Explain the circular flow of income in a two sector, economy., (3 marks)
Page 807 :
Question 7, Distinguish between final goods and intermediate goods., Give suitable examples., (3 marks)
Page 808 :
Question 8, Define the following:, (6 marks), (a) Value addition, (b) Gross Domestic Product, (c) Flow variables, (d) Income from property and entrepreneurship, (e) Net factor income from abroad, (f) Net exports, OR, Explain any four precautions while calculating national, income by expenditure method., (6 marks)
Page 809 :
Question 9, Given the following data, find the value of, ‘Government Final Consumption Expenditure’ and, ‘Mixed Income of Self-Employed’:, (6 marks), S. No., , Items, , (` in crore), , (i), , National Income, , 7,100, , (ii), , Government Final Consumption Expenditure, , (iii), , Gross Domestic Capital Formation, , (iv), , Mixed Income of Self-Employed, , (v), , Net Indirect Taxes, , 200, , (vi), , Net Factor Income from Abroad, , 100, , (vii), , Private Final Consumption Expenditure, , ?, 1,000, ?, , 4,000
Page 810 :
(viii), , Consumption of Fixed Capital Indirect Taxes, , 300, , (ix), , Profits, , 120, , (x), , Wages and Salaries, , (xi), , Net Exports, , (xii), , Operating Surplus, , 1,500, 500, 3,000
Page 811 :
Answer 9, Government final Consumption Expenditure= i – iii – vii –, xi + v + viii – vi, = 7100 –1000 – 4000 – 500+200+300 – 100 =, `2,000crore, Mixed Income of Self Employed = i – x – xii – vi, = 7100 – 1500 – 3000 – 100 = ` 2500 crore
Page 812 :
Self-Assessment Test 5, , National Income and Related Aggregates, Time Allowed: 1 hour, , Maximum Marks: 25
Page 813 :
Question 1, National income and money creation are examples of, stock concept., True/False? (1 mark)
Page 814 :
Answer 1, False: National income and money creation are, examples of flow concept as they are measured, during a period of time. False: National income, and money creation are examples of flow concept, as they are measured during a period of time.
Page 815 :
Question 2, To avoid double counting , we should:, (1 mark), (a) Take the value of final goods and services only, ignoring all intermediate products., (b) Take the value added at different stages in, production process instead of total output., (c) Either (a) or (b), (d) Neither (a) nor (b)
Page 816 :
Answer 2, (c) Either (a) or (b) (c) Either (a) or (b)
Page 817 :
Question 3, Goods which are not bought for meeting immediate, needs of the consumers but are producing other goods, are called _____________., (1 mark)
Page 818 :
Answer 3, Capital goods
Page 819 :
Question 4, How will you treat the following in the calculation of, Net Domestic Product (NDP) of India? Give reasons for, your answer., (3 marks), (a) Factor income from abroad., (b) Remittances from non-resident Indians to their, families in India.
Page 820 :
Answer 4, (a) No, it is not included in NDP of India because the, factor income is earned outside the domestic, territory of India., (b) No, it is not included in NDP of India because it is a, transfer income from abroad.
Page 821 :
Question 5, What are ‘non-monetary exchange’? Discuss with suitable, example., (3 marks)
Page 822 :
Question 6, State under what conditions in the following statements, may be true:, (4 marks), (a) Domestic Income is equal to National Income., (b) Value of output is equal to Value Added., (c) Gross domestic capital formation = Gross domestic, fixed capital formation, (d) Operating surplus = Rent + Royalty + Profit
Page 823 :
Answer 6, (a), (b), (c), (d), , When Net Factor Income from Abroad is zero., When intermediate consumption is zero., When net change in stocks is zero., When there is no income in the form of interest.
Page 824 :
Question 7, Explain the meaning of Real Gross Domestic Product and, Nominal Gross Domestic Product. Which of the two, indicates economic welfare? Explain using a numerical, example., (6 marks)
Page 825 :
Question 8, Calculate Gross Domestic Product at market prices and, national income from the following data., (6 marks), S. No., , Items, , (` in crore), , (i), , Net imports, , (–) 30, , (ii), , Private final consumption expenditure, , (iii), , Subsidies, , 5, , (iv), , Net domestic fixed capital formation, , 50, , (v), , Government final consumption expenditure, , 100, , (vi), , Net factor income from abroad, , (-)10, , (vii), , Closing stock, , 10, , (viii), , Consumption of fixed capital, , 40, , 400
Page 826 :
(ix), , Indirect taxes, , 55, , (x), , Opening stock, , 20
Page 827 :
Answer 8, Gross Domestic Product at Market Price, = Private final consumption expenditure, + Government final consumption expenditure, + Net domestic fixed capital formation, + Consumption of fixed capital, + Closing stock – Opening stock – Net imports, = 400 + 100 + 50 + 40 + 10 – 20 – (– 30) = `610, crore, National Income (NNPfc) = GDPmp – Consumption of, fixed capital– Indirect taxes + Subsidies + Net factor
Page 828 :
income from abroad, = 610 – 40 – 55 + 5 + (–10) = `510 crore
Page 829 :
b
Page 830 :
Money – meaning and supply of money –, , Currency held by the public and net demand, deposits held by commercial banks, Money creation by the commercial banking, system, Central bank and its functions (example of the, Reserve Bank of India) : Bank of issue, Govt., Bank, Banker’s Bank, Controller of Credit
Page 831 :
2.1, , Money and Supply of Money, , Money — Its Meaning, Anything which is commonly accepted as a medium, of exchange is called money., It is usable for undertaking transactions, i.e., receipts, and payments. In a modern economy, money comprises, cash and bank deposits. Currency notes and coins can be, used for settlement of any economic transactions. Bank, deposits, e.g. the balance in savings and current account, deposits with commercial banks, are also used to settle, transactions through cheques, debit cards, etc.
Page 832 :
Supply of Money, Meaning, Money supply refers to the total quantity of money, in circulation in the economy at a given point of, time., , , , Top Tip, , Money supply is a stock variable since the total stock of, money in circulation among the public is measured at a, particular point of time.
Page 833 :
Components, The basic measure of money supply (M1) has two, components–Currency with public and demand deposits, in commercial banks., 1. Currency held by the public (CU): Money supply, consists of currency notes and coins held by the public, outside the banks. The Reserve Bank of India (RBI) is, the only institution which can issue currency in India., Currency notes are issued by the RBI. However, coins, are issued by the Government of India., The currency issued by the central bank (Reserve, Bank of India in India) can be held by the public or, by the commercial banks, and is called the, high-powered money or 'reserve money' or, 'monetary base' as it acts as a basis for credit creation.
Page 834 :
Currency notes and coins are called legal tenders, as they cannot be refused by any citizen of the, country for settlement of any transaction., Currency notes and coins are called fiat money, because every currency note bears on its face a, promise from the Governor of RBI that if someone, produces the note to RBI ,or any other commercial, bank, RBI will be responsible for giving the person, purchasing power equal to the value printed on, the note. The same is also true of coins.
Page 835 :
2. Net demand deposits held by commercial banks, (DD): Demand deposits are the deposits which can, be withdrawn on demand by the depositors from, banks, example, current account and savings account, deposits., Demand deposits are created by the commercial, banks and are called bank money., The word 'net' implies that only deposits of the, public held by the banks are to be included in, money supply. The inter-bank deposits, which a, commercial bank holds in other commercial, banks,are not to be regarded as part of money, supply.
Page 836 :
, , Top Tip, , Commercial banks also hold time deposits of the public., Time deposits are those deposits in banks which have a, fixed period of maturity, e.g., Fixed Deposits (FD)., However, the basic measure of money supply (M1), includes only demand deposits, not time deposits.
Page 837 :
Key Term, Money — Anything which is commonly accepted as a medium, of exchange is called money., Money supply — Money supply refers to the total quantity of, money in circulation in the economy at a given point of time., High powered money — The currency issued by the central, bank (Reserve Bank of India in India) can be held by the public, or by the commercial banks, and is called the high-powered, money., Demand deposits — Demand deposits are the deposits which, can be withdrawn on demand by the depositors from banks, e.g., current account and savings account deposits., Time deposits — Those deposits in banks which have a fixed, period of maturity, e.g., Fixed Deposits (FD)., Bank money — Demand deposits are created by the commercial, banks and are called bank money.
Page 838 :
RECAP, , Money and Supply of Money, Anything which is commonly accepted as a medium of exchange is, called money., Money supply refers to the total quantity of money in circulation, in the economy at a given point of time. Thus, it is a stock variable., It has two components:, (i) Currency held by the public (CU): The currency issued by the, central bank (Reserve Bank of India) can be held by the public, or by the commercial banks, and is called the high-powered, money., (ii) Net demand deposits held by commercial banks (DD): Demand, deposits are the deposits which can be withdrawn on demand, by the depositors from banks, e.g. current account and savings, account deposits. Demand deposits are created by the, commercial banks and are called bank money. The word ‘net’, implies that money supply includes only deposits of the public, held by the banks, not inter-bank deposits).
Page 839 :
Question 1, Demand deposits created by the commercial banks are, called _________., (Choose the correct alternative), (a) High powered money, (b) Money, (c) Bank money, (d) Time deposits, Objective Type Questions 2.1
Page 840 :
Answer 1, (c) Bank money, , Objective Type Questions 2.1
Page 841 :
Question 2, _________ are called legal tenders., (Choose the correct alternative), (a) Demand deposits, (b) Time deposits, (c) Inter-bank deposits, (d) Currency notes and coins, , Objective Type Questions 2.1
Page 842 :
Answer 2, (d) Currency notes and coins, , Objective Type Questions 2.1
Page 843 :
Question 3, Which of the following is not included in money supply?, (Choose the correct alternative), (a) High powered money, (b) Bank money, (c) Time deposits, (d) Inter-bank deposits, , Objective Type Questions 2.1
Page 844 :
Answer 3, (d) Inter-bank deposits, , Objective Type Questions 2.1
Page 845 :
Question 4, Supply of money refers to quantity of money ________., (CBSE 2017) (Choose the correct alternative), (a), (b), (c), (d), , as on 31st March, during any specified period of time, as on any point of time, during a fiscal year, , Objective Type Questions 2.1
Page 846 :
Answer 4, (c) as on any point of time, , Objective Type Questions 2.1
Page 847 :
Question 5, Demand deposits include __________., (CBSE 2017) (Choose the correct alternative), (a), (b), (c), (d), , Saving account deposits and fixed deposits, Saving account deposits and current account deposits, Current account deposits and fixed deposits, All types of deposits, , Objective Type Questions 2.1
Page 848 :
Answer 5, (b) Saving account deposits and current account deposits, , Objective Type Questions 2.1
Page 849 :
Question 6, _____________ is the main source of money in an, economy., (Choose the correct alternative), (a) Central bank of the economy, (b) Commercial banking system, (c) Both (a) and (b), (d) Government, , Objective Type Questions 2.1
Page 850 :
Answer 6, (c) Both (a) and (b), , Objective Type Questions 2.1
Page 851 :
Question 7, Currency issued by the central bank is called:, (Choose the correct alternative), (a) Fiat money, (b) Legal tenders, (c) High powered money, (d) All of the above, , Objective Type Questions 2.1
Page 852 :
Answer 7, (d) All of the above, , Objective Type Questions 2.1
Page 853 :
Question 8, Apart from currency notes and coins, the balance in, (i) ___________, held by the public in commercial banks, is also considered money since the amount in these, accounts can be used to settle transactions. Such deposits, are called demand deposits because (ii) ___________., (Fill in the blanks), , Objective Type Questions 2.1
Page 854 :
Answer 8, (i) savings, or current account deposits, (ii) they are payable by the bank on demand from the, account-holder., , Objective Type Questions 2.1
Page 855 :
Question 9, Demand deposits created by commercial banks are, called ________., (Fill in the blank), , Objective Type Questions 2.1
Page 856 :
Answer 9, bank money, , Objective Type Questions 2.1
Page 857 :
Question 10, Demand deposits are not _______ since cheques drawn, on these accounts can be refused by anyone as a mode of, payment., (Fill in the blank), , Objective Type Questions 2.1
Page 858 :
Answer 10, legal tenders, , Objective Type Questions 2.1
Page 859 :
Question 11, Bank deposits which have fixed period to maturity, e.g., fixed deposits are referred to as _______., (Fill in the blank), , Objective Type Questions 2.1
Page 860 :
Answer 11, Time deposits, , Objective Type Questions 2.1
Page 861 :
Question 12, M1 measure of money supply is defined as follows:, M1 = CU +DD, where, CU is Currency (notes plus coins) held by, the public and DD is ‘net’ demand deposits held by, commercial banks. The word ‘net’ here implies that, _____________., (Fill in the blank), , Objective Type Questions 2.1
Page 862 :
Answer 12, Only deposits of the public held by the banks are to be, included in money supply. The interbank deposits, which, a commercial bank holds in other commercial banks, are, not to be regarded as part of money supply., , Objective Type Questions 2.1
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Question 13, In a modern economy, money comprises _______., (Fill up the blank with correct answer), , Objective Type Questions 2.1
Page 864 :
Answer 13, Cash and bank deposits, , Objective Type Questions 2.1
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Question 14, The currency issued by the central bank can be held by, the public or by the commercial bank, and is called the, ‘___________’ or ‘reserve money’ or ‘monetary base’, as it acts as basis for credit creation., (Fill up the blank with correct answer), , Objective Type Questions 2.1
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Answer 14, high powered money, , Objective Type Questions 2.1
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Question 15, Besides central bank, ________ are the other type of, institutions which are a part of the money-creating system, of the economy., , Objective Type Questions 2.1
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Answer 15, commercial banks, , Objective Type Questions 2.1
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Question 16, __________ accept deposits from the public and lend, out part of these funds to those who want to borrow., , Objective Type Questions 2.1
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Answer 16, Commercial banks, , Objective Type Questions 2.1
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Question 17, _______ is the only institution which can issue currency, notes. However, coins are issued by the _______., , Objective Type Questions 2.1
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Answer 17, The Reserve Bank of India (RBI): Government of India., , Objective Type Questions 2.1
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Question 18, Which of the following is not a function of the Reserve, Bank of India?, (Choose the correct alternative), (a) It issues the currency of the country., (b) It acts as a bank to the banking system., (c) It is the custodian of the foreign exchange reserves, of the economy., (d) None of the above, , Objective Type Questions 2.1
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Answer 18, (d) None of the above, , Objective Type Questions 2.1
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Question 19, Central Bank is a very important institution in a modern, economy. Almost every country has one central bank., India got its central bank in 1935. Its name is ________., (Fill up the blanks with correct answer), , Objective Type Questions 2.1
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Answer 19, The Reserve Bank of India (RBI), , Objective Type Questions 2.1
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Question 20, Currency notes and coins are called fiat money., True/False? Give reason., , Objective Type Questions 2.1
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Answer 20, True: RBI is responsible for giving the bearer of the, currency equal purchasing power., , Objective Type Questions 2.1
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Question 21, Currency notes and coins are called legal tenders., True/False? Give reason., , Objective Type Questions 2.1
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Answer 21, True: They cannot be refused by any citizen of the, country for settlement of any kind of transaction., , Objective Type Questions 2.1
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Question 22, Demand deposits are called legal tenders., True/False? Give reason., , Objective Type Questions 2.1
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Answer 22, False: Cheques drawn on savings or current accounts, can be refused by anyone as a mode of payment. Hence,, demand deposits are not legal tenders., , Objective Type Questions 2.1
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Question 23, Money supply is a stock variable., True/False? Give reason., , Objective Type Questions 2.1
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Answer 23, True: Money supply is the total stock of money in, circulation among the public at a particular point of time., , Objective Type Questions 2.1
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Question 24, Currency created by the Central Bank is called bank, money., True/False? Give reason., , Objective Type Questions 2.1
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Answer 24, False: The currency created by the Central bank, (Reserve Bank of India in India) is called High Powered, Money., , Objective Type Questions 2.1
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Question 25, Who regulates money supply in India?, (CBSE 2015) (Choose the correct alternative), (a), (b), (c), (d), , Government of India, Reserve Bank of India, Commercial Banks, Planning Commission, , Objective Type Questions 2.1
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Answer 25, (b) Reserve Bank of India, , Objective Type Questions 2.1
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Question 26, The components of money supply are:, (Choose the correct alternative), (a), (b), (c), (d), , Currency held by the public, demand deposits of the public in commercial banks, other deposits with the RBI, currency held by the public and demand deposit of, the public in commercial banks, , Objective Type Questions 2.1
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Answer 26, (d) currency held by the public and demand deposit of, the public in commercial banks, , Objective Type Questions 2.1
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Question 27, Fixed deposit is also termed as:, (Choose the correct alternative), (a), (b), (c), (d), , Chequeable deposits, Demand deposit, Time deposit, Non-chequeable deposits, , Objective Type Questions 2.1
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Answer 27, (c) Time deposit, , Objective Type Questions 2.1
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2.2, , Money Creation by Commercial, Banking System: Working of Money, Multiplier/ Lending Process of Banks, , Process of Money Creation by, Commercial Banks, Commercial banks receive deposits from the public., The depositors are free to withdraw, in part or in, full,their deposit amounts by writing cheques. The, banks use the money in these deposits to give loans., These functions of the commercial banking system are, the basis of money creation. Note that money creation, is also called 'deposit creation' or 'credit creation‘.
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Commercial banks cannot use the total deposits for, giving loans. It is legally compulsory for the banks to, keep a certain minimum fraction of net total demand, and time deposits as legal reserves. The fraction is, called the Legal Reserve Ratio (LRR)., LRR is the minimum reserve that a commercial, bank must maintain as per the instructions of the, central bank., , , , Top Tip, , Legal Reserve Ratio is also called Reserve Ratio or Required, Reserve Ratio or Reserve Deposit Ratio or Legal Reserve, Deposit Ratio.
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The LRR is fixed by the Central Bank. It has two, components:, (i) Cash reserve ratio (CRR): It is the fraction of net, total demand and time deposits that commercial, banks must keep as cash reserves with the Central, Bank., (ii) Statutory liquidity ratio (SLR): It is the fraction, of net total demand and time deposits that, commercial banks must keep with themselves in, the form of specified liquid assets., How much are the deposits created is determined by, primary deposits and Legal Reserve Ratio (LRR). Primary, deposits refer to initial deposits with the commercial banks.
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Given the amount of primary deposits (or initial deposits), and the legal reserve ratio (LRR), total deposits creation, (or credit creation or money creation) will be:, Total credit creation (or money creation), = Initial deposits × 1/Legal Reserve Ratio, , Money creation (or deposits creation or credit creation) is, a process by which a commercial bank creates total, deposits number of times the primary deposits., Process of money creation (or deposits creation or credit, creation) is based on the following assumptions:, (i) There is single banking system in the economy., (ii) All transactions are routed through banks. One who, makes payment does it by writing cheque. The one who, receives payment deposits the same in his deposit account.
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Numerical Example, Suppose customer deposits `10,000 in bank and the, legal reserve ratio (LRR) proposed by the Central Bank, is 20%. Bank has to pay interest on this amount for, which bank should lend this money to someone. A part, of the amount is to be retained with bank to meet its, customers' obligations. Since LRR is 20%,the bank will, keep 20% of deposits as reserves, i.e., `2,000 and will, lend the remaining 80%, i.e. `8,000. Those who borrow, will spend this money and same `8,000 will come back, to bank in the form of deposits. This raises the total, deposits to `18,000 now. Bank again keeps 20% of, `8,000,i.e. `1,600 as reserves and lend `6,400 to those, who needs. This will further raise the deposits with
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bank. In this way deposits will go on increasing @ 80%, of the last deposit., , , , Top Tip, , The deposits creation comes to an end when total reserves, become equal to the initial deposit, i.e. `10,000., Deposits creation by commercial bank, (with initial deposits `10,000 and LRR 20%), Rounds, , Deposits (`), , Loans (`), , Reserves (`), , I, II, III, , , 10,000, 8,000, 6,400, , , 8,000, 6,400, 5,120, , , 2,000, 1,600, 1,280, , , Total, , 50,000, , 40,000, , 10,000
Page 899 :
Total deposits creation (or credit creation or money, creation) = Initial deposits × 1/LRR, = `10,000 × 1/0.2, = `10,000 × 5, = `50,000, How many times the total deposits would be of the, initial deposit is determined by the LRR. The multiple, called the money multiplier (or deposit multiplier or, credit multiplier) is:, Money multiplier = 1/Legal Reserve Ratio, , In our example, Legal Reserve Ratio is 20%, therefore,, money multiplier = 1/0.2 = 5, Thus, the total deposit creation is 5 times the initial, deposit.
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Money Multiplier – Its role in determining, credit creation power of banks, Meaning, Money Multiplier (or Credit Multiplier or Deposit, Multiplier) is the number by which total deposits, can increase due to a given change in deposits., Money Multiplier (or Credit Multiplier or Deposit, Multiplier) is inversely related to legal reserve ratio., Money multiplier = 1/Legal Reserve Ratio, Money multiplier measures the amount of money that, the banks are able to create in the form of total deposits, with every initial deposit.
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Role in determining credit creation power, of banks, The credit creation by commercial banks depends on, money multiplier. There is a direct relationship, between money multiplier and total credit creation by, commercial banks., Lower the money multiplier, lesser will be total, credit creation by the commercial banking system, and vice-versa., Total credit creation, = Initial deposits × Money Multiplier (1/LRR)
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Numerical Example, Suppose the LRR is 20% and initial deposit is `10,000., Money multiplier = 1/LRR = 1/0.20 = 5; and Total credit created =, `10,000 × 5 = `50,000, Whereas, suppose LRR is increased by the Central Bank to 50%, and initial deposits remain the same, i.e. `10,000., Then, Money multiplier = 1/0.50 = 2; and Total credit created =, `10,000 × 2 = `20,000., Direct relationship between money multiplier and credit creation, Legal Reserve, Ratio, , Money multiplier, (= 1/LRR), , Credit creation = Initial, deposits × 1/LRR, , 20%, , 1/0.20 = 5, , `10,000 × 5 = `50,000, , 50%, , 1/0.50 = 2, , `10,000 × 2 = `20,000, , Thus, with the same initial deposit total credit creation decreases, with a decrease in the value of money multiplier.
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Legal Reserve Ratio – Its influence in, the process of credit creation by banks, Legal Reserve Ratio (LRR) is the minimum reserves, that a commercial bank must maintain as per the, instructions of the Central Bank., Credit creation is inversely related to the legal, reserve ratio., Total credit creation (or money creation) = Initial, deposits × 1/Legal Reserve Ratio, Higher the legal reserve ratio, lesser will be the, credit creation by the commercial banking, system and vice-versa.
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Numerical Example, Suppose the LRR is 20% and initial deposit is `10,000., Total credit creation = Initial Deposits × 1/LRR = 10,000 × 1/0.2 =, 10,000 × 5 = `50,000, Now suppose, if the LRR is increased by the Central Bank to, 50% and initial deposits remain the same., Total credit creation = Initial Deposits × 1/ LRR = 10,000 × 1/0.5 =, 10,000 × 2 = `20,000., Inverse relationship between LRR and credit creation, Legal Reserve Ratio, , Credit creation = Initial deposits × 1/LRR, , 20%, , 10,000 × 1/0.2 = `10,000 × 5 = `50,000, , 50%, , 10,000 × 1/0.5 = `10,000 × 2 = `20,000, , Thus, any increase in LRR will decrease the credit creation power of, the commercial banks (banking system).
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Key Term, Legal Reserve Ratio (LRR) – It is the minimum reserve that a commercial, bank must maintain as per the instructions of the central bank., Cash reserve ratio (CRR) – It is the fraction of net total demand, and time deposits that commercial banks must keep as cash, reserves with the Central Bank., Statutory liquidity ratio (SLR) – It is the fraction of net total, demand and time deposits that commercial banks must keep with, themselves in the form of specified liquid assets., Money creation (or deposits creation or credit creation) – It is a, process by which a commercial bankcreates total deposits number, of times the primary deposits., Primary deposits – It refers to the initial deposits with commercial, banks., Money Multiplier (or Credit Multiplier or Deposit Multiplier) – It, is the number by which total deposits can increase due to a given, change in deposits.
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RECAP, , Money creation by commercial banks, Money creation (or credit creation or deposit creation) is a, process by which a commercial bankcreates total deposits, number of times the primary deposits. Primary deposits refer, to initial deposits with the commercial banks., Process of credit creation is based on the following, assumptions:, (i) There is single banking system in the economy., (ii) All transactions are routed through banks., Total credit creation = Initial deposits, × 1/Legal Reserve Ratio, LRR is the minimum reserve that a commercial bank must, maintain as per the instructions of the central bank., Initially, customer deposits `10,000 and LRR is 20%. Bank, keeps `2,000 as reserves to meet customers’ obligations and
Page 907 :
give loans of `8,000. Those who borrow will spend this, money and same `8,000 will ultimately come back to bank as, fresh deposits. Out of these `8,000, bank keeps 20%, i.e., `1,600 as reserves and give loans of `6,400. In this way, in, every round 80% of loans are converted into fresh deposits., Total deposits creation (or credit creation or money creation), = Initial deposits × 1/LRR, = 10,000 × 1/0.2 = 10,000 × 5 = `50,000, , Credit creation is inversely related to the legal, reserve ratio., For example, suppose LRR is 0.2 and initial deposits are, `10,000., Total credit creation = Initial Deposits × 1/LRR = 10,000 ×, 1/0.2 = 10,000 × 5 = `50,000, Now suppose, if the LRR is increased by the Central Bank to, 0.5 and initial deposits remain the same, i.e. `10,000.
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Now, total credit creation = Initial Deposits × 1/ LRR = 10,000 ×, 1/0.5 = 10,000 × 2 = `20,000., Thus, any increase in LRR will decrease the credit creation, power of the commercial banks (banking system)., , Credit creation is directly related to money multiplier., Money Multiplier (or Credit Multiplier or Deposit Multiplier), is the number by which total deposits can increase due to a, given change in deposits. Lower the money multiplier, lesser, will be the total credit created and vice-versa., Total credit creation = Initial deposits × Money Multipler, (1/LRR), For example, suppose the LRR is 0.2 and initial deposit is, `10,000. Money multiplier = 1/LRR = 1/0.2 = 5; and Total credit, created = `10,000 × 5 = `50,000., Whereas, suppose LRR is increased by the Central Bank to 0.5, and initial deposits remain the same, i.e. `10,000.
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Then, Money multiplier = 1/0.5 = 2; and Total credit created =, `10,000 × 2 = `20,000., Thus, with the same initial deposit total credit creation, decreases with a decrease in the value of money multiplier.
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Question 1, There is a limit to money or credit creation by banks,, and this is determined by the central bank (RBI). The RBI, decides a certain percentage of (i)_______ which every, bank must keep as reserves, called (ii)_______. This is, done to ensure that no bank is ‘Over lending’, (Fill in the blanks), , Objective Type Questions 2.2
Page 911 :
Answer 1, (i) Net total demand and time deposits, (ii) Legal Reserve Ratio/Reserve Ratio, , Objective Type Questions 2.2
Page 912 :
Question 2, Since banks earn interest from loans they make, any, bank would like to land the maximum possible. But, there is a limit to money or credit creation by banks, and this is determined by ___________., (Fill in the blank), , Objective Type Questions 2.2
Page 913 :
Answer 2, the central bank (RBI), , Objective Type Questions 2.2
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Question 3, Apart from the CRR, banks are also required to keep, some reserves in liquid form in the short term. This, ratio is called __________________., (Fill in the blank), , Objective Type Questions 2.2
Page 915 :
Answer 3, Statutory Liquidity Ratio (SLR), , Objective Type Questions 2.2
Page 916 :
Question 4, Deposit creation by banks comes to an end when, __________________., (Choose the correct alternative), (a), (b), (c), (d), , fresh deposits with banks become zero, legal reserve ratio becomes zero, money multiplier becomes zero, total reserves equal initial deposits, , Objective Type Questions 2.2
Page 917 :
Answer 4, (d) total reserves equal initial deposits, , Objective Type Questions 2.2
Page 918 :
Question 5, State, giving reason, whether the following, statement is true or false:, Higher the Legal Reserve Ratio (LRR), greater, would be the money creation in the economy., , Objective Type Questions 2.2
Page 919 :
Answer 5, False: Value of money multiplier is inversely related to, LRR since money multiplier = 1/LRR. Therefore, higher, the LRR, lower would be the value of money multiplier, and hence, money creation will be less in the economy., , Objective Type Questions 2.2
Page 920 :
Question 6, LRR and money creation has ____________., (Choose the correct alternative), (a) positive relation, (b) negative relation, (c) No relation, (d) Both (a) and (b), , Objective Type Questions 2.2
Page 921 :
Answer 6, (b) negative relation, , Objective Type Questions 2.2
Page 922 :
Question 7, The value of credit multiplier will be high when ______., (Choose the correct alternative), (a), (b), (c), (d), , Legal reserve ratio is high, Legal reserve ratio is low, Legal reserve ratio is zero, Legal reserve ratio is infinity, , Objective Type Questions 2.2
Page 923 :
Answer 7, (b) Legal reserve ratio is low, , Objective Type Questions 2.2
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NUMERICAL 1, Calculate the value of credit multiplier if the legal reserve, deposit ratio is 20%., (CBSE Sample Question Paper 2019) (1 mark), Solution: Credit Multiplier = 1/Legal Reserve Deposit, Ratio = 1/0.2 = 5, , Do it yourself 1, Calculate the value of money multiplier if Required Reserve, Ratio is 12.5%., (1 mark), [Ans. 8]
Page 925 :
NUMERICAL 2, If the Reserve Ratio is 20% and the primary deposits are, `100, what is the value of deposit multiplier and total, lending by the banking system?, Given the same amount of initial deposits, if the RBI, increased the Reserve Ratio to 25%, what would happen in, the economy? Explain., (NCERT) (4 marks), Solution: Deposit multiplier (or Money multiplier or, Credit multiplier) = 1/Reserve ratio = 1/20% = 1/0.2 = 5, Credit creation (or Money creation or Deposit creation) =, Primary Deposits × 1/Reserve ratio = `100 × 5 = `500, Total lending by the banking system = 500 –100 = `400
Page 926 :
If the RBI increases the Reserve Ratio to 25%, total money, creation = `100 × 1/0.25 = `100 × 4 = `400, Thus, the banking system would now be able to loan `300, only (`400 – `100). It would have to call back some loans to, meet the increased reserve requirements. Hence, money, supply would fall., , Do it yourself 2, If the Reserve Deposit Ratio is 25% and the initial deposits, of the public are `2,000, what is the value of deposit, multiplier, total deposit creation and total lending by the, banking system?, (4 marks), [Ans. Deposit multiplier = 4; Total deposit creation =, `8,000 and total lending by the banking system `6,000]
Page 927 :
NUMERICAL 3, If the total deposits created by commercial banks is `50,000, crore, and CRR is 12% and SLR is 8%, then calculate the, amount of initial deposit with the bank., (3 marks), Solution: LRR = CRR + SLR = 12 + 8 = 20% = 0.2, Therefore, Money Multiplier = 1/LRR = 1/0.2 = 5, Deposits creation = Initial deposit × 1/LRR, 50,000 = Initial deposit × 5, Initial deposit = 50,000/5 = `10,000 crore, , Do it yourself 3, Total deposits created by commercial banks is `12,000 crore, and LRR is 25%. Calculate the amount of initial deposits., [Ans. `3,000 crore], (3 marks)
Page 928 :
NUMERICAL 4, Calculate the legal reserve ratio if the initial deposit of, `10,000 crore lead to a creation of total deposits of `1,00,000, crore., (3 marks), Solution: Deposits creation = Initial deposits × 1/LRR, 1,00,000 = 10,000 × 1/LRR, 1/LRR = 1,00,000/10,000, 1/LRR = 10, LRR = 1/10 = 0.1 or 10%, , Do it yourself 4, Calculate the legal reserve ratio if the initial deposit of `25,000, crore lead to a creation of total deposits of `1,25,000 crore., [Ans. 20%], (3 marks)
Page 929 :
2.3, , Central Bank and Its Functions, , Central Bank – Meaning, The Central Bank is the apex institution of a, country's monetary system. The design and the, control of the country's monetary policy is its, main responsibility., India got its Central Bank in 1935. Its name is the, 'Reserve Bank of India (RBI)'. It is the apex bank, engaged in regulating commercial banks in India.
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Functions of the Central Bank, 1. Authority of Currency Issue/Bank of issue, The Central Bank is the sole authority for the issue of, currency in the country. It promotes efficiency in the, financial system. Firstly, because this leads to uniformity, in the issue of currency. Secondly, because it gives, Central Bank direct control over money supply.
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2. Banker to the Government/Government's, Bank, The Central Bank acts as a banker to the government, (both Central government as well as State governments)., Banker to the government means that the Central Bank, gives the same banking facilities to the government, which commercial banks give to the general public. The, Central Bank does not give such facilities to the general, public., As the banker to the government, the central bank, provides a large number of routine banking, functions to the government like maintaining the, balances, arranging and managing funds of the, government and so on.
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It gives loan to the government., It accepts receipts and makes payments for the, government., It works as agent of the government in matters of, collection of taxes, etc., It manages public debt., It also acts as a financial advisor to the government.
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3. Bankers' Bank, , As the banker to the commercial banks, the Central, Bank holds surplus cash reserves of commercial banks., It also gives loans to the commercial banks when, they are in need of funds., The Central Bank also provides a large number of, routine banking functions to the commercial banks,, like cheque clearing, remittance facilities, etc., It also acts as a supervisor and a regulator of the, banking system. It makes rules regarding their, licensing, branch expansion, liquidity of assets,, amalgamation (merging of banks) and liquidation, (the winding up of banks), etc. The control is, exercised by periodic inspection of banks and the, returns filed by them.
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What role of RBI is known as 'lender of last resort'?, When commercial banks need more funds in order to be, able to create more credit,they may go to market for, such funds or go to the Central Bank. Central bank, provides them funds through various instruments., ‘Lender of Last Resort' refers to the role of the Central, Bank (RBI), of being ready to lend to banks, especially, when a bank is faced with unanticipated severe financial, crises, and due to this central bank is said to be the, ‘lender of last resort’., If the central bank refuses to extend this help, there is, no option for the bank but to shut down.
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, , Top Tip, , Commercial banks are legally required to keep only a, fraction of deposits as cash reserves. This is because not all, depositors approach the banks for withdrawal of money at, the same time, and also that normally they withdraw a, fraction of deposits. Secondly, there is a constant flow of, new deposits into the banks. Therefore, to meet the daily, demand for withdrawal of cash, it is sufficient for banks to, keep only a fraction of deposits as cash reserves. However,, if suppose all the account-holders want to withdraw their, deposits at the same time, the bank will not have enough, funds to satisfy the need of every account holder. This, situation is called 'bank run'. The bank may approach the, Central Bank, which then lends money to meet its emergent, needs.
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4. Controller of Credit, 'Credit control' is the most crucial function played by, any Central Bank in the modern times. The primary, objective of credit control is to remove causes, responsible for instability in price fluctuations which, in turn are related to the supply of money. By, controlling credit, the Central Bank can exercise an, effective control over economic activity and mobilise it, in the desired direction., In India, The RBI controls the money supply in the, economy in various ways. The tools used by the Central, bank to control money supply can be quantitative or, qualitative.
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Quantitative tools control the extent of money, supply by changing the Cash Reserve Ratio (CRR), or Statutory Liquidity Ratio (SLR) or Bank Rate or, Repo Rate or Reverse Repo Rate, or through Open, market operations (OMO)., Qualitative tools include persuasion by the, Central Bank in order to make commercial banks, discourage or encourage lending which is done, through margin requirement, moral suasion, etc., , , , Top Tip, , The policy adopted by the Central Bank of a country in the, direction of credit control or money supply is known as Monetary, Policy. Instruments of Monetary Policy are Bank Rate, Cash, Reserve Ratio (CRR), Open Market Operations (OMO), etc.
Page 938 :
Key Term, Central Bank – Central Bank is the apex institution of a country's, monetary system. The design and the control of the country's, monetary policy is its main responsibility., Bank of issue – The Central Bank is the sole authority for the issue, of currency in the country., Lender of Last Resort – It refers to the role of the Central Bank, (RBI), of being ready to lend to banks, especially when a bank is, faced with unanticipated severe financial crises., Monetary Policy – The policy adopted by the Central Bank of a, country in the direction of credit control or money supply is, known as Monetary Policy., Credit Control – The central bank controls the money supply and, credit in the best interests of the economy by taking recourse to, various quantitative and qualitative tools.
Page 939 :
RECAP, , Functions of the Central Bank, The Central Bank is the apex institution of a country’s, monetary system. India’s central bank is the ‘Reserve Bank of, India’. It is the apex bank engaged in regulating commercial, banks. Four main functions of Central Bank are:, 1. Authority of Currency Issue/Bank of issue: The Central, Bank is the sole authority for the issue of currency in the, country. It promotes efficiency in the financial system., Firstly, because this leads to uniformity in the issue of, currency. Secondly, because it gives Central Bank direct, control over money supply., 2. Government’s Bank: The Central Bank acts as a banker to, both central as well as state governments. • The Central, Bank keeps accounts of government and accepts deposits, from government.
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• The Central Bank accepts receipts and makes payments, for the government. • It carries out exchange, remittance, and other banking operations for the government. • It, advances credit/loan to the government to meet its, requirements in case of crisis. • It also acts as an agent to, buy and sell government securities and advises the, government on various financial matters., 3. Bankers’ Bank: • As the banker to the banks, the Central, Bank holds surplus cash reserves of commercial banks. • It, also lends to commercial banks when they are in need of, funds. • Central Bank also provides a large number of, routine banking functions to the commercial banks. • It also, acts as a supervisor and a regulator of the banking system., Central Bank acts as the ‘Lender of Last Resort’: It refers, to the role of the Central Bank (RBI), of being ready to lend, to banks, especially when a bank is faced with unanticipated
Page 941 :
severe financial crises, and due to this central bank is said to be, the ‘lender of last resort’. If the central bank refuses to extend, this help, there is no option for the bank but to shut down., 4. Controller of Credit: The primary objective of credit control, is to remove causes responsible for instability in price, fluctuations which in turn are related to the supply of money., By controlling credit, the Central Bank can exercise an, effective control over economic activity and mobilise it in the, desired direction. Central Bank regulates the volume and use, of credit by using quantitative and qualitative tools., Quantitative tools control the extent of money supply by, changing the Cash Reserve Ratio (CRR) or Statutory, Liquidity Ratio (SLR) or Bank Rate or Repo Rate or Reverse, Repo Rate, or through Open market operations (OMO)., Qualitative tools include persuasion by the Central Bank in order, to make commercial banks discourage or encourage lending, which is done through margin requirement, moral suasion, etc.
Page 942 :
Question 1, When commercial banks need more funds in order to, be able to create more credit, they may go to market for, such funds or go to the Central Bank. Central Bank, provides them funds through various instruments. This, role of RBI, that of being ready to lend to banks at all, times is a important function of the central bank, and, due to this central bank is said to be the __________., (Fill in the blank), Objective Type Questions 2.3
Page 943 :
Answer 1, lender of last resort, , Objective Type Questions 2.3
Page 944 :
Question 2, The RBI controls the money supply in the economy in, various ways. The tools used by the central bank to, control money supply can be quantitative or qualitative., ____________ tools include persuasion by the central, bank in order to make commercial banks discourage or, encourage lending. ________ tools control the extent of, money supply. (Quantitative/Qualitative), (Fill in the blanks), , Objective Type Questions 2.3
Page 945 :
Answer 2, Qualitative; Quantitative, , Objective Type Questions 2.3
Page 946 :
Question 3, Match the following:, (a) CRR, Bank rate, open, market operations, etc., (b) Moral suasion, margin, requirements, etc., , (i) Quantitative credit control, techniques, (ii) Qualitative credit control, techniques, , Objective Type Questions 2.3
Page 947 :
Answer 3, (a) — (i), (b) — (ii), , Objective Type Questions 2.3
Page 948 :
Question 4, Monetary policy is the policy of, (Choose the correct alternative), (a), (b), (c), (d), , Government, Central Bank, Commercial Bank, NABARD, , Objective Type Questions 2.3
Page 949 :
Answer 4, (b) Central Bank, , Objective Type Questions 2.3
Page 950 :
Question 5, The bank that operates without any profit motive in, public interest is, (Choose the correct alternative), (a), (b), (c), (d), , Central Bank, Nationalised Commercial Bank, Canara Bank, Punjab National Bank, , Objective Type Questions 2.3
Page 951 :
Answer 5, (a) Central Bank, , Objective Type Questions 2.3
Page 952 :
Question 6, CRR stands for, (Choose the correct alternative), (a), (b), (c), (d), , Credit Reserve Ratio, Cash Reserve Ratio, Commercial Reserve Ratio, Central Reserve Ratio, , Objective Type Questions 2.3
Page 953 :
Answer 6, (b) Cash Reserve Ratio, , Objective Type Questions 2.3
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Question 7, Which of the following is the function of the Central, Bank?, (Choose the correct alternative), (a) Accepting deposits from the general public, (b) Giving loans to general public, (c) Bankers’ Bank, (d) Credit Creation, , Objective Type Questions 2.3
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Answer 7, (c) Bankers’ Bank, , Objective Type Questions 2.3
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Aggregate demand and its components., Propensity to consume and propensity to save, , (average and marginal)., Short-run equilibrium output; investment, multiplier and its mechanism., Meaning of full employment and involuntary, unemployment.
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Problems of excess demand and deficient, , demand; measures to correct them - changes in, government spending, taxes and money supply, through Bank Rate, CRR, SLR, Repo Rate and, Reverse Repo Rate, Open Market Operations,, Margin requirement.
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Ex-ante and Ex-post Measures, Ex-ante measures, The planned values of the variables are called their exante measures. For example, ex-ante consumption, exante savings and ex-ante investment., Ex-ante consumption: It refers to planned, consumption expenditure on final goods in the, economy., Ex-ante investment: It refers to planned, investment expenditure on final goods in the, economy., Ex-ante savings: It refers to the planned savings at, different levels of income in an economy.
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Ex-post measures, The actual (or realised or accounting) values of the, variables is called their ex-post measures. For, example, ex-post savings, ex-post investment, etc., Ex-post savings: Ex-post savings are the actual, amount of savings made in the economy during a, period., Ex-post investment: Ex-post investments are the, actual amount of investments made in the economy, during a period.
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, , Top Tip, , Ex-ante savings and ex-post savings may or may not be equal, because ex-ante savings are those which all the households, plan to make at different levels of income during a period,, whereas ex-post savings are the actual amount of savings, made in the economy during a period., , The ex-ante variables (e.g. ex-ante consumption,, ex-ante investment, etc.) are the basis of, determination of national income.
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3.1, Consumption Function:, Propensity to Consume, Consumption Function:, Propensity to Consume
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Consumption Function, The most important determinant of consumption demand, is household income., A consumption function describes the relation, between consumption and income., The simplest consumption function assumes that, consumption changes at a constant rate as income, changes. Of course, even if income is zero, some, consumption still takes place. If your income is zero in, a certain period, you use your past savings or borrow, money to buy certain minimum consumption items in, order to survive. Hence, it is not possible to think of a, situation where there is no consumption at all. Since, this level of consumption is independent of income,
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it is called autonomous consumption., We can describe consumption function as:, , Here, C = Consumption expenditure by households, Y = Level of income in the economy, = Autonomous consumption (i.e. consumption, expenditure at zero income), b = Slope of the consumption function (It measures, rate of change in consumption per unit change in, income.)
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, , Top Tip, , Note that the equation of a straight line is y = mx + c, where y, is the dependent variable, x is the independent variable, m is, the slope of the straight line (i.e. Dy/Dx) and c is the intercept,, i.e. value of y when x is zero., Therefore, C = C + bY is a linear consumption function, i.e. a, straight line consumption function, where:, • Consumption (C) is the dependent variable and income (Y), is the independent variable. Clearly, consumption, expenditure depends on the level of income., • b = Slope of the consumption function, i.e. DC/DY (slope, means change in dependent variable due to a given, change in independent variable), • The intercept C is the level of consumption (C) when, income (Y) is zero, i.e. autonomous consumption
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Components of Consumption Function, The consumption function C = + bY consists of the, two components – (i) Autonomous consumption, and (ii) Induced consumption ( bY )., 1. Autonomous consumption: It refers to the, minimum level of consumption for survival even at a, zero level of income. It is called autonomous, consumption because the consumption expenditure, does not depend upon the level of income., If consumption takes place even when income is zero,, it is because of autonomous consumption. It is denoted, by and shows the consumption which is independent, of income., 2. Induced consumption: Induced consumption is
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directly determined by the level of income. Clearly, bY, shows dependence of consumption on income. directly, determined by the level of income. Clearly, bY shows, dependence of consumption on income., Example: Suppose the consumption function in an, economy is C = `100 crore + 0.8Y and the level of, income is `800 crore. Autonomous Consumption, = ` 100 crore and Induced Consumption (bY) = 0.8Y =, 0.8 × `800 crore = `640 crore (since Y = `800 crore)
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Marginal Propensity to Consume, In the consumption function equation C =, + bY, 'b', represents the slope of the consumption function. It is, called Marginal Propensity to Consume (MPC)., MPC may be defined as change in consumption, due to a given change in income.
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, , Top Tip, , MPC represents the slope of the consumption function as it, represents change in consumption due to a given change in income, (MPC = ∆C/∆Y). In Keynesian analysis, MPC is assumed to be, constant. Therefore, the consumption function will be a straight line, (linear) consumption curve. However, in reality, MPC has a tendency, to decline., , What can be the value of MPC?, Generally, MPC lies between 0 and 1 (inclusive of both, values)., As income increases, consumers may choose not to, change consumption at all (i.e. ∆C = 0). In this case, MPC = 0 (since MPC = ∆C/∆Y = 0/ ∆Y = 0)
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On the other hand, as income increases, consumers, may use entire increase in income on consumption,, i.e. ∆C = ∆Y. Thus, MPC = ∆C/∆Y = ∆C/ ∆C = 1., Also, as income increases, consumers may use a part of, the increase in income for increasing consumption, i.e., ∆C < ∆Y. Thus, MPC < 1. However, MPC is greater than, 0 because consumption cannot be zero even at zero, income. There has to be a minimum or subsistence, level of consumption even at zero income, called, autonomous consumption. Thus, when consumers, use a part of the increase in income for increasing, consumption, 0< MPC < 1.
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, , Top Tip, , When income changes, change in consumption (∆C) can never, exceed the change in income (∆Y). Therefore, value of MPC, cannot exceed 1. In other words, the maximum value of MPC, can be 1.
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Average Propensity to Consume, Average Propensity to Consume (APC) is the consumption, per unit of income. In other words, APC is the ratio of, consumption and income at a given level of income.
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Consumption Schedule, Imagine a country Imagenia which has a consumption, function described by: C = 100 + 0.8Y, This indicates that even when Imagenia does not have, any income, its citizens still consume `100 crore worth, of goods. Thus, Imagenia’s autonomous consumption, is `100 crore. Its marginal propensity to consume is 0.8., This means that if income goes up by `100 in Imagenia,, consumption will go up by `80. In other words, people, spend 80% of rise in income on consumption.
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Table 3.1: Consumption Schedule, Income, (Y), , DY, , Consumption, (C), , DC, , MPC, (DC/DY), , APC, (C/Y), , 0, , –, , 100, , –, , –, , –, , 100, , 100, , 180, , 80, , 0.8, , 1.80, , 200, , 100, , 260, , 80, , 0.8, , 1.30, , 300, , 100, , 340, , 80, , 0.8, , 1.13, , 400, , 100, , 420, , 80, , 0.8, , 1.05, , 500, , 100, , 500, , 80, , 0.8, , 1, , 600, , 100, , 580, , 80, , 0.8, , 0.97, , 700, , 100, , 660, , 80, , 0.8, , 0.94, , 800, , 100, , 740, , 80, , 0.8, , 0.93, , 900, , 100, , 820, , 80, , 0.8, , 0.91, , 1000, , 100, , 900, , 80, , 0.8, , 0.90
Page 975 :
Column (3) shows the consumption expenditure at, various levels of income. The values in column (3), are obtained from the consumption function, equation C = 100 + 0.8Y. For example:, When income (Y) = `100 crore, consumption (C) =, 100 + 0.8 × 100 = 100 + 80 = ` 180 crore., When Y = ` 200 crore, C = 100 + 0.8 × 200 = 100 +, 160 = ` 260 crore., Column (5) shows MPC, which is equal to ∆C/∆Y., For example, as income increases from ` 100 crore, to `200 crore (∆Y=`100 crore), the consumption, increases from ` 180 crore to ` 260 crore, (∆C = ` 80 crore) and thus MPC = 80/100 = 0.8.
Page 976 :
Consumption Curve, Figure 3.1 shows the graph of the consumption, function given by the equation: C = 100 + 0.8Y, The consumption curve does not start from origin, because of the assumption that there is some, minimum level of consumption even at zero level of, income, called autonomous consumption., Thus, the consumption curve starts from the Y-axis at a, distance equal to autonomous consumption from the, origin., The 45° line from origin has the feature that every, point on it has the same horizontal and vertical, coordinates. Since income is shown on the horizontal, axis (i.e. X-axis) and consumption on the vertical axis
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(i.e. Y-axis), therefore at every point on the 45° line,, consumption is equal to income., Thus, the 45° line tells us whether consumption is, equal to, greater than, or less than income.
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The consumption curve crosses the 45° line at point, B. This point is known as the break-even point, (B.E.P.)., Break-even point is the point at which the level of, consumption is equal to the income., In Figure 3.1, point B is the B.E.P. because consumption, (C) = income (Y) = `500 crore., Since C = Y, therefore APC = C/Y = C/C = 1. (Thus, at, break even point APC = 1), When the consumption curve lies above the 45° line,, consumption is greater than income (C > Y). For example,, at an income level (Y) = `200 crore, the consumption (C) is, ` 260 crore. The households must find funds (`60 crore) to, meet this consumption expenditure. They will either
Page 979 :
sell the assets acquired in the past, or will borrow. This, act of the households is called dis-saving., Since C > Y, APC > 1. (Thus, before break even point, APC > 1), When the consumption curve lies below the 45° line,, consumption is less than income (C < Y). For example,, at an income level (Y) = ` 900 crore, consumption (C), is `820 crore., Since C < Y, APC < 1. (Thus, after break even point APC, < 1)
Page 980 :
, , Top Tip, , The value of APC can be greater than one when total, consumption is greater than total income (i.e., C > Y) before, break even point, due to the existence of autonomous, consumption.
Page 981 :
RECAP, , Ex-ante and Ex-post Measures, The planned values of the variables–consumption, savings,, investment etc.–are called their ex-ante measures whereas, the actual or realised value of the variables is called their expost measures. The ex-ante variables (ex-ante consumption, and ex-ante investment) are the basis of determination of, national income., •Ex-ante consumption refers to planned consumption, expenditure on final goods in the economy., •Ex-ante investment refers to planned investment, expenditure on final goods in the economy., •Ex-ante savings refers to the planned savings at different, levels of income in an economy., Consumption Function, Consumption function describes the relation between
Page 982 :
consumption and income. Consumption function:, C = C + bY., Consumption function has two components:, (i) Autonomous consumption (C): It refers to to the, minimum level of consumption for survival even at a zero, level of income. It is called autonomous consumption, because the consumption expenditure does not depend, upon the level of income., (ii) Induced consumption (bY): It is directly determined, by the level of income. Clearly, bY shows dependence of, consumption on income., For example, if the consumption function equation is C =, 100 + 0.8Y, C = 100 and MPC = 0.8, so when income rises by, `100, induced consumption rises by ` 80 (0.8 × 100)., Marginal propensity to consume (MPC), MPC is the change in consumption due to a given change in
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income. It is denoted by ‘b’ and is equal to ∆C/∆Y., MPC represents the slope of the consumption function as it, represents change in consumption due to a given change in, income (MPC = ∆C/∆Y)., • When income changes, change in consumption (∆C) can, never exceed the change in income (∆Y). Therefore, the, maximum value of MPC can be 1., • Generally, MPC lies between 0 and 1 (inclusive of both, values). This means that as income increases either the, consumers do not increase consumption at all (MPC = 0), or use entire change in income on consumption (MPC =, 1) or use part of the change in income for changing, consumption (0< MPC<1)., Average Propensity to consume (APC), APC is the consumption per unit of income, i.e. C/Y. In, other words, APC is the ratio of consumption and income, at a given level of income.
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Key Terms, Ex-ante and ex-post — Ex-ante variable is the planned or, expected value of the variable whereas, ex-post variable is the, actual or realised value of the variable. Ex-ante and ex-post — Exante variable is the planned or expected value of the variable, whereas, ex-post variable is the actual or realised value of the, variable., Ex-ante consumption — It refers to planned consumption, expenditure on final goods in the economy., Ex-ante investment — It refers to planned investment, expenditure on final goods in the economy., Ex-ante savings — It refers to the planned savings at different, levels of income in an economy., Ex-post investment — Ex-post investments are the actual amount, of investments made in the economy during a period., Consumption function — It describes the relation between, consumption and income.
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Break-even point — The point at which the level of consumption, is equal to the income., Autonomous consumption — Consumption at zero level of, income i.e., consumption which is independent of income. It is the, subsistence level of consumption., Induced consumption — The consumption expenditure which is, dependent on the level of income., Marginal propensity to consume (MPC) — Change in, consumption per unit change in income, i.e. DC/DY., Average propensity to consume (APC) — APC is the consumption, per unit of income, i.e. C/Y.
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NUMERICAL 1, Given the consumption function of an economy:, C = `100 crore + 0.75Y, The equilibrium level of income is `900 crore., Calculate the values of the two components of the, consumption function when the economy is in, equilibrium., (3 marks), Solution: The values of the two components of the, consumption function are:, Autonomous Consumption (a) = `100 crore, Induced consumption (bY)= 0.75 × `900 crore = `675, crore
Page 987 :
Do it yourself 1, Calculate autonomous consumption and induced consumption, from the following:, National income = `1,000 crore, MPC = 0.75 and, Consumption expenditure = ` 850 crore, (3 marks), [Ans. (i) Autonomous consumption, a = ` 100 crore; (ii), Induced consumption, bY = ` 750 crore]
Page 988 :
Solution of Do it yourself 1, C = a + bY, where b = MPC = 0.75, Therefore, 850 = a + 0.75 × 1,000 ⇒ 850 = a + 750 ⇒ a =, 100, (i) Autonomous consumption, a = `100 crore, (ii) Induced consumption, bY = `750 crore
Page 989 :
NUMERICAL 2, Given the consumption function of an economy C = `100, crore + 0.8Y., (a) What are the values of autonomous consumption, and the slope of consumption function?, (b) What is the level of income at Break-Even Point?, (3 marks), Solution: (a) From the consumption function C = 100 +, 0.8Y, autonomous consumption = `100 crore, Slope of consumption function = MPC = 0.8, (b), At Break even point, C = Y, 100 + 0.8Y = Y, Y – 0.8 Y = 100, 0.2Y = 100, Y = 100/0.2 = 500
Page 990 :
Therefore, break even level of income = `500 crore
Page 991 :
Do it yourself 2, Given the consumption function of an economy C = `100, crore + 0.75Y, calculate:, (a)Values of autonomous consumption and slope of, consumption function., (b) The level of income corresponding to the Break-Even, Point., (3 marks), [Ans. Autonomous consumption = `100 crore; Slope of, consumption function = 0.75; Level of income corresponding to, the Break-Even Point = `400 crore]
Page 992 :
Solution of Do it yourself 2, (a) Autonomous consumption = `100 crore, Slope of consumption function = MPC = 0.75, (b) Break-even point is the level of income at which, consumption and income are equal, i.e., C = Y, C = 100 + 0.75Y ⇒, 100 + 0.75Y = Y ⇒ Y – 0.75Y =, 100, 0.25Y = 100 ⇒ Y = 100/0.25 = 400, Therefore, the level of income corresponding to the, Break-Even Point = `400 crore
Page 993 :
NUMERICAL 3, Given that National Income is ` 80 crore and, consumption expenditure `64 crore, find out average, propensity to consume. When income rises to ` 100 crore, and consumption expenditure to ` 78 crore, what will be, the APC and MPC?, (3 marks), Solution:, Income, (Y), , ∆Y, , Consumption, (C), , ∆C, , APC, (C/Y), , MPC, (∆C/∆Y), , 80, 100, , –, 20, , 64, 78, , –, 14, , 0.8, 0.78, , –, 0.7
Page 994 :
Do it yourself 3, If national income is `50 crore and consumption `45 crore,, find out average propensity to consume. When income rises, to `60 crore and consumption by `6 crore, what will be the, APC and MPC?, (3 marks), [Ans. APC 0.9, 0.85 and MPC 0.6]
Page 995 :
Solution of Do it yourself 3, Income, (Y), , ∆Y, , Consumption, (C), , ∆C, , APC, (C/Y), , MPC, (∆C/∆Y), , 50, 60, , –, 10, , 45, 51, , –, 6, , 0.9, 0.85, , –, 0.6
Page 996 :
Question 1, State which of the following statements are true or false., Give valid reasons., (CBSE 2019) (3 marks), (a) According to Keynesian theory of employment, Ex-ante, savings and Ex-post savings are always equal., (b) In a two-sector economy if income is zero, consumption, will also be zero., , HOTs 3.1— Analysing, Evaluating & Creating Type Questions
Page 997 :
Answer 1, (a) The given statement is false, as ex-ante savings are, those which all the households plan to make at, different level of income during a period, whereas, ex-post savings are the actual amount of savings, made in the economy during a period. So, the two, may or may not be equal., (b) The given statement is false, even at zero level of, income there is still some minimum consumption, (autonomous consumption) in the economy, as it is, essential for survival., HOTs 3.1— Analysing, Evaluating & Creating Type Questions
Page 998 :
Question 2, Why does consumption curve not start from the origin, ?, (CBSE 2018) (1 mark), , HOTs 3.1— Analysing, Evaluating & Creating Type Questions
Page 999 :
Answer 2, Consumption curve does not start from origin because of, the assumption that there is some minimum level of, consumption even at zero level of income., , HOTs 3.1— Analysing, Evaluating & Creating Type Questions
Page 1000 :
Question 3, Value of which of the following can be greater than one, and why?, (1 mark), (a) Marginal Propensity to Consume (MPC), (b) Average Propensity to Consume (APC), , HOTs 3.1— Analysing, Evaluating & Creating Type Questions
Page 1001 :
Answer 3, (b) The value of Average Propensity to Consume (APC) can, be greater that one. This is because total consumption can, be greater than total income, due to the existence of, autonomous consumption., , HOTs 3.1— Analysing, Evaluating & Creating Type Questions
Page 1002 :
Question 4, Giving valid reason, state whether the following, statement is true or false:, (1 mark), Marginal propensity to consume represents the slope of, the consumption function., , HOTs 3.1— Analysing, Evaluating & Creating Type Questions
Page 1003 :
Answer 4, The given statement is true, as MPC represents change in, consumption due to a given change in income., (MPC = ΔC/ΔY), , HOTs 3.1— Analysing, Evaluating & Creating Type Questions
Page 1004 :
Question 1, The ratio of change in consumption to change in income, is called _________., (Choose the correct alternative), (a) Marginal propensity to consume, (b) Marginal propensity to save, (c) Average propensity to consume, (d) Average propensity to save, , Objective Type Questions 3.1
Page 1005 :
Answer 1, (a) Marginal propensity to consume, , Objective Type Questions 3.1
Page 1006 :
Question 2, Average propensity to consume can never be zero., (True/False), , Objective Type Questions 3.1
Page 1007 :
Answer 2, True:, , APC = C/Y and APC will be zero if consumption, (C) is zero which is not possible. Even if income is, zero, there is some consumption expenditure to, survive (called autonomous consumption)., , Objective Type Questions 3.1
Page 1008 :
Question 3, Average propensity to consume can be greater than one., (True/False), , Objective Type Questions 3.1
Page 1009 :
Answer 3, True, average propensity to consume can be greater than, one, when total consumption in an economy is greater than, national income due to the existence of autonomous, consumption. Households will either sell the assets acquired in, the past or will borrow to meet extra consumption, expenditure., , Objective Type Questions 3.1
Page 1010 :
Question 4, The minimum level of consumption for survival even if, income is zero is called ________ because ______ ., (Fill in the blanks), , Objective Type Questions 3.1
Page 1011 :
Answer 4, Autonomous consumption; this level of consumption is, independent of income., , Objective Type Questions 3.1
Page 1012 :
Question 5, The value of MPC can exceed one., True/False? Give valid reason., , Objective Type Questions 3.1
Page 1013 :
Answer 5, False: MPC = DC/DY. When income changes, change in, consumption (DC) can never exceed the change, in income (DY)., The maximum value of MPC can be one (MPC =, 1) when the consumers use entire change in, income on consumption (i.e. DC = DY)., , Objective Type Questions 3.1
Page 1014 :
Question 6, Which of the following is not true for MPC in an, economy?, (Choose the correct alternative), (a) MPC can be zero., (b) MPC lies between zero and one., (c) MPC can exceed one, (d) None of these, , Objective Type Questions 3.1
Page 1015 :
Answer 6, (c) MPC can exceed one, , Objective Type Questions 3.1
Page 1016 :
Question 7, The consumption function of an imaginary country is: C, = ` 80 crore + 0.7Y. Which of the following is true for, his economy?, (Choose the correct alternative), (a) Even if the country does not have any income, its, citizens still consume `80 crore., (b) People spend 70% of rise in income on consumption, (c) Both (a) and (b), (d) Autonomous consumption is `80 crore and people, spend 70% of income on consumption., Objective Type Questions 3.1
Page 1017 :
Answer 7, (c) Both (a) and (b), , Objective Type Questions 3.1
Page 1018 :
Question 8, When the consumption curve in an economy lies above, the 45° line from origin, the value of APC is :, (Choose the correct alternative), (a) Greater than one, (b) Zero, (c) One, (d) Less than one, , Objective Type Questions 3.1
Page 1019 :
Answer 8, (a) Greater than one, , Objective Type Questions 3.1
Page 1020 :
Question 9, APC can be zero at a particular level of income., True/False? Give reason., , Objective Type Questions 3.1
Page 1021 :
Answer 9, False: APC can never be zero because even at zero, income, some consumption still takes place, called, autonomous consumption., , Objective Type Questions 3.1
Page 1022 :
Question 10, The planned values of the variables are their, ___________ (ex-ante/ex-post) measures., (Fill in the blank with correct option), , Objective Type Questions 3.1
Page 1023 :
Answer 10, ex-ante, , Objective Type Questions 3.1
Page 1024 :
Question 11, In order to understand the determination of national, income, we need to know the ________ (ex-ante/expost) values of the components of aggregate demand., (Fill in the blank with correct option), , Objective Type Questions 3.1
Page 1025 :
Answer 11, ex-ante, , Objective Type Questions 3.1
Page 1026 :
Question 12, ___________ describes the relation between, consumption and income., (Fill in the blank), , Objective Type Questions 3.1
Page 1027 :
Answer 12, A consumption function, , Objective Type Questions 3.1
Page 1028 :
Question 13, Even if income is zero, some consumption still takes, place. Since this level of consumption is independent of, income, it is called __________ ., (Fill in the blank), , Objective Type Questions 3.1
Page 1029 :
Answer 13, autonomous consumption, , Objective Type Questions 3.1
Page 1030 :
Question 14, If consumption takes place even when income is zero, it, is because of __________ ., (Fill in the blank), , Objective Type Questions 3.1
Page 1031 :
Answer 14, autonomous consumption, , Objective Type Questions 3.1
Page 1032 :
Question 15, Given the consumption function of an economy: C = a +, bY, The autonomous consumption and induced, consumption are respectively denoted by _________., (Fill in the blank), , Objective Type Questions 3.1
Page 1033 :
Answer 15, a ; bY, , Objective Type Questions 3.1
Page 1034 :
Question 16, The maximum value of MPC can be _________ when, ___________ . (Fill in the blanks) The maximum value, of MPC can be _________ when ___________ ., (Fill in the blanks), , Objective Type Questions 3.1
Page 1035 :
Answer 16, 1 (one); the consumers use entire change in income on, consumption., , Objective Type Questions 3.1
Page 1036 :
Question 17, The minimum value of MPC can be ______ when, _______ ., (Fill in the blanks) The minimum value of, MPC can be ______ when _______ .(Fill in the blanks), , Objective Type Questions 3.1
Page 1037 :
Answer 17, 0 (zero) ; consumers do not increase consumption as, income increases., , Objective Type Questions 3.1
Page 1038 :
Question 18, The range of MPC is: (Choose the correct alternative), (a) between 0 and 1, (b) from 0 to 1, (c) between 1 and ∞, (d) from 1 to ∞The range of MPC is:, , Objective Type Questions 3.1
Page 1039 :
Answer 18, (b) from 0 to 1, , Objective Type Questions 3.1
Page 1040 :
Question 19, When consumers consume part of change in income,, which of the following is true?, (Choose the correct alternative), (a) MPC > 1, (b) MPC = 1, (c) MPC = 0, (d) 0 < MPC < 1, , Objective Type Questions 3.1
Page 1041 :
Answer 19, (d) 0 < MPC < 1, , Objective Type Questions 3.1
Page 1042 :
Question 20, At zero level of income, consumption is, (Choose the correct alternative), (a) zero, (b) positive, (c) negative, (d) zero or negative, , Objective Type Questions 3.1
Page 1043 :
Answer 20, (b) positive, , Objective Type Questions 3.1
Page 1044 :
Question 21, In consumption function C = a + bY, b represents, (Choose the correct alternative), (a) autonomous consumption, (b) savings, (c) MPC, (d) MPS, , Objective Type Questions 3.1
Page 1045 :
Answer 21, (c) MPC, , Objective Type Questions 3.1
Page 1046 :
Question 22, If MPC is 0.5, what will be change in consumption, if, income increases by `100 crore?, (Choose the correct alternative), (a) ` 60 crore, (b) ` 50 crore, (c) ` 40 crore, (d) ` 70 crore, , Objective Type Questions 3.1
Page 1047 :
Answer 22, (b) `50 crore, , Objective Type Questions 3.1
Page 1048 :
Question 23, APC can never be equal to 1., , True/False? Give reason., , Objective Type Questions 3.1
Page 1049 :
Answer 23, False: APC is equal to 1 when total consumption (C) is, equal to total income (Y) corresponding to the break, even point., , Objective Type Questions 3.1
Page 1050 :
3.2, Savings and Investment, Functions
Page 1051 :
Savings Function, The relationship between savings and income is called, the savings function. There is a direct (positive) relation, between income and savings. Higher the income, higher is, the level of savings and vice-versa., , Derivation of savings function from, consumption function, Savings is that part of income which is not consumed,, that is, , This equation tells us that by definition, saving is equal, to income minus consumption.
Page 1052 :
Substituting the consumption function equation C =, + bY into the above equation, we can get the savings, function equation., S = Y – ( + bY), S = Y–, – bY, S = – + (1 – b)Y, S = – + Sy, This is the savings function, where Y is the level of, income in the economy, i.e. national income and S is, the desired or planned savings at that income level., The intercept term is the amount of savings done, when there is zero level of income. It is already, shown that is, positive., Therefore, savings is, negative.
Page 1053 :
Thus, there is negative savings at zero level of, income. Since negative savings is nothing but, dissaving, this means that at zero level of income,, there is a dissaving of amount, . Note that the, amount of autonomous consumption is exactly, equal to the amount of dissaving at zero level of, income. This is because of the fact that Y = C + S, (whether S is positive or negative)., s = (1 – b) is the slope of the savings function. The, slope of the savings function gives the change in, savings due to a given change in income. This is, known as the Marginal Propensity to Save (MPS).
Page 1054 :
, , Top Tip, , MPS represents the slope of the savings function as it, represents change in savings due to a given change in income, (MPS = ∆S/∆Y).
Page 1055 :
Marginal propensity to save (MPS) is, defined as the change in savings per unit, change in income., or,, , MPS refers to the change in savings due to a, given change in income, i.e. MPS = ∆S/∆Y., , Relationship between MPC and MPS, MPC + MPS = 1, Explanation:, Since S = Y – C, therefore
Page 1056 :
⇒, , ⇒, MPS = 1 – MPC, ⇒, MPS + MPC = 1 or MPC + MPS = 1, Numerical Example:, Given the consumption function C = 100 + 0.8Y, we can, derive the corresponding savings function., , Substituting the consumption function equation C =, 100 + 0.8Y into the above equation, we can get the, savings function equation., S = Y – (100 + 0.8Y)
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S = Y – 100 – 0.8Y, S = – 100 + 0.2Y, Here, MPS = 0.2, which means that in the economy, 20% of total additional income is put into additional, savings by the people; and dissaving at zero income = `100, crore (which is equal to autonomous consumption)
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, , Top Tip, , Derivation of consumption function from savings function, Given the savings function, we can derive the corresponding, consumption function. The two functions are closely related, since, income always equals consumption plus saving (Y = C + S)., C=Y– S, Substituting the savings function equation S = – + sY into the, above equation, we can get the consumption function equation., C = Y – (– + sY) ⇒ C = Y +, – sY ⇒ C = + (1 – s) Y ⇒, C = + bY, Example: Given the savings function S = –100 + 0.2Y, we can, derive the corresponding consumption function. C = Y – S, Substituting the savings function S = –100 + 0.2Y into the, above equation, we can get the consumption function., C = Y – (–100 + 0.2Y) ⇒ C = Y + 100 – 0.2Y ⇒ C = 100 + 0.8Y
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Derivation of savings curve from, consumption curve, Figure 3.2 shows the derivation of savings curve from, consumption curve., Step 1: Draw a 45° line from origin. Given consumption, curve CC intersects it at B (Break-even point)., Corresponding to the Break-even point is the, level of income at which consumption equals, income (C = Y). Therefore, savings is zero (S =, 0)., Step 2: Take OS1 equal to O because at zero income,, negative savings is exactly equal to the, autonomous consumption., Step 3: From the break-even point B, we draw a
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perpendicular on X-axis which cuts the X-axis at, B1. At OB1 level of income, savings must be zero, because at this level of income consumption, equals income., Step 4: Join S1 and B1 and extend it by a straight line to, get the savings curve S1S.
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, , Top Tip, , Derivation of consumption curve from savings curve, Since income equals consumption plus savings, therefore,, consumption and savings curves can be called complementary, curves. Consumption curve can be derived from savings curve., Fig. 3.2 shows the derivation of consumption curve from, savings curve., Step 1: Draw a 45° line from origin., Step 2: Given the savings curve S1S, take O equal to OS1, because in the economy the autonomous consumption, is exactly equal to negative savings at zero income., Step 3: At point B1, savings = 0. We draw a perpendicular from, B1 till it intersects the 45° line at B. B is the break-even, point where consumption equals income., Step 4: Join, C and B and extend it by a straight line to get, the consumption curve C.
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Average propensity to save (APS), Average propensity to save (APS) is the savings per unit, of income, i.e. S/Y. In other words, APS is the ratio of, savings and income at a given level of income., Relationship between APC and APS: The sum of, APC and APS is equal to one., Explanation: Income is either consumed or saved., , Dividing both sides of the equation by Y, we have, , ⇒, , 1 = APC + APS
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Therefore, APS =1 – APC and APC = 1 – APS, Income, (Y), , ∆Y, , Consumpt, ion (C), , ∆C, , Savings ∆S APC APS, (S = Y–, (C/Y (S/Y), C), ), , MPC, (∆C/∆Y), , MPS, (∆S/∆Y), , 0, , —, , 100, , —, , –100, , —, , —, , —, , —, , —, , 100, , 100, , 180, , 80, , –80, , 20, , 1.80, , –0.80, , 0.8, , 0.2, , 200, , 100, , 260, , 80, , –60, , 20, , 1.30, , –0.30, , 0.8, , 0.2, , 300, , 100, , 340, , 80, , –40, , 20, , 1.13, , –0.13, , 0.8, , 0.2, , 400, , 100, , 420, , 80, , –20, , 20, , 1.05, , –0.05, , 0.8, , 0.2, , 500, , 100, , 500, , 80, , 0, , 20, , 1, , 0, , 0.8, , 0.2, , 600, , 100, , 580, , 80, , 20, , 20, , 0.97, , 0.03, , 0.8, , 0.2, , 700, , 100, , 660, , 80, , 40, , 20, , 0.94, , 0.06, , 0.8, , 0.2, , 800, , 100, , 740, , 80, , 60, , 20, , 0.93, , 0.07, , 0.8, , 0.2, , 900, , 100, , 820, , 80, , 80, , 20, , 0.91, , 0.09, , 0.8, , 0.2, , 1000, , 100, , 900, , 80, , 100, , 20, , 0.90, , 0.10, , 0.8, , 0.2, , Important observations from Figure 3.2 and Table, 3.2
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1. APC is continuously declining as income increases; and, APS is continuously increasing as income increases. This, means that as income increases, the proportion of, income saved increases and the proportion of income, consumed decreases., 2. APC can never be zero because consumption, expenditure in the economy cannot be zero. Even at zero, income, there has to be a minimum or subsistence level, of consumption expenditure, called autonomous, consumption, 3. APC (= C/Y) can be greater than one, equal to one or, less than one., • APC can be greater than one, when total consumption is, greater than national income before Break-even point,
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due to the existence of autonomous consumption. (Since, C > Y, therefore, APC > 1), • APC can be equal to one, when consumption is, equal to income (at Break-even point). (Since C = Y,, therefore, APC = 1), • APC can be less than one, when consumption is less, than income. (Since C < Y, therefore, APC < 1), 4. APS can be negative, zero or positive., • APS can be negative because of negative savings at a, low level of income(before break even point) when, total consumption is greater than national income,, due to the existence of autonomous consumption., (Since C > Y, therefore, S is negative and APS is also, negative.)
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APS can be zero when savings is zero at a level of, income when consumption is equal to income, i.e., at break even point. (Since C = Y, therefore, S = Y –, C = C –C = 0. So, APS = S/Y = 0/Y = 0), • APS is positive because of positive savings at a level,, when consumption is less than income. (Since C <, Y, therefore, S is positive and APS is also positive.), 5. Both MPC and MPS range from 0 to 1, i.e. MPC or, MPS can be 0 or 1 or between 0 and 1., 6. MPC represents the slope of the consumption, function as it represents change in consumption, due to a given change in income (MPC = ∆C/∆Y). In, Keynesian analysis, MPC is assumed to be constant., Therefore, MPC is 0.8 at all levels of income. Similarly,, •
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MPS, i.e. the slope of the savings function is the, same at all levels of income because of a linear curve, with constant slope we used in our example., 7. MPC cannot be negative because as income increases,, consumption cannot decrease. Similarly, MPS cannot be, negative because as income increases, savings cannot, decrease., 8. The sum of MPC and MPS is equal to one. This, means that the part of the increase in income, which, is not consumed, is saved. This is because income is, either consumed or saved., 9. The APC gives the average consumption- income, relationship at different levels of income. Similarly, from, the savings function, we can find out the average savings-
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income ratio. The sum of the APC and APS is always, equal to one. This is because income is either consumed, or saved.
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Investment Function, Investment expenditure refers to the addition to the, stock of physical capital and change in inventories of a, firm in an economy., Investment decisions by firms, such as whether to buy, a new machine, depend, to a large extent, on the, market rate of interest. However, for simplicity, we, assume here that firms plan to invest the same amount, every year. We can write the ex-ante investment, demand as:, where, is a positive constant which represents the, autonomous investment (or ex-ante investment), in the economy in a given year. Autonomous, investment refers to the investment expenditure which
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is independent of income. The investment expenditure, is the same, no matter whatever is the level of income., Since firms plan to invest the same amount I regardless, of the level of income or output, the investment, function/schedule/curve will be a horizontal line (i.e.,, parallel to X-axis). This is because every point on the, investment curve lies at the same height above the Xaxis. That is, the level of investment demand is the, same at every level of income.
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, , Top Tip, , Autonomous investment refers to the investment expenditure, which is independent of income whereas, Induced investment, refers to the investment expenditure which is dependent on, the level of income.
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Key Terms, Savings Function — The relationship between savings and income, is called the savings function., Marginal propensity to save (MPS) — It refers to the change in, savings due to a given change in income, i.e. MPS = ∆S/ ∆Y., Average propensity to save (APS) — It is the savings per unit of, income, i.e. S/Y., Investment expenditure — It refers to the addition to the stock of, physical capital and change in inventories of a firm in an economy., Autonomous investment — It refers to the investment, expenditure which is independent of income., Induced investment — It refers to the investment expenditure, which is dependent on the level of income.
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RECAP, , Savings Function, Savings is that part of income which is not consumed. In other, words, S = Y – C., Substituting C =, + bY, we get S = Y – ( + bY) ⇒ S = –, + (1 –, b)Y ⇒ S = – + Sy, where – is the dissavings at zero level of income. Since even at, zero level of income, there will be some minimum amount of, consumption (i.e. autonomous consumption) for survival,, therefore at zero level of income, there will be dissavings., ‘s’ is Marginal propensity to save (MPS), which refers to the, change in savings due to a given change in income, i.e. DS/DY. It, is equal to 1 – MPC., It implies that the sum of MPC and MPS is equal to 1., Explanation: Since S = Y – C, therefore, MPS = ∆S/∆Y = ∆ (Y – C)/∆Y = ∆Y/∆Y – ∆C/∆Y = 1 – MPC.
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MPS represents the slope of the savings function as it, represents change in savings due to a given change in, income (MPS = ∆S/∆Y)., Average propensity to save (APS) is the savings per unit of, income, i.e. S/Y. In other words, APS is the ratio of savings, and income at a given level of income., The sum of APC and APS is equal to one. Explanation: Y = C, + S. Dividing both sides of the equation by Y,, Y/Y = C/Y + S/Y ⇒ 1 = APC + APS., Therefore,, APS = 1 – APC and APC = 1 – APS., • When the consumption and income are equal, the savings, will be zero. Hence, APS = S/Y = 0/Y = zero., • When total consumption is greater than total income,, Savings will be negative and APS (= S/Y)will also be, negative., • When consumption is less than income, saving is
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positive. Then, APS (= S/Y) is positive., , Investment Function, Investment refers to the addition to the stock of physical, capital and change in inventories of a firm in an economy., For simplicity, we assume that firms plan to invest the same, amount every year. We can write the ex-ante investment, demand as I = I where I is a positive constant which, represents the autonomous investment in the economy in a, given year. So, investment curve will be a horizontal straight, line parallel to X-axis.
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NUMERICAL 4, Given the consumption function of an economy C =, 100 + 0.8Y., (a) Derive the corresponding savings function., (b) What is the value of slope of the savings function?, (c) Show that in this economy as income increases,, APC declines and APS increases., (6 marks), Solution:, (a) C = 100 + 0.8Y, Savings is that part of income which is not consumed,, i.e. S = Y – C = Y – (100 + 0.8Y) = –100 + 0.2Y, Thus, S = –100 + 0.2Y is the required savings function., (b) From the savings function S = – 100 + 0.2Y, the slope, of savings function (i.e. MPS) = 0.2
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(c) At Y = 1000, C = 100 + 0.8 (1000) = 100 + 800 = `900, crore, At Y = 2000, C = 100 + 0.8 (2000) = 100 + 1600 = ` 1700, crore, At Y = 3000, C = 100 + 0.8(3000) = 100 + 2400 = ` 2500, crore, Income Consumption, (Y), (C), , Savings, (S = Y – C), , APC, (C/Y), , APS, (S/Y), , 1000, , 900, , 100, , 0.9, , 0.1, , 2000, , 1700, , 300, , 0.85, , 0.15, , 3000, , 2500, , 500, , 0.83, , 0.17, , As income increases from 1000 to 3000, APC declines from, 0.9 to 0.83 but APS increases from 0.1 to 0.17.
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Do it yourself 4, Given the consumption function of an economy C = 200 +, 0.75Y., (a) Derive the corresponding savings function., (b) What is the value of slope of the savings function?, (c) Show that in this economy as income increases, APC, declines and APS increases., (6 marks), [Ans. (a) S = – 200 + 0.25Y (b) 0.25]
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Solution of Do it yourself 4, (a), , (b), , (c), , C = 200 + 0.75Y, Savings is that part of income which is not, consumed, i.e. S = Y – C, S = Y – (200 + 0.75Y) ⇒ S = –200 + 0.25Y, Thus, S = – 200 + 0.25Y is the required savings function, From the savings function S = – 200 + 0.25Y, the, slope of savings function (i.e. MPS) = 0.25, At Y = 1,000, C = 200 + 0.75 (1,000) = 200 + 750 =, `950 crore At Y = 2,000, C = 200 + 0.75 (2,000) =, 200 + 1,500 = ` 1,700 crore, At Y = 3,000, C = 200 + 0.75(3,000) = 200 + 2,250 =, ` 2,450 crore
Page 1082 :
Income, (Y), 1,000, , 2,000, , 3,000, , Consumption Savings, (C), (S = Y – C), 950, , 1,700, , 2,450, , 50, , 300, , 550, , APC, (C/Y), , APS, (S/Y), , 0.95, , 0.05, , 0.85, , 0.81, , 0.15, , 0.19, , The table shows that as income increases from 1000 to, 3000, APC declines from 0.95 to 0.81 but APS increases, from 0.05 to 0.19. The table shows that as income, increases from 1000 to 3000, APC declines from 0.95 to, 0.81 but APS increases from 0.05 to 0.19.
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NUMERICAL 5, Complete the following table:, Income, , Savings, , MPC, , APC, , 0, , –20, , 50, , –10, , –, , –, , 100, , 0, , –, , –, , 150, , 30, , –, , –, , 200, , 60, , –, , –
Page 1084 :
Solution:, (a) C = 100 + 0.8Y, Incom, e, (Y), , ∆Y, , Savings, C, (S), (Y – S), , ∆C, , MPC, (DC/DY), , APC, (C/Y), , 1000, , 900, , 100, , 0.9, , –, , –, , –, , 2000, , 1700, , 300, , 0.85, , 40, , 0.8, , 1.2, , 3000, , 2500, , 500, , 0.83, , 40, , 0.8, , 1, , 20, , 0.4, , 0.8, , 20, , 0.4, , 0.7, , As income increases from 1000 to 3000, APC declines from, 0.9 to 0.83 but APS increases from 0.1 to 0.17.
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Do it yourself 5, Complete the following table:, Income, , Savings, , 0, , –40, , 50, , (3 marks), APC, , MPC, , –20, , –, , –, , 100, , 0, , –, , 0.6, , 150, , 30, , 0.8, , –, , 200, , 50, , –, , –, , [Ans. APC 1.4, 1, 0.75 and MPC = 0.6, 0.4, 0.6]
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Solution of Do it yourself 5, Income, (Y), , ∆Y, , Savings, (S), , Consumption, (C = Y – S), , ∆C, , APC =, C/Y, , 0, , –, , – 40, , 40, , –, , –, , 50, , 30, , 50, , 100, , 150, , 200, , 50, , 50, , 50, , – 20, 0, , 50, , MPC =, DC/DY, , 70, , 30, , 1.4, , 0.6, , 150, , 30, , 0.75, , 0.6, , 100, , 120, , 30, , 20, , 1, , 0.8, , 0.6, , 0.4
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NUMERICAL 6, Complete the following table:, Income, , Consumption, , APS, , MPS, , 200, , 120, , 0.40, , 400, , 220, , –, , –, , –, , 250, , 0.50, , –
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Solution:, , *Note: APC = C/Y. When APC = 0.50, C = 250., Therefore, 0.50 = 250/Y, ⇒ Y = 250/0.50 = 500
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Do it yourself 6, Complete the following table:, , (3 marks), , Income, , Savings, , APS, , 400, , 240, , 0.4, , 800, , 440, , –, , –, , –, , 520, , 0.48, , –, , [Ans. Income = 1,000, APS = 0.45, MPS = 0.5 and 0.6], , MPC
Page 1090 :
Solution of Do it yourself 6, Income, (Y), , ∆Y, , Consum, ption, (C), , ∆C, , Savings, (S = Y – C), , ∆S, , APS, (S/Y), , APC, (1–APS), , MPS, (DS/DY), , 400, , –, , 240, , –, , 160, , –, , 0.4, , 0.6, , –, , 800, , 1,000*, , 400, , 200, , 440, , 520, , 200, 80, , 360, , 480, , 200, , 120, , 0.45, 0.48, , 0.55, , 0.52, , 0.5, 0.6, , *Note: APC = C/Y. When APC = 0.52, C = 520. Therefore, 0.52, = 520/Y, ⇒ Y = 520/0.52 = 1000
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NUMERICAL 7, In an economy, the ratio of average propensity to, consume and average propensity to save is 5 : 3. The, level of income is `6000. How much is the savings?, Calculate., (3 marks), Solution:, , Thus, savings in the economy are `2,250 crore.
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Do it yourself 7, In an economy, total savings are `2000 crore and the ratio, of average propensity to save and average propensity to, consume is 2 : 7. Calculate the level of income in the, economy., (3 marks), [Ans. ` 9,000 crore]
Page 1093 :
Solution of Do it yourself 7, APS/APC = 2/7 ⇒ (S/Y)/(C/Y) = 2/7 ⇒ S/C = 2/7, 2,000/C = 2/7 ⇒ C = 7,000, Therefore, level of income in the economy Y = C + S =, 7,000 + 2,000, = `9,000 crore
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Question 1, If APC = 0.6,APS = ___________, (Choose the correct alternative), (a) 0.4, (b) 1, (c) 2.4, (d) None of these, , Objective Type Questions 3.2
Page 1095 :
Answer 1, (a) 0.4, , Objective Type Questions 3.2
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Question 2, Average propensity to save is always greater than zero., (True/False), , Objective Type Questions 3.2
Page 1097 :
Answer 2, False: APS = S/Y. At low levels of income, consumption, (C) exceeds income (Y). So, saving (S) is negative., Therefore, APS is negative. Also, when C = Y, S =, 0. Then APS = 0. Thus, APS can be zero or, negative., , Objective Type Questions 3.2
Page 1098 :
Question 3, The value of marginal propensity to save can never be, negative., (True/False), , Objective Type Questions 3.2
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Answer 3, True: MPS = ∆S/∆Y. When income increases (∆Y is, positive), savings also increases (∆S is positive); so, MPS is positive. Also, when income decreases (∆Y, is negative), savings also decreases (∆S is negative);, so MPS is positive., , Objective Type Questions 3.2
Page 1100 :
Question 4, Average propensity to save cannot be negative., (True/False), , Objective Type Questions 3.2
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Answer 4, False: Average propensity to save can be negative at a, level when there is dissavings, i.e. when total, consumption is greater than national income, due to, the existence of autonomous consumption., , Objective Type Questions 3.2
Page 1102 :
Question 5, _____________ refers to actual or realised savings in, an economy during a year., (Choose the correct alternative), (a) Ex-ante savings, (b) APS, (c) MPS, (d) Ex-post savings, , Objective Type Questions 3.2
Page 1103 :
Answer 5, (d), , Ex-post savings, , Objective Type Questions 3.2
Page 1104 :
Question 6, Which of the following can have a negative value?, (Choose the correct alternative), (a) APC, (b) MPC, (c) MPS, (d) APS, , Objective Type Questions 3.2
Page 1105 :
Answer 6, (d) APS, , Objective Type Questions 3.2
Page 1106 :
Question 7, If C = 100 + 0.75 Y, then the corresponding Savings, Function will be expressed as:, (Choose the correct alternative), (a) S = 100 + 0.25 Y, (b) S = –100 + 0.75 Y, (c) S = –100 + 0.25 Y, (d) S = 75 + 0.25 Y, , Objective Type Questions 3.2
Page 1107 :
Answer 7, (c) S = –100 + 0.25 Y, , Objective Type Questions 3.2
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Question 8, If the savings function of an economy is given as: S = –, 100 + 0.40Y, then MPC is:, (Choose the correct alternative), (a) 1, (b) 0.40, (c) 0.60, (d) None of these, , Objective Type Questions 3.2
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Answer 8, (c) 0.60, , Objective Type Questions 3.2
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Question 9, Sum of average propensity to consume and marginal, propensity to consume is always equal to 1. (True/False), , Objective Type Questions 3.2
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Answer 9, False: Sum of APC and APS is equal to 1 and Sum of, MPC and MPS is equal to 1., , Objective Type Questions 3.2
Page 1112 :
Question 10, If APC = 1.2, APS will be zero., , (True/False), , Objective Type Questions 3.2
Page 1113 :
Answer 10, False: Since APC + APS = 1, therefore, APS = 1 – APC, = 1 – 1.2 = –0.2.Thus,APS will be negative., , Objective Type Questions 3.2
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Question 11, When the consumption function lies below the 45° line,, APS will be positive., (True/False), , Objective Type Questions 3.2
Page 1115 :
Answer 11, True: When the consumption function lies below the, 45° lines, the level of consumption is less than, the level of income. This means that there is, positive savings. Since APS = S/Y and S is positive,, therefore,APS will be positive., , Objective Type Questions 3.2
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Question 12, The value of average propensity to save can never be, greater than 1., (True/False), , Objective Type Questions 3.2
Page 1117 :
Answer 12, True: Average propensity to save (APS = S/Y) can never, be greater than 1 as savings (S) can never be, more than income (Y)., , Objective Type Questions 3.2
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Question 13, The point at which consumption curve intersects the 45, degree line,APS is zero., (True/False), , Objective Type Questions 3.2
Page 1119 :
Answer 13, True: Because at this point (called Break-even point),, consumption is equal to income and hence,, saving is zero.Therefore,APS = S/Y = 0/Y = 0, , Objective Type Questions 3.2
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Question 14, Out of the following, which can have a value more than, one?, (Choose the correct alternative), (a) MPC, (b) APC, (c) APS, (d) MPS, , Objective Type Questions 3.2
Page 1121 :
Answer 14, (b) APC, , Objective Type Questions 3.2
Page 1122 :
Question 15, The value of MPS ranges from ________ ., (Fill in the blank), , Objective Type Questions 3.2
Page 1123 :
Answer 15, 0 to 1, , Objective Type Questions 3.2
Page 1124 :
Question 16, (i)________is the rate of change in savings per unit, change in income, and is equal to (ii)________ ., (Fill in the blanks), , Objective Type Questions 3.2
Page 1126 :
Question 17, As income increases, APS ______. (increases/decreases), (Fill in the blank with correct option), , Objective Type Questions 3.2
Page 1127 :
Answer 17, increases, , Objective Type Questions 3.2
Page 1128 :
Question 18, As income increases, APC ______., (increases/decreases), (Fill in the blank with correct option), , Objective Type Questions 3.2
Page 1129 :
Answer 18, decreases, , Objective Type Questions 3.2
Page 1130 :
Question 19, __________ is the savings per unit of income., (Fill in the blank), , Objective Type Questions 3.2
Page 1131 :
Answer 19, Average Propensity to Save (APS), , Objective Type Questions 3.2
Page 1132 :
Question 20, Investment decisions by producers, such as whether to, buy a machine, depend, to a large extent on, _________., (Fill in the blank), , Objective Type Questions 3.2
Page 1133 :
Answer 20, the market rate of interest, , Objective Type Questions 3.2
Page 1134 :
Question 21, In the Keynesian analysis, we assume that firms plan to, invest the same amount every year. We can write the exante investment demand as: I = I, where I is a positive, constant which represents the ___________ in the, economy in a given year., (Fill in the blank), , Objective Type Questions 3.2
Page 1135 :
Answer 21, Autonomous (or exogenous) investment (which, means, it is the same no matter whatever is the level of, income), , Objective Type Questions 3.2
Page 1136 :
Question 22, In the consumption function, C = 200 + 0.6Y, the value, of dis-saving will be, (Choose the correct alternative), (a) 200, (b) –200, (c) 0.6, (d) 0.4, , Objective Type Questions 3.2
Page 1137 :
Answer 22, (b)–200, , Objective Type Questions 3.2
Page 1138 :
Question 23, When consumption function starts from Y-axis, it, indicates that:, (Choose the correct alternative), (a) consumption is zero when income is zero, (b) saving is negative when income is positive, (c) consumption is positive when income is zero, (d) saving is positive when income is zero, , Objective Type Questions 3.2
Page 1139 :
Answer 23, (c), , consumption is positive when income is zero, , Objective Type Questions 3.2
Page 1140 :
Question 24, Break even point occurs when, (Choose the correct alternative), (a) Y = S, (b) S = 0, (c) C > Y, (d) Y > C, , Objective Type Questions 3.2
Page 1141 :
Answer 24, (b), , S=0, , Objective Type Questions 3.2
Page 1142 :
Question 25, When consumption function starts from Y-axis, it, indicates that:, (Choose the correct alternative), (a) consumption is zero when income is zero, (b) saving is negative when income is positive, (c) consumption is positive when income is zero, (d) saving is positive when income is zero, , Objective Type Questions 3.2
Page 1143 :
Answer 25, (a), , a horizontal straight line., , Objective Type Questions 3.2
Page 1144 :
Question 26, If the MPS is 1, how much will be MPC?, (Choose the correct alternative), (a) 1, (b) 0.5, (c) 0, (d) 0.4, , Objective Type Questions 3.2
Page 1145 :
Answer 26, (c), , 0, , Objective Type Questions 3.2
Page 1146 :
Question 27, How are both APC and APS associated with National, Income?, (Choose the correct alternative), (a) both APC and APS fall with increase in National, Income, (b) both APC and APS rise with increase in National, Income, (c) APC falls APS rises with increase in national income, (d) APC rises APS falls with increase in national income, , Objective Type Questions 3.2
Page 1147 :
Answer 27, (c), , APC falls APS rises with increase in national, income, , Objective Type Questions 3.2
Page 1148 :
Question 28, If MPC = 0.4 and change in income is `1,000 crore, what, will be change in savings?, (Choose the correct alternative), (a) `400 crore, (b) `500 crore, (c) `600 crore, (d) `250 crore, , Objective Type Questions 3.2
Page 1149 :
Answer 28, (c), , `600 crore, , Objective Type Questions 3.2
Page 1150 :
Question 29, Ex-post investment means fixed capital with production, units during a particular period of time., True/False? Give reason., , Objective Type Questions 3.2
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Answer 29, False: As ex-post investment includes both fixed as well as, inventory investment with the production units, during a period of time., , Objective Type Questions 3.2
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3.3, Aggregate Demand and, Aggregate Supply
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Aggregate Demand, Aggregate Demand (AD) means the total demand for, final goods in an economy during an accounting year., It also means the aggregate expenditure on final goods, in the economy., , Components of aggregate demand, The components of aggregate demand are:, (i) Consumption Expenditure (C), (ii) Investment Expenditure(I), (iii) Government’s final expenditure (G), (iv) Net exports., 1. Consumption Expenditure(C)– It is that portion, of income which is spent on purchase of goods and
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services by the consumers in an economy during the, accounting period., 2. Investment Expenditure (I)– It refers to the, addition to the stock of physical capital and change, in inventories of a firm in an economy., Thus, in a two sector economy without a government, and external trade, ex-ante aggregate demand is sum, total of ex-ante consumption expenditure and ex-ante, investment expenditure, viz., , Substituting the values of C =, + bY and I = , ex-ante, aggregate demand for final goods can be written as:, AD = + bY +
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⇒ AD = (, Or, AD =, Where, , , , + ) + bY +, + bY, is the total autonomous expenditure., , Top Tip, , Note that the slope of aggregate demand function AD = A +, bY is given by ‘b’, i.e. MPC., , There are two components of autonomous expenditure :, (i) Autonomous consumption, (ii) Autonomous investment, In reality, these two components of autonomous, expenditure behave in different way s. representing, subsistence consumption level of an economy, remains
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more or less stable over time. However, has been, observed to undergo periodic fluctuations. We have, assumed that investment is autonomous. However, it, just means that it does not depend on income. There, are a number of factors other than income which can, affect investment. One such factor is availability of, credit, for example, easy availability of credit encourages, investment. Another factor is market rate of interest, for, example, interest rate is the cost of investible funds, and at, higher interest rates, firms tend to lower investment.
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, , Top Tip, , AD can change if there is change in consumption or/and, change in investment., 1.Change in consumption: This can happen due to (i) change in, autonomous consumption (C) or/and (ii) change in MPC., 2. Change in investment: Easy availability of credit encourages, investment. Similarly, at lower market rate of interest, firms, tend to increase investment.
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Diagrammatic Presentation, The ex-ante aggregate demand curve shows the total, demand (ex-ante consumption + ex-ante investment ), at each level of income. Graphically, it means the, aggregate demand curve can be obtained by vertically, adding the consumption and investment curves., The aggregate demand curve is parallel to the, consumption curve since they have the same slope, i.e., MPC. This is because AD = C + I, where I remains, constant irrespective of the level of income. So, AD rises, only with the rise in consumption, C. So, the slope of, the aggregate demand curve remains the same as that, of the consumption curve.
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Aggregate Supply, Aggregate Supply (AS) is the value of total quantity of, final goods and services produced in the economic, teritory of a country., In Keynesian analysis, aggregate supply refers to the, ex-ante, i.e. In a two sector economy, in the absence of, indirect taxes or subsidies, the value of total final goods, and services is distributed among the factors of, production (wages to labour, interest to capital and, rent to land). Whatever is left over is appropriated by, the entrepreneur and is called profit. Thus, the sum, total of aggregate factor payments in the economy, i.e., National Income, is equal to the aggregate value of the, output of final goods, i.e. Aggregate Supply.
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Therefore, aggregate supply curve is represented by a, 45° line from the origin because the 45° line from the, origin establishes the relation of Y = C + S., Also, since the 45° line from the origin has the feature, that every point on it has the same horizontal and, vertical coordinates, therefore, corresponding to every, point on the 45° line, AS = Y.
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Key Terms, Aggregate Demand (AD) – It means the total demand for final, goods in an economy during an accounting year., �) – It is the sum of autonomous, Autonomous expenditure (A, consumption (C� ) and Autonomous investment (I)̅, Aggregate Supply (AS) – It is the value of total quantity of final, goods and services produced in the economic teritory of a, country.
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RECAP, , Aggregate Demand (AD), It means total expenditure planned to be incurred on final goods, and services. Its components are:, (i) Consumption Expenditure(C), (ii) Investment Expenditure(I), (iii) Government’s final expenditure (G), (iv) Net exports., In a two sector economy, there are only two components of, aggregate demand, viz., (i) Consumption Expenditure (C), (ii) Investment Expenditure (I)., Consumption Expenditure(C)– It is that portion of income, which is spent on purchase of goods and services by the, consumers in an economy during the accounting period.
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Investment Expenditure (I)– It refers to the addition to, the stock of physical capital and change in inventories of a, firm in an economy., Thus, in a two sector economy, AD = C + I ⇒ AD = C� + bY +, � + bY, �I ⇒ AD = ( C + �I ) + bY ⇒ AD = A, � = C� + �I = Autonomous expenditure., where A, Note that the slope of aggregate demand function is given by, ‘b’, i.e. MPC. Thus, the aggregate demand curve is parallel to, the consumption curve since they have the same slope., Aggregate Supply (AS), It is the value of total quantity of final goods and services, produced in the economic teritory of a country. It refers to, the ex-ante, i.e. planned aggregate output in the economy. It, is equal to the National Income and is represented by a 45, degree line from origin because at every point on it, AS = Y.
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NUMERICAL 8, Estimate the value of Aggregate Demand in an, economy if:, (a) Autonomous Investment = `100 crore, (b) Marginal Propensity to Save = 0.2, (c) Level of Income = `4,000 crore, (d) Autonomous Consumption Expenditure = `50, crore, (3 marks), Solution: MPC = b = 1 – MPS = 1 – 0.2 = 0.8, C� = 50, Y =, 4,000 and I̅ = 100, Aggregate demand, AD = C + I, AD = C� + bY + I̅, AD = 50 + 0.8 × 4,000 + 100, AD = 50 + 3,200 + 100 = `3,350 crore
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Do it yourself 8, Estimate the value of ex-ante AD, when autonomous, investment and consumption expenditure (A) is ` 50, crore, and MPS is 0.2 and level of income is ` 300, crore., (3 marks), [Ans. `290 crore]
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Solution of Do it yourself 8, Since MPS = 0.2, therefore, MPC = b = 1 – MPS = 1 – 0.2 = 0.8, Autonomous investment and consumption expenditure (A) = C + I, = `50 crore, Level of income (Y) = `300 crore., The value of ex-ante AD = C + I = C + bY + I = (C + I) + bY= A + bY, = 50 + 0.8 × 300 = `290 crore
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Question 1, Why is aggregate demand curve parallel to the, consumption curve?, (3 marks), , HOTs 3.3— Analysing, Evaluating & Creating Type Questions
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Answer 1, The aggregate demand curve is parallel to the, consumption curve since they have the same slope, i.e., MPC. This is because AD = C + I, where I remains, constant irrespective of the level of income. So, AD, rises only with the rise in consumption, C. So, the slope, of the aggregate demand curve remains the same as, that of the consumption curve., , HOTs 3.3— Analysing, Evaluating & Creating Type Questions
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Question 2, State the two components of autonomous expenditure., How do they behave in general?, (3 marks), , HOTs 3.3— Analysing, Evaluating & Creating Type Questions
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Answer 2, Consumption curve does not start from origin because of, the assumption that there is some minimum level of, consumption even at zero level of income., �):, There are two components of autonomous expenditure (A, �), (i) Autonomous consumption (C, (ii) Autonomous investment (I)̅, In reality, the two components of autonomous expenditure, � remains more or less stable over, behave in different ways. C, time. However, I̅ undergoes periodic fluctuations. We have, assumed that investment is autonomous, which means, that, it, does, not, depend, on, HOTs 3.3— Analysing, Evaluating & Creating Type Questions
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income. But, investment may increase at lower interest, rates., , HOTs 3.3— Analysing, Evaluating & Creating Type Questions
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Question 1, Which of the following is not a component of aggregate, demand in a two-sector economy?, (Choose the correct alternative), (a) Net Exports, (b) Government Expenditure, (c) Consumption expenditure, (d) Both (a) and (b), Objective Type Questions 3.3
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Answer 1, (d) Both (a) and (b), , Objective Type Questions 3.3
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Question 2, In a two sector economy and without any indirect tax, and subsidy, aggregate supply and ______ are always, equal., (Choose the correct alternative), (a) National Income, (b) Aggregate Demand, (c) Marginal Propensity to save, (d) Average Propensity to Consume, , Objective Type Questions 3.3
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Answer 2, (a), , National Income, , Objective Type Questions 3.3
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Question 3, What causes the Aggregate Demand Curve swing, downwards from AD1 to AD2?, , Objective Type Questions 3.3
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Answer 3, Decline in MPC, i.e. slope of the AD curves decreases., , Objective Type Questions 3.3
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Question 4, Aggregate demand curve is parallel to ________ because, they have the same _________ ., (Fill in the blanks), , Objective Type Questions 3.3
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Answer 4, consumption curve; slope, i.e. MPC consumption curve;, slope, i.e. MPC, , Objective Type Questions 3.3
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Question 5, In a two sector economy, the aggregate demand curve, shifts in parallel upwards. In which of the following case, the above situation is possible?, (Choose the correct alternative), (a) Change in autonomous consumption, MPC and, autonomous investment., (b) Change in autonomous investment only, while, autonomous consumption and MPC remain the, same., (c) Change in both the autonomous consumption and, Objective Type Questions 3.3
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autonomous investment; but MPC remains the same., (d) Both (b) and (c), , Objective Type Questions 3.3
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Answer 5, (d), , Both (b) and (c), , Objective Type Questions 3.3
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3.4, Short-Run Equilibrium, Level of Income/Output
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We shall confine our analysis of the determination of, the equilibrium level of income or output in an, economy with only two sectors, households and firms., Hence, the only components of aggregate demand will, be consumption and investment., , , , Top Tip, , The level of output, income and employment in an economy, move together in the same direction till full employment is, reached. In other words, increase in output means increase in, level of employment and increase in level of income. Decrease, in output means less employment and lower level of income.
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Consumption plus investment, approach (or AD-AS approach), Meaning of equilibrium level of, income/output, Equilibrium level of income or output is that level, of income or output at which ex-ante aggregate, demand becomes equal to ex-ante aggregate, supply., It is also called ‘effective demand principle’., Since AS = Y, therefore the economy is in equilibrium if, Y = AD, or,, Y=C+I
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The Adjustment Mechanism, When ex-ante aggregate demand (i.e. planned demand, or planned expenditure) is not equal to ex-ante, aggregate supply (i.e. planned output) of final goods, and services, then output will tend to adjust up or, down until the two are equal again., If planned demand falls short of planned, output (AD < Y), It means buyers are planning to buy less goods and, services than producers are planning to produce., Thus, inventories of unsold goods will be piling up in, the warehouses (i.e. unplanned accumulation of, inventories). As a result, producers will plan to cut, down production. This will decrease planned output
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and income. The process continues till the planned, output produced in the economy becomes equal to, planned demand, i.e. Y = AD., If planned demand exceeds planned output (AD >, Y), It means buyers are planning to buy more goods and, services than producers are planning to produce., Thus, the inventories in hand with the producers, will start falling (i.e. unplanned decumulation of, inventories). As a result, producers will plan to raise, the production. This will increase planned output, and income. The process continues till planned, output produced in the economy becomes equal to, the planned demand, i.e. Y = AD.
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Thus, Y = AD is a necessary condition for equilibrium, level of income or output., Diagrammatic Presentation, Equilibrium is shown graphically by putting ex-ante, aggregate demand and supply together in a diagram., The point where ex-ante aggregate demand is equal to, ex-ante aggregate supply will be equilibrium. Thus,, equilibrium point is E and equilibrium level of income, is OM.
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Savings and Investment Approach, Derivation of S-I approach from C + I, approach, Under C + I approach, the equilibrium level of income, or output is determined at that level of income or, output at which planned aggregate demand is equal to, ex-ante aggregate supply, i.e. AD = Y or Y = C + I, Planned output or income is either consumed or saved,, i.e. Y = C + S, Substituting Y = C + S in the equilibrium condition, equation, we have, C+S=C+I, ⇒
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Equilibrium level of income or output is that level of, income or output at which ex-ante savings and ex-ante, investment are equal., , The Adjustment Mechanism, When planned savings and planned investment are not, equal, output will tend to adjust up or down till they, are equal again., If planned saving is greater than planned investment (S > I), It implies buyers are planning to buy less goods, than producers are planning to produce. In other, words, planned demand is less than planned output, (i.e. AD < Y). Thus, inventories of unsold goods will, be piling up in the warehouses (i.e. unplanned
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accumulation of inventories). accumulation of, inventories). As a result, producers will plan to cut, down production. This will decrease planned output, and income. The process continues till the planned, output produced in the economy becomes equal to, planned demand, i.e. planned investment becomes, equal to planned savings and the economy achieves, the equilibrium level of national income., If planned saving is less than planned, investment (S < I), It implies buyers are planning to buy more goods than, producers are planning to produce (i.e. AD > Y). Thus,, the inventories in hand with the producers will start, falling (i.e. unplanned decumulation of inventories)., As a result, producers will plan to raise the production.
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This will increase planned output and income. The, process continues till planned output produced in the, economy becomes equal to the planned demand, i.e., planned investment becomes equal to planned savings, and the economy achieves the equilibrium level of, national income., Thus, S = I is a necessary condition for equilibrium, level of income or output., Diagrammatic Presentation, Fig. 3.7 shows that the economy is in equilibrium at, point E, where OM is equilibrium level of income or, output., At this level of income or output, planned savings of, households is equal to the planned investment of firms.
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'Effective Demand' Principle, Table 3.3: Determination of Equilibrium Income, or Output (𝐂𝐂� = 100, MPC = 0.8 and I = 300), , At Y = 0, and Y = 1,000; AD > AS. This causes unplanned, , decrease in inventories inducing producers to, produce more output., At Y = 2,000; AD = AS. This keeps the inventory level, unchanged. Thus, Effective Demand (AD = AS) is, obtained at `2,000 crore level of income/output
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which is the equilibrium level of income/output. is, the equilibrium level of income/output., At Y = 3,000 and Y = 4,000; AD < AS. This causes, unplanned increase in inventory of unsold goods, inducing producers to produce less.
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Key Terms, Equilibrium level of income or output – It is that level of income or, output at which ex-ante aggregate demand becomes equal to ex-ante, aggregate supply or ex-ante savings and ex-ante investment are equal., Effective Demand – It refers to that level of income/output where, ex-ante aggregate demand is equal to the ex-ante aggregate, supply, i.e. AD = AS.
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RECAP, , C + I approach or AD-AS approach, Equilibrium income/output (or effective demand) refers to that, level of income/output where ex-ante aggregate demand is equal, to the ex-ante aggregate supply, i.e. AD = AS., Since AS = Y, therefore the economy is in equilibrium if Y = AD ⇒, Y = C + I (the equilibrium condition in a two sector economy), • When AD < Y, it means buyers are planning to buy less goods, and services than producers are planning to produce. Thus,, there will be unplanned accumulation of inventories. As a, result, producers will plan to cut down production. This, reduces output and income till Y = AD., • When AD > Y, it means buyers are planning to buy more, goods and services than producers are planning to produce., Thus, inventories in hand with the producers will start falling., As a result, producers will plan to raise the production. This
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Savings-Investment Approach: Derivation from, C+I Approach, Under C + I approach that equilibrium level of income is, determined where AD = Y, or Y = C + I ...(i), Also,, From (i) and (ii), we have C + S = C + I ⇒ S = I, Thus, equilibrium level of income/output is that level of, income at which planned savings and planned investment, are equal., • When S > I, it implies AD < Y. There is unplanned, accumulation of inventories. Producers plan to cut down, production. This reduces output and income till Y = AD and, hence, S = I., • When S < I, it implies AD > Y. Inventories start falling., Producers plan to raise the production. This raises output, and income till Y = AD and hence, S = I.
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NUMERICAL 9, If in an economy consumption function is given by C, = 100 + 0.75 Y, and autonomous investment is `150, crore. Estimate (i) Equilibrium level of income by C +, I approach and (ii) Consumption and Savings at the, equilibrium level of income., (6 marks), Solution: C = 100 + 0.75Y; I = `150 crore, (i), , At equilibrium level of income:, , Y=C+I, Y = 100 + 0.75Y + 150, Y – 0.75Y = 250, 0.25Y = 250, Y = 250/0.25 = 1,000
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The equilibrium level of income in the economy Y = `1,000, crore, (ii), Consumption at the equilibrium level of income:, C=, 100 + 0.75Y
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Do it yourself 9, Find equilibrium level of national income from the, following:, 3 marks, [Ans. `750 crore], S. No. Items, (i), (ii), (iii), , Autonomous consumption, Marginal propensity to consume, Investment, , (`crore), 100, 0.8, 50
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Solution of Do it yourself 9, Autonomous consumption C = 100, MPC = b = 0.8,, Investment I = 50, Consumption function equation, C = C + bY = 100 + 0.8Y\Equilibrium level, of national income Y = C + I, Y = 100 + 0.8Y + 50 ⇒ Y – 0.8Y = 150 ⇒, 0.2Y = 150, Y = 150/0.2 = `750
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NUMERICAL 10, In an economy, C = 100 + 0.4Y is the consumption, function, where C is consumption and Y is National, Income. If investment expenditure is `1,100 crore,, calculate:, (i) Equilibrium level of National Income using savings, and investment approach., (ii) Consumption expenditure at equilibrium level of, National Income., (6 marks), Solution: Consumption function C = 100 + 0.4Y., Therefore, savings function, S=Y–C, S = Y – (100 + 0.4Y), S = –100 + 0.6Y
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Investment expenditure I = `1,100 crore, At equilibrium level of national income, S = I, –100 + 0.6Y = 1,100, 0.6Y = 1,100 + 100 = 1,200, Y = 1,200/0.6 = 2,000, (i) Equilibrium level of national income = ` 2,000 crore, (ii) At equilibrium level of national income, Savings (S) =, Investment (I) = `1,100 crore, Consumption expenditure at equilibrium level of national, income, C = Y – S = 2,000 – 1,100 = `900 crore
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Do it yourself 10, In an economy, S = –100 + 0.6Y is the saving function,, where S is Saving and Y is National Income. If, investment expenditure is 1,100, calculate:, (i) Equilibrium level of National Income, (ii) Consumption expenditure at equilibrium level of, National Income., (6 marks), [Ans. (i) 2,000 (ii) 900]
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Solution of Do it yourself 10, Savings function S = –100 + 0.6Y, Investment expenditure I = 1100, At equilibrium level of national income S = I, –100 + 0.6Y = 1100 ⇒ 0.6Y = 1100 + 100 = 1200, Y = 1200/0.6 = 2000, (i), Equilibrium level of national income = 2000, (ii) Savings at equilibrium level of national income, S = Investment expenditure = 1100, Consumption expenditure at equilibrium level of, national income, C = Y – S = 2000 – 1100 = 900
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NUMERICAL 11, The savings function of an economy is S = –200 + 0.25Y., The economy is in equilibrium when income is equal to, `2,000 crore. Calculate: (i) Investment expenditure at, equilibrium level of income and (ii) Autonomous, consumption., (6 marks), Solution: (i) Equilibrium level of income Y = `2,000, crore, Savings function S = –200 + 0.25Y, Savings at equilibrium level of income S = –200 + 0.25(2,000), S = –200 + 500 = `300 crore, At equilibrium, planned savings and planned investment, expenditure are equal. Therefore, investment expenditure, at equilibrium level of income I = `300 crore, (ii), From the Savings function S = –200 + 0.25Y, we
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get dissavings at zero income = `200 crore, which is equal, to autonomous consumption., Therefore, autonomous consumption = `200 crore
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Do it yourself 11, If in an economy Consumption function is given by C =, 100 + 0.75 Y, and Autonomous investment is `150 crore., Estimate (i) Equilibrium level of income and (ii), Consumption and Savings at the equilibrium level of, income., (3 marks), [Ans. (i) `1,000 crore (ii) `150 crore]
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Solution of Do it yourself 11, C = 100 + 0.75Y ⇒ I = 150, (i) At equilibrium level of income: Y = C+I ⇒ Y = 100 +, 0.75Y + 150, Y – 0.75Y = 250 ⇒ Y = 250/0.25 = `1000 crore, (ii)C = 100 + 0.75Y = 100 + 0.75(1000) = 100 + 750 =, `850 crore, Y = C + S or S = Y – C = 1000 – 850 = `150 crore
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NUMERICAL 12, Measure the level of ex-ante aggregate demand when, autonomous investment and consumption expenditure, � ) is `50 crore, and MPC is 0.8 and level of income (Y) is, (A, `4000 crore. State whether the economy is in equilibrium, or not (cite reasons)., (3 marks), Solution: Sum of autonomous investment (I)̅ and, � =A, � = `50 crore, MPC = b =, autonomous consumption (C), 0.8 and national income (Y) = `4,000 crore, Ex-ante aggregate demand, AD = C + I, AD = C� + bY + I̅, � + bY, AD = (C� + I)̅ + bY = A, AD = 50 + 0.8 × 4,000 = `3,250 crore, Since AD (`3,250 crore) is less than National Income (Y =
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`4,000 crore), therefore, the economy is not equilibrium., The economy is in equilibrium when AD = Y.
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Do it yourself 12, In an economy the autonomous investment is ` 100 crore, and the consumption is C = 80 + 0.4Y. Is the economy in, equilibrium at an income level ` 400 crore ? Justify your, answer., [Ans. No, equilibrium level of income = `300 crore]
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Solution of Do it yourself 12, At equilibrium, Y = C + I (since at equilibrium AD = Y, C + I = Y) ⇒ Y = 80 + 0.4Y + 100 ⇒ Y – 0.4Y = 80 + 100, 0.6Y = 180 ⇒ Y = 180/0.6 = 300, Thus, equilibrium level of income = `300 crore., Since the given income of ` 400 crore is greater than, equilibrium level of income, the economy is not at, equilibrium at the income level ` 400 crore.
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NUMERICAL 13, In an economy the autonomous investment is ` 60 crore, and the marginal propensity to consume is 0.8. If the, equilibrium level of income is `400 crore, then the, autonomous consumption is ` 30 crore. True or False?, Justify your answer., (3 marks), Solution: At equilibrium, Y = C + I (since at equilibrium, AD = Y ⇒ C + I = Y), Y = C� + bY + I̅, 400 = C� + 0.8 × 400 + 60 (since Y = 400, MPC = b= 0.8 and I̅, = 60), � + 320 + 60, 400 = C, � = 400 – 320 – 60 = 20, C, � = `20 crore, Autonomous consumption C
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The given value of autonomous consumption (`30 crore), is incorrect.
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Do it yourself 13, In an economy, C = 50 + 0.5Y is the consumption function,, where C is consumption expenditure and Y is National, Income. If investment expenditure is 2,000, calculate:, (i) Equilibrium level of National Income, (ii) Consumption expenditure at equilibrium level of, National Income., (iii) Savings at equilibrium level of income, (6 marks), [Ans. (i) 4,100 (ii) 2,100 (iii) 2,000]
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Solution of Do it yourself 13, Consumption function C = 50 + 0.5Y, Investment expenditure I = 2000, At equilibrium level of national income, Y = C + I ⇒ Y = 50 + 0.5Y + 2000 ⇒ Y – 0.5Y = 2050, 0.5Y = 2050 ⇒ Y = 2050/0.5 = 4100, (i) Equilibrium level of national income = 4100, (ii) Consumption expenditure at equilibrium level of, national income C, = 50 + 0.5(4100) = 50 + 2050 = 2100, (iii) Savings at equilibrium level of income = Investment, expenditure = 2000, Alternately, Savings at equilibrium level of income S = Y – C, = 4100 – 2100 = 2000
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NUMERICAL 14, From the data given below about an economy, calculate, investment expenditure and consumption expenditure:, Equilibrium level of income = `5,000 crore, Autonomous consumption = ` 500 crore, Marginal propensity to consume = 0.4, (3 marks), Solution: Equilibrium income Y = `5,000 crore,, � = `500 crore, MPC = b = 0.4, Autonomous consumption C, � = C + By, Consumption expenditure C, C = 500 + 0.4(5,000), C = 500 + 2,000, C = `2,500 crore, At equilibrium income, Y=C+I, (since at equilibrium AD = Y ⇒ C + I = Y)
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∴, , Investment expenditure, , 5000 = 2,500 + I, I = 5,000 – 2,500, I = 2,500, I = `2,500
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Do it yourself 14, Calculate Investment expenditure from the following data, about an economy which is in equilibrium:, National income = `1,000 crore, Marginal propensity to save = 0.25, Autonomous consumption expenditure = ` 200 crore, (3 marks), [Ans. ` 50 crore]
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Solution of Do it yourself 14, Autonomous consumption expenditure C = 200., MPC = b = 1 – MPS = 1 – 0.25 = 0.75, At equilibrium level of national income, Y = C + I ⇒ Y = C + bY + I ⇒ Y = 200 + 0.75Y + I, 1000 = 200 + 0.75 (1000) + I ⇒ 1000 = 200 + 750 + I, 1000 = 950 + I ⇒ I = 1000 – 950 = 50, Therefore, investment expenditure = `50 crore
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NUMERICAL 15, An economy is in equilibrium. Calculate Marginal, Propensity to Save from the following:, National Income = `1,000, Autonomous Consumption = ` 100, Investment Expenditure = ` 200, (4 marks), Solution : At equilibrium, Y = C + I, � + by + I̅, Y=C, 1,000 = 100 + b(1,000) + 200, b (1,000) = 1,000 – 100 – 200 = 700, b = 700/1,000 = 0.7 = MPC, Therefore,, MPS = 1 – MPC = 1 – 0.7 = 0.3
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Do it yourself 15, An economy is in equilibrium. From the following data,, calculate the marginal propensity to save:, (a) Income = 10,000, (b) Autonomous consumption = 500, (c) Consumption expenditure = 8,000, (4 marks), [Ans. 0.25]
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Solution of Do it yourself 15, C = C + mpc(Y), 8000 = 500 + mpc(10,000), mpc = 7,500/10,000 = 0.75, So,, mps = 1 – 0.75 = 0.25
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NUMERICAL 16, Calculate Autonomous consumption expenditure from the, following data about an economy which is in equilibrium:, National income = `1,200 crore, Marginal propensity to save = 0.20, Investment expenditure = ` 100 crore, (3 marks), Solution: Since MPS = 0.20, therefore, MPC = b = 1 – MPS, = 1 – 0.20 = 0.80, � + bY = C, � + 0.80Y, Consumption function equation C = C, At equilibrium level of national income Y = C + I (since at, equilibrium AD = Y ⇒ C + I = Y), � + 0.80Y + I, Y= C, � + 0.80 × 1,200 + 100, 1,200 = C, (since Y = 1200, I = 100), � + 960 + 100, 1,200 = C
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� = 1,200 – 960 – 100 = 140, C, Autonomous consumption expenditure = `140 crore
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Do it yourself 16, Calculate Marginal Propensity to Consume from the, following:, Equilibrium income = `350 crore, Consumption expenditure at zero income = `20 crore, Investment = ` 50 crore, (3 marks), [Ans. 0.8]
Page 1232 :
Solution of Do it yourself 16, Consumption expenditure at zero income, (Autonomous consumption) C = 20,, Equilibrium income Y = 350, Investment I = 50, Consumption function equation C = C + bY = 20 + 350b, At equilibrium level of national income Y = C + I, 350 = 20 + 350b + 50 ⇒ 350 = 70 + 350b, 350b = 350 – 70 = 280, b = 280/350 = 4/5 = 0.8, Marginal propensity to consume = 0.8
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NUMERICAL 17, If in an economy savings function is given by S = (–) 50 +, 0.2 Y and Y = `2,000 crore; consumption expenditure for, the economy would be ` 1650 crore and the autonomous, investment is ` 350 crore and the marginal propensity to, consume is 0.8. True or False? Justify your answer with, proper calculations., (3 marks), Solution: Level of income Y = `2,000 crore, Savings S = –50 + 0.2Y, S = –50 + 0.2(2,000) = –50 + 400 = `350 crore, Consumption expenditure C = Y – S = 2,000 – 350 = `1,650, crore (Which is true.), From the savings function equation S = (–) 50 + 0.2 Y, we, have MPS = 0.2
Page 1234 :
Since MPC + MPS = 1, therefore, MPC = 1 – MPS = 1 – 0.2, = 0.8 (Which is true.), At equilibrium level of income, Savings = Investment =, `350 crore (Which is also, true.), Thus, all the given values are correct.
Page 1235 :
Do it yourself 17, In an economy C = 200 + 0.5 Y is the consumption function, where C is the consumption expenditure and Y is the, national income. Investment expenditure is `400 crore. Is, the economy in equilibrium at an income level ` 1,500, crore? Justify your answer., (3 marks), [Ans. No, the equilibrium level of income is ` 1,200 crore]
Page 1236 :
Solution of Do it yourself 17, No, the Economy is not in a state of equilibrium at, `1500 crore, Given Consumption function, C = 200 + 0.5Y, Investment expenditure (I) = `400 crore, At the equilibrium level, Y = C + I, Substituting the values from the question:, Y = 200 + 0.5Y + 400 ⇒ Y – 0.5Y = 600, 0.5Y = 600 ⇒ Y = 600/0.5 = 1200, The equilibrium level of income is ` 1200 crore. The, given income ` 1500 crore is greater than equilibrium, level of income., Therefore, the economy is not in equilibrium.
Page 1237 :
NUMERICAL 18, The saving function of an economy is given as: S = – 250 +, 0.25Y, If the planned investment is `2,000 crore, calculate the, following:, (a) Equilibrium level of income in the economy., (b) Aggregate demand at income of ` 5,000 crore., (CBSE 2019) (6 marks), Solution: S = –250+ 0.25Y (Given), (a) Equilibrium level of income in the economy exist when, S=I, Substitute the values of saving and investment, we get, –250 + 0.25Y = 2,000, 0.25Y = 2,000 + 250
Page 1238 :
0.25Y = 2,250, Y = 2,250/0.25, Equilibrium level of income Y = `9,000 crore, (b) C = Y – S = Y – (– 250 + 0.25Y), C = 250 + 0.75Y, Given that Y = 5,000, C = 250 + 0.75 (5,000) = 250 + 3,750 = 4,000, AD = C + I = 4,000 + 2,000 = 6,000, Aggregate demand at income of `5,000 crore = `6,000, crore
Page 1239 :
Do it yourself 18, The saving function of an economy is given as: S = – 10 +, 0.20Y, If the planned investment is ` 100 crore, calculate the, following:, (a) Equilibrium level of income in the economy., (b) Aggregate demand at income of ` 300 crore., [Ans. (a) `550 crore (b) ` 350 crore]
Page 1240 :
Solution of Do it yourself 18, S = –10 + 0.20Y, (a) Equilibrium level of income in the economy exist, when S = I, Substitute the values of saving and investment, we get, – 10 + 0.20Y = 100, 0.20Y = 100 + 10 = 110 ⇒ Y = 110/0.20, Equilibrium level of income Y = `550 crore, (b) C = Y – S = Y – (– 10 + 0.20Y), C = 10 + 0.80Y, Given that Y = 300, C = 10 + 0.80 (300) = 10 + 240 = 250, Aggregate demand AD = C + I = 250 + 100 = `350, crore
Page 1241 :
Question 1, Ex-post value of total output is always equal to the expost aggregate expenditure in the economy., True/False? Give reason., (3 marks), , HOTs 3.4— Analysing, Evaluating & Creating Type Questions
Page 1242 :
Answer 1, True; ex-post value of total output (Y) must always be, equal to the sum total of ex-post consumption, expenditure (C) and ex-post investment expenditure (I) in, the economy., However, ex-ante aggregate supply is equal to ex-ante, aggregate demand only when the final goods market and, hence the economy, is in equilibrium., Thus, even though planned Y is greater than planned C + I,, actual Y will be equal to actual C + I, with the extra output, showing up as unplanned accumulation of inventories in the, ex-post I on the right hand side of the accounting identity., HOTs 3.4— Analysing, Evaluating & Creating Type Questions
Page 1243 :
Question 2, “Inventories accumulate when planned investment is less, than planned saving.” Is the statement true or false? Give, reason in support of your answer., (3 marks), , HOTs 3.4— Analysing, Evaluating & Creating Type Questions
Page 1244 :
Answer 2, True: When planned investment is less than planned saving,, AD < Y. It implies that consumers are not planning, to buy as much goods and services as the firms are, planning to produce. This will lead to an unplanned, accumulation of inventories., , HOTs 3.4— Analysing, Evaluating & Creating Type Questions
Page 1245 :
Question 3, Explain how the level of effective demand is attained in, an economy if, Aggregate Demand is more than the, Aggregate Supply., (CBSE Sample Question Paper 2019) (3 marks), , HOTs 3.4— Analysing, Evaluating & Creating Type Questions
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Answer 3, Effective demand refers to that level of output where, Aggregate demand is equal to the Aggregate supply. If, Aggregate Demand exceeds Aggregate Supply, it means, buyers are planning to buy more goods and services than, producers are planning to produce. Thus, the inventories, in hand with the producers will start falling. As a result,, producers will plan to raise the production. This will, increase the level of income upto the level Aggregate, Demand is equal to Aggregate Supply., , HOTs 3.4— Analysing, Evaluating & Creating Type Questions
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Question 4, How is ‘saving and investment’ approach derived from, the ‘aggregate demand and supply’ approach of income, determination? Explain using diagram., (6 marks), , HOTs 3.4— Analysing, Evaluating & Creating Type Questions
Page 1248 :
Answer 4, Equilibrium level of income/output is that level at which, aggregate planned expenditure is equal to aggregate, planned output, i.e.AD = AS. In other words, C + I = Y, We know that planned income/output is either consumed, or saved, viz.Y = C + S, Therefore, equality of aggregate planned expenditure and, aggregate planned output at equilibrium implies that, C+I=C+S, ⇒ S=I, Equilibrium level of income/output is that level at which, planned savings and planned investment are equal., HOTs 3.4— Analysing, Evaluating & Creating Type Questions
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Thus, the two alternative approaches of national income, determination are:, (i) AD = Y which is on E in the upper part of diagram, when AD curve intersects the 45˚ line with, equilibrium income OM., (ii) S = I which is on E1 in the lower part of the diagram, when saving curve intersects the investment curve at, E1 with OM as the equilibrium income level., , HOTs 3.4— Analysing, Evaluating & Creating Type Questions
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Question 5, Discuss the significance of 45-degree line in Keynesian, Economics., (3 marks), , HOTs 3.4— Analysing, Evaluating & Creating Type Questions
Page 1252 :
Answer 5, • The straight line obtained which will originate from, point of origin O forming a 45° angle establishes the, relation of: Income = Consumption + Savings (Y = C, + S). Therefore, the 45° line from origin represents the, aggregate supply curve., • At any point on the 45° line, consumption expenditure, is exactly equal to income. Thus, the 45° line from, origin tells us whether consumption is equal to,, greater than, or less than income., • The 45° line also helps to identify the equilibrium level, of income/output in the economy. At all points, HOTs 3.4— Analysing, Evaluating & Creating Type Questions
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on the 45° line, the aggregate demand equals the level, of income/output in the economy. Thus, the point, where the aggregate demand curve (C + I curve) will, intersect the 45° line must be the equilibrium point, because at that point on the 45° line aggregate, demand must be equal to the income/output in the, economy., , HOTs 3.4— Analysing, Evaluating & Creating Type Questions
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Question 1, AD curve starts:, (Choose the correct alternative), (a) From the origin, (b) Point below to the origin, (c) Point above the origin, (d) None of these, , Objective Type Questions 3.4
Page 1255 :
Answer 1, (c) Point above the origin, , Objective Type Questions 3.4
Page 1256 :
Question 2, In determination of equilibrium level of income by AD–, AS approach, AD is represented by:, (Choose the correct alternative), (a) C + S, (b) C + I, (c) S + I, (d) C +Y, , Objective Type Questions 3.4
Page 1257 :
Answer 2, (b) C + I, , Objective Type Questions 3.4
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Question 3, Which of the following is the equilibrium condition in a, two sector economy?, (Choose the correct alternative), , Objective Type Questions 3.4
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Answer 3, , Objective Type Questions 3.4
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Question 4, When Aggregate Demand is more than Aggregate, Supply, this will lead to _________., (Choose the correct alternative), (a) a planned inventories accumulation, (b) a planned inventories decumulation, (c) an unplanned inventories accumulation, (d) an unplanned inventories decumulation, , Objective Type Questions 3.4
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Answer 4, (d) an unplanned inventories decumulation, , Objective Type Questions 3.4
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Question 5, When Planned Savings is more than Planned Investment,, then _________., (Choose the correct alternative), (a) National income is likely to fall, (b) There will be no change in national income, (c) National income is likely to rise, (d) None of these, , Objective Type Questions 3.4
Page 1263 :
Answer 5, (a), , National income is likely to fall, , Objective Type Questions 3.4
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Question 6, When aggregate demand is greater than aggregate, supply, inventories _________., (Choose the correct alternative), (a) fall, (b) rise, (c) do not change, (d) first fall, then rise, , Objective Type Questions 3.4
Page 1265 :
Answer 6, (a), , fall, , Objective Type Questions 3.4
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Question 7, The equilibrium level of income changes if there is, _________., (Choose the correct alternative), (a) change in autonomous consumption, (b) change in MPC, (c) change in autonomous investment, (d) All of the above, , Objective Type Questions 3.4
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Answer 7, (d), , All of the above, , Objective Type Questions 3.4
Page 1268 :
Question 8, In the Keynesian analysis of determination of equilibrium, income in the short run, the justification for taking the, price level as fixed is:, (Choose the correct alternative), (a) We are assuming an economy with unused, resources: machineries, buildings and labours., (b) In such a situation, the law of diminishing returns, will not apply., (c) Additional output can be produced without, increasing marginal cost., (d) All of the above, Objective Type Questions 3.4
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Answer 8, (d), , All of the above, , Objective Type Questions 3.4
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3.5, Investment Multiplier and, its Mechanism
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Meaning of Investment Multiplier, A change in the investment spending will affect output, and therefore employment. It is logical that an increase, in fixed business investment will increase the level of, equilibrium income,output and employment through, increase in productive capacity. Conversely, a decrease, in investment will decrease the level of income,output, and employment. The operation of the multiplier, ensures that a change in investment causes a change in, income/output by an amplified amount, which is a, multiple of the change in investment., The multiplier is the number by which the change in, investment must be multiplied in order to determine, the resulting change income/output.
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For example, Suppose the consumption function of the, economy is C = 100 + 0.8Y and autonomous investment, is `300 crore. Then, the equilibrium level of income/ouput, is:, Y=C+I, Y = 100 + 0.8Y + 300, Y – 0.8Y = 100 + 300, 0.2Y = 400, Y = 400/0.2 = `2,000 crore, Suppose, autonomous investment increases by `100 crore,, i.e. new investment I = `400 crore. Then, the equilibrium, level of income/output will be:, Y=C+I, Y = 100 + 0.8Y + 400
Page 1273 :
Y – 0.8Y = 100 + 400, 0.2Y = 500, Y = 500/0.2 = `2,500 crore, Thus, the increase in equilibrium level of, income/output (i.e. `500 crore) exceeds the initial, increase in autonomous investment of ` 100 crore., Here, the value of multiplier is 5 (i.e. `500 crore/`100, crore)., Investment Multiplier (k) is the ratio of the change in, final income/output (∆Y) due to a given change in, initial investment (∆I).
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, , Top Tip, , We know that there are two components of autonomous, expenditure— Autonomous consumption and Autonomous, � = C� + I̅, investment. A, Autonomous consumption C� remains more or less stable over, time. Therefore, ∆C� = 0, Autonomous investment I,̅ on the other hand, may increase, due to factors other than income. For example, at low market, rate of interest, firms tend to increase investment. Note that, we have assumed that investment is autonomous. However, it, just means that it does not depend on income. Autonomous, investment may increase due to other factors such as market, rate of interest, availability of credit, etc., � = C� + I,̅ therefore ∆ A, � = ∆C� + ∆ I̅, Since, A, � = 0 + ∆ I̅ (since DC = 0), ∆A, � =∆ I̅, ∆A
Page 1275 :
Hence, change in autonomous investment is equal to change, in autonomous expenditure., Therefore,, Thus, investment multiplier may also be defined as the ratio of, the total increment in equilibrium level of income/output to, the initial increment in autonomous expenditure.
Page 1276 :
Investment Multiplier Mechanism—, Diagrammatic Presentation, We know that equilibrium level of income/output is, determined at that level where planned aggregate, demand/expenditure (C + I) becomes equal to the, planned aggregate output/income (Y). In Figure 3.11,, this happens when the AD (C + I) curve intersects the, 45° line from origin (i.e., AS curve) at point E1. The, equilibrium level of income/output is OY1. Here, we, assume that investment expenditure is autonomous,, i.e., firms plan to investment a fixed amount I., Now suppose there is an increase in autonomous, investment, i.e., firms to plan to invest a higher amount, I + DI. As a result, aggregate demand in the economy
Page 1277 :
increases and thus, the AD curve shifts in parallel upwards, and assumes the position AD2. Now at output/income OY1,, AD > Y by an amount ∆I. Thus, E1 no longer represents the, equilibrium. Since AD > Y, there will be unplanned, decrease in inventories inducing producers to produce, more output to meet this extra demand. This raises income., This will happen till Y = AD at new equilibrium point E2, where the new aggregate demand curve AD2 intersects 45°, line. The new equilibrium level of income/output is OY2., Observe that increase in income/output (∆Y) is greater, than the initial increase autonomous investment (∆I)., That is, a change in investment causes a multiple change in, income.
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Relationship between MPC and, investment multiplier, The value of investment multiplier depends on the, value of marginal propensity to consume., There exits a direct (or positive) relation between MPC, and investment multiplier. If MPC rises, value of, multiplier increases and vice-versa., Example: Suppose the MPC of an economy increases, from 0.6 to 0.8, the value of multiplier will be calculated as, follows:
Page 1280 :
MPC, 0.6, 0.8, , Thus, if the MPC of an economy increases from 0.6 to, 0.8, the value of multiplier increases from 2.5 to 5, i.e.,, direct/positive relation. Therefore, national income will, increase more number of times the initial increase in, investment. Thus, coefficient of investment multiplier, carries direct relation with rate of growth in an economy,, i.e. higher the MPC more chance of growth exists in an, economy., Note that investment multiplier is a two sided sword.
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Hence, if investment falls in an economy the income, may also fall by a multiple times., , , , Top Tip, , Derivation of Investment Multiplier (for reference only), At equilibrium,, Y=, C+I, Substituting C = C� + bY, we get Y = C� + bY + I, Y – bY = C� + I, Y (1 – b) = C� + I, Y=, Since 'b' is nothing but the MPC, we have, Y=, , In the above equation, MPC and C� are constant. To find out, the effect of a change in investment on income, we, differentiate the above equation to obtain:
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Derivation of Investment Multiplier (for reference only), differentiate the above equation to obtain:
Page 1283 :
Relation between MPS and investment, multiplier, Since and, 1 – MPC = MPS, therefore, value of, investment multiplier is:, , There exists a negative/inverse relation relation between, MPS and investment multiplier., Example: Suppose the MPS of an economy increases from, 0.2 to 0.5, the value of multiplier will be calculated as, follows:
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MPS, 0.2, 0.5, , Thus, if the MPS of an economy rises from 0.2 to 0.5,, the value of multiplier decreases from 5 to 2. National, income increases less number of times the increase in, investment. Thus, rising MPS hampers the rate of, growth in the economy. So, the economists are always, concerned with the rising MPS.
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Why does a change in investment cause a, multiple change in income?, A change in investment causes a multiple change in, income, i.e. change in income is greater than the, change in investment, ∆Y > ∆I because value of, investment multiplier is always greater than one (i.e., k, > 1)., Explanation: Value of multiplier depends on the value, of MPC since, Minimum value of investment multiplier can be 1 when, MPC = 0.
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Maximum value of investment multiplier can be ∞, (infinity) when MPC = 1., However, in an economy generally 0 < MPC < 1,, therefore, 1 < k < ∞ (i.e. value of multiplier ranges, between one and infinity.), 1 < k < ∞ implies that k > 1, i.e., ⇒ ∆Y > ∆I (i.e. change in income is greater than the, change in investment), Hence, a change in investment will always cause a, multiple change in income.
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Working/Process of Investment, Multiplier – Numerical Example, Suppose in an imaginary country, MPC is 0.8 and an, additional investment of `1000 crore (DI) is made by, government for a bullet train project in the country., This extra investment will generate an additional income, of `1000 crore in the country in first round, as expenditure, of one is income for another., Since MPC of this country is 0.8, the nationals who are, receiving this additional income will spend 80% portion, of this additional income, i.e. `800 crore, which in return, becomes additional income during second round., Similarly, in third round `640 crore of income is, generated.
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Consumption expenditure in every round will be 0.8, , times of additional income received from previous round., This process will go on infinitely and comes to an end, when increase in savings (i.e., total leakages) become, equal to the increase in investment, i.e. `1000 crore., Table 3.4: Working of Investment Multiplier (with, increase in investment `1000 crore and MPC 0.8), Roun, ds, , Increase in, Income (∆Y), , Increase in Induced, Consumption (∆C), , Additional, Savings/Leakages, (∆S), , I, , `1,000 crore, , `800 crore, , `200 crore, , II, , `800 crore, , `640 crore, , `160 crore, , III, , `640 crore, , `512 crore, , `128 crore, , …, , …, , …, , …, , Total, , 5,000, , 4,000, , 1,000
Page 1289 :
Total increase in income will be:, , As a result, value of Investment Multiplier,, , , , Top Tip, , Why did DI of `1,000 crore cause DY `5,000 crore? (for, reference only), An endless chain of secondary consumption spending is set in, motion by the primary investment of `1,000. However. not, only is the chain of secondary consumption spending endless,, it is also ever-diminishing. Eventually, the sum of the, secondary consumption expenditures will be a finite amount., We can calculate the total increase in income as follows:, ∆Y = `1,000 crore + [0.8 × `1,000 crore] + [0.8 × (0.8 × `1,000, crore)] + ... ∞
Page 1290 :
∆Y = `1,000 crore + [0.8 × `1,000 crore] + [(0.8)2 × ` 1,000, crore] + ... ∞, This is of the form of the sum of an infinite geometric, progression series [a + ar + ar2 + ... ∞], whose first term (a), is 1,000 and common ratio (r) is 0.8. The formula for the, sum of such an infinite geometric progression is, Thus,
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RECAP, , Investment Multiplier, Investment Multiplier (k) is a measure of the effect of an, initial increase in investment on increase in final income, based on MPC since k = 1/(1 – MPC)., Investment multiplier is the ratio of the change in income, due to a given change in initial investment, i.e. k = ∆Y/∆I., Relationship between MPC and investment multiplier, Direct/Positive relation between MPC and investment, multiplier since k = 1/(1 – MPC). If MPC rises, value of multiplier, increases. For example, if MPC of an economy increases from 0.6, to 0.8, value of multiplier increases from k = 1/(1–0.6) = 1/0.4 = 2.5, to k = 1/(1–0.8) = 1/0.2 = 5. Thus, investment multiplier carries, direct relation with rate of growth in an economy., Relationship between MPS and investment multiplier, Inverse/Negative relation between MPS and investment multiplier
Page 1292 :
since k = 1/MPS. If MPS rises, value of multiplier decreases., For example, if MPS of an economy increases from 0.2 to 0.5,, value of multiplier decreases from k = 1/0.2 = 5 to k = 1/0.5 =, Thus, rising MPS hampers the rate of growth in the, economy. That is why, economists are concerned with rising, MPS., Minimum value of investment multiplier is 1 when MPC, = 0 since k = 1/(1 – MPC) = 1/(1–0) = 1/1 = 1., Maximum value of multiplier can be infinity when MPC, = 1 since k = 1/(1 – MPC) = 1/(1–1) = 1/0 = ∞., However, in reality 0 < MPC < 1, therefore, 1 < k < ∞, (Investment multiplier ranges between one and infinity.), ⇒ k > 1 ⇒ ∆Y/∆I > 1 ⇒ ∆Y > ∆I., Thus, change in final income is greater than initial change in, investment since k >1., Working of Investment Multiplier – Numerical Example
Page 1293 :
Suppose increase in investment by government for a bullet, train project, DI = `1000 crore and MPC = 0.8. In Ist round,, this additional investment will generate an extra income of, `1000 crore. Since MPC is 0.8, people will spend `800 crore, (0.8 × 1000), which in return becomes additional income of, other people during second round (as one man’s expenditure is, another man’s income). Similarly, in third round `640 crore of, additional income is generated. This process will go on, infinitely till the total increase in income is equal to multiplier, times the initial investment., Total increase in income,, , Value of multiplier, k = ∆Y/∆I = 5000/1000 = 5
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NUMERICAL 19, In an economy 75% of the increase in income is spent on, consumption. Investment is increased by `1,000 crore., Calculate:, (i), Total increase in income, (ii), Total increase in consumption expenditure, (iii) Change in savings, (3 marks), Solution: In the economy 75% of the increase in income, is spent on consumption, i.e., MPC = 75% = 0.75, Increase in investment ∆I = `1,000 crore, k=, 1/(1–MPC) = 1/(1–0.75) = 1/0.25 = 4, k=, ∆Y/∆I ⇒ 4 = DY/1,000 ⇒ ∆Y = 4,000, MPC =∆C/∆Y ⇒ 0.75 = ∆C/4,000 ⇒ ∆C = 0.75 × 4,000 =, 3,000
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∆S =, (i), (ii), (iii), , ∆Y – ∆C = 4,000 – 3,000 = 1,000, Total increase in income = `4,000 crore, Total increase in consumption expenditure =, `3,000 crore, Change in savings = ` 1,000 crore
Page 1296 :
Do it yourself 19, In an economy, with every increase in income 10% of the, rise in income is saved. Suppose a fresh investment of `120, crore takes place in the economy. Calculate:, (i) Change in consumption, (ii) Change in savings, [Ans. (i) Total increase in consumption expenditure =, `1,080 crore (ii) Increase in savings = ` 120 crore]
Page 1297 :
Solution of Do it yourself 19, In the economy, with every increase in income 10% of, the rise in income is saved, i.e., MPS = 10% = 0.10, Increase in investment DI = ` 120 crore, k= 1/MPS = 1/0.10 = 10, k = DY/DI ⇒ 10 (DY/120) ⇒ DY = 1,200, MPS = DS/DY ⇒ 0.10 = DS/1,200 ⇒ DS =, 0.10× 1,200 = 120, DC = DY – DS = 1,200 – 20 = 1,080, (i), Total increase in consumption, expenditure = ` 1,080 crore, (ii) Increase in savings = `120 crore
Page 1298 :
NUMERICAL 20, An increase of `250 crore in investment in an economy, results in income increasing by three times more than the, increase in investment. Calculate:, (i), Marginal propensity to consume, (ii), Change in savings, (iii) Change in consumption expenditure, (iv), Value of multiplier (4 marks), Solution: Increase in investment ∆I = 250, Increase in, income ∆Y = 250 + 3 × 250 = 1,000, Therefore, investment multiplier k = ∆Y/∆I = 1,000/250 = 4, k = 1/(1–MPC) ⇒ 4 = 1/(1–MPC), 1–MPC = 1/4 ⇒ MPC = 1 – (1/4) = 3/4, MPC =∆C/∆Y ⇒ 3/4 = ∆C/1,000 ⇒ 3/4 × 1,000 = 750
Page 1299 :
∆S =, (i), (ii), (iii), (iv), , ∆Y – ∆C = 1,000 – 750 = 250, Marginal propensity to consume = 3/4 = 0.75, Change in savings = `250 crore, Change in consumption expenditure = `750 crore, Value of multiplier = 4
Page 1300 :
Do it yourself 20, In an economy an increase in investment leads to increase, in national income which is three times more than the, increase in investment. Calculate marginal propensity to, consume., (3 marks), [Ans. MPC = 0.75]
Page 1301 :
Solution of Do it yourself 20, Suppose increase in investment be DI. Therefore,, increase in income DY= DI + 3DI = 4DI, Value of multiplier, k = DY/DI = 4DI/DI = 4, k = 1/(1 – MPC) ⇒ 4 = 1/(1 – MPC), 1 – MPC = 1/4 ⇒ MPC = 1 – 1/4 = 3/4 = 0.75
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NUMERICAL 21, In an economy, the marginal propensity to save is 0.4., National income in the economy decreases by `200 crore, as a result of change in investment. Calculate the change, in investment, (? marks), Solution: MPS = 0.4, therefore, value of multiplier, k =, 1/MPS = 1/0.4 = 10/4 = 5/2, National income decreases by `200 crore, i.e., ∆Y = –200, k = ∆Y/∆I ⇒ 5/2 = –200/∆I, ⇒ ∆I = (–200 × 2)/5 = –80, The investment decreases by `80 crore.
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Do it yourself 21, Investment in an economy decreases by `400 crore., Marginal propensity to consume is zero. Calculate the, change in national income., 3 marks, [Ans. ` 400 crore]
Page 1304 :
Solution of Do it yourself 21, Decrease in investment DI = –400, MPC = 0, Value of multiplier, k = 1/(1 – MPC) = 1/(1 – 0) = 1/1 = 1, k = ∆Y/∆I ⇒ 1 = ∆Y/(–)400 ⇒ ∆Y = – 400, Therefore, national income decreases by `400 crore.
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NUMERICAL 22, In an economy, 60% of the additional income is spent on, consumption. Assuming that the investment increases by, `900 crore, explain the working of multiplier., (CBSE 2017) (6 marks), Solution: Working of multiplier (with increase in, investment `900 crore and MPC = 0.6), , • Increase in investment will generate an extra income of, `1000 crore in first round, as expenditure of one is, income for another.
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• Since MPC is 0.6, the nationals who are receiving this, additional income will spend `540 crore (0.6 × 900),, which in return becomes additional income during, second round., • Similarly, in third round `324 crore of income is, generated., • This process will go on infinitely and total increase in, income will be:, ∆Y = ∆I. 1/(1–MPC), = 900 × 1/(1 – 0.6), = 900 × 1/0.4 = 900 × 2.5, = `2,250 crore, As a result, value of Investment Multiplier, k = ∆Y/∆I =, 2,250/900 = 2.5
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Do it yourself 22, In an economy, 75% of the additional income is spent on, consumption. Assuming that the investment increases by `, 800 crore, explain the working of multiplier., [Ans. ∆Y = `3,200 crore]
Page 1308 :
Solution of Do it yourself 22, Working of multiplier (with increase in investment, `800 crore and MPC = 0.75), , • Increase in investment will generate an extra, income of `800 crore in first round, as expenditure, of one is income for another., •Since MPC is 0.75, the nationals who are receiving this
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additional income will spend `600 crore (0.75 × 800),, which in return becomes additional income during, second round., •, Similarly, in third round `450 crore of income is, generated., •, This process will go on infinitely and total, increase in income will be:, ∆Y = ∆I. 1/(1–MPC) = 800 × 1/(1 – 0.75) = 800 ×, 1/0.25 = 800 × 4, = `3,200 crore, As a result, value of Investment Multiplier, k = ∆Y/∆I =, 3,200/800 = 4
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NUMERICAL 23, In an economy, C = 100 + 0.75Y is the consumption, function, where C is consumption expenditure and Y is, National Income. If investment expenditure is 1,000., (i) Derive the savings function, (ii) Calculate equilibrium level of National Income, (iii) Calculate additional investment needed to reach the, new equilibrium level of income 6,000., (6 marks), Solution: Consumption function C = 100 + 0.75Y,, Investment expenditure I = 1,000, (i), Savings function S = Y – C, S = Y – (100 + 0.75Y), S = Y – 100 – 0.75Y, S =– 100 + 0.25Y
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(ii), , At equilibrium level of income Y = C + I, Y = 100 + 0.75Y + 1000, Y – 0.75Y = 1100, 0.25Y = 1100, Y = 1,100/0.25, ∴ Equilibrium level of national income = 4,400, (iii), From the consumption function C = 100 + 0.75Y,, we get MPC = 0.75, Value of multiplier k = 1/(1–MPC) = 1/(1–0.75) =, 1/0.25 = 4, To reach the new equilibrium level of income 6000,, required increase in income, DY = 6000 – 4400 =, 1600, k = ∆Y/∆I ⇒ 4 = 1,600/∆I ⇒ ∆I = 1,600/4 = 400, ∴ Additional investment needed = 400
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Do it yourself 23, If in an economy C = 500 + 0.9Y and I = `1000 crore. (Where C =, Consumption expenditure, Y = National income,, I =, Investment), Calculate the following: (i) equilibrium level of income (ii), value of investment multiplier, (3 marks), [Ans. (i) `15000 crore (ii) 10]
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Solution of Do it yourself 23, (i) Equilibrium level of income will be determined, when, Y = C + I ⇒ Y = 500 + 0.9Y + 1000, Y – 0.9Y = 1500 ⇒ Y = 1500/0.10 = `15000 crore., (ii) Value of Investment Multiplier = 1/(1 – MPC) =, 1/(1 – 0.9) = 1/0.1 = 10
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NUMERICAL 24, There is increase in investment of `100 crore in an, economy. Marginal propensity to consume is 1. What can, you say about total increase in income? Calculate., (3 marks), Solution: Increase in investment ∆I = 100, MPC = 1, Value of multiplier,, k = 1/(1 – MPC) = 1/(1 –, 1) = 1/0 = ∞, Therefore, there will be an infinite increase in income in, the economy due to an increase in investment of `100, crore.
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Do it yourself 24, There is increase in investment of `1,000 crore in an, economy. Marginal propensity to consume is zero. What is, the total increase in income? Calculate., (3 marks), [Ans. ` 1,000 crore]
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Solution of Do it yourself 24, Increase in investment DI = 1,000, MPC = 0, Value of multiplier, k = 1/(1 – MPC) = 1/(1 – 0) = 1/1 = 1, k = ∆Y/∆I ⇒ 1 = ∆Y/∆I, ∆Y = ∆I = 1,000, Therefore, total increase in income = `1,000 crore,, which is exactly equal to the increase in investment.
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NUMERICAL 25, In an economy the equilibrium level of income is ` 12,000, crore. The ratio of marginal propensity to consume and, marginal propensity to save is 3 : 1. Calculate the additional, investment needed to reach a new equilibrium level of income, of `20,000 crore., (3 marks), Solution: Required increase in income ∆Y = 20,000 –, 12000 = 8,000, MPC : MPS = 3 : 1. Therefore, MPC = 3MPS, Since MPC + MPS = 1, therefore, 3MPS + MPS = 1 ⇒, 4MPS = 1 ⇒ MPS = 1/4, Value of multiplier k = 1/MPS = 4, k = ∆Y/∆I ⇒ 4 = 8,000/DI ⇒ DI = 8,000/4 = 2,000, Therefore, additional investment needed = `2,000 crore
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Do it yourself 25, Investment in an economy increases by `1000 crore., Suppose marginal propensity to save is zero. What can you, say about increase in national income? Calculate. (3 marks), [Ans. ` 1,000 crore]
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Solution of Do it yourself 25, Increase in investment ∆I = 1000, MPS = 0, Value of multiplier, k = 1/MPS = 1/0 = ∞, k = ∆Y/∆I ⇒ ∞ = ∆Y/∆I ⇒ ∆Y = ∆I × ∞, Therefore, an increase in investment by `1000 crore, causes infinite increase in national income.
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NUMERICAL 26, In an economy investment increases from 300 to 500. As a, result of this equilibrium level of income increases by, 2,000. Calculate the marginal propensity to consume., (CBSE 2015) (3 marks), Solution: Increase in investment ∆I = 500 – 300 = 200, Increase in income ∆Y = 2,000, Therefore, value of investment multiplier k =, ∆Y/∆I = 2,000/200 = 10, Since k = 1/MPS, therefore, 10 = 1/MPS ⇒ MPS, = 1/10, Hence, MPC = 1 – MPS = 9/10 = 0.9
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Do it yourself 26, In an economy, a 20% increase in investment results in a, 100% increase in income. Calculate the marginal propensity, to consume., (3 marks), [Ans. MPC = 0.8]
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Solution of Do it yourself 26, Increase in investment ∆I = 20%, Increase in income ∆Y= 100%, Value of multiplier, k = ∆Y/∆I = 100%/20% = 5, k = 1/(1 – MPC) ⇒ 5 = 1/(1 – MPC), 1 – MPC = 1/5, MPC = 1 – 1/5 = 4/5 = 0.8
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NUMERICAL 27, Calculate Multiplier when MPC is 4/5 and 1/2. From the, calculations establish the relation between size of, Multiplier and size of MPC., (4 marks), Solution: Multiplier k = 1/(1–MPC), MPC, , Value of Multiplier, k, , 4/5 = 0.8, , k = 1/(1–0.8) = 1/0.2 = 5, , 1/2 = 0.5, , k = 1/(1–0.5) = 1/0.5 = 2, , Observing the same we may conclude that there exists, positive or direct relation between MPC and Investment, Multiplier. Investment multiplier coefficient measures the, change in final income with respect to given change in the, initial investment in the economy. It carries direct relation
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With rate of growth in an economy, i.e., higher the MPC, more chance of growth exists in an economy. But, it is a, two sided sword hence if investment falls in an economy, the income may also fall.
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Do it yourself 27, In an economy, investment increased by `1,100 crore and as, a result of it income increased by ` 5,500 crore. Calculate, the value of multiplier and MPS., Had the marginal propensity to save been 25 percent, what, would have been the increase in income?, (4 marks), [Ans. 5, 0.2, ` 4,400 crore], [Ans. MPC = 0.8]
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Solution of Do it yourself 27, Increase in Investment (∆I) = 1,100, Increase in Income (∆Y) = 5,500, Value of multiplier, k = ∆Y/∆I = 5,500/1,100 = 5, k = 1/MPS, i.e. 5 = 1/MPS, MPS = 1/5 = 0.2, Now, if MPS = 0.25, then k = 1/MPS = 0.25 = 4, Therefore, increase in income (∆Y) = k × ∆I = 4 ×, 1,100 = 4,400
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NUMERICAL 28, If in an economy, income increases from `5,000 crore to `, 8,000 crore as a result of 20% increase in investment,, calculate the value of investment multiplier., (3 marks), Solution: Increase in income ∆Y = (8,000 – 5,000)/5,000 × 100, = 3,000/5,000 × 100, = 60%, Increase in investment ∆I = 20%, Therefore, value of investment multiplier k, = ∆Y/∆I, = 60%/20%, = 0.6/0.2, =3
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Do it yourself 28, If in an economy C = 500 + 0.9 Y and I = ` 1,000 crore., (where C = Consumption expenditure, Y = National, income, I = Investment), Calculate the following:, (i) Equilibrium level of income, (ii) Value of investment multiplier (CBSE 2018) (4 marks), [Ans. (i) `15000 crore (ii) 10]
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Solution of Do it yourself 28, (i) Equilibrium level of income will be determined when, Y=C+I, Y = 500 + 0.9Y + 1,000 ⇒ Y – 0.9Y = 1,500, Y = 1,500/0.10 = `15000 crore., (ii) From the consumption function C = 500 + 0.9Y,, MPC = 0.9, Therefore, value of Investment Multiplier = 1/(1–MPC), - 1/(1–0.9) = 10
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NUMERICAL 29, The consumption function of an economy is given by C = `100, crore + 0.8Y., As a result of increase in autonomous expenditure in this, economy, national income increases by `500 crore. Calculate the, increase in autonomous expenditure in the economy. (3 marks), Solution : From the consumption function C = `100 crore +, 0.8Y, we have MPC = 0.8, Value of investment multiplier, k = 1/(1–MPC) = 1/ (1–0.8) = 1/0.2, =5, Now, Investment multiplier, k = ∆Y/∆I, ∆Y = `500 crore (given) and k = 5, Therefore, 5 = 500/∆I ⇒ ∆I = 100, Since ∆A = ∆I, therefore increase in autonomous expenditure, ∆A = `100 crore
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Do it yourself 29, Suppose in a hypothetical economy, the savings increase by, `20 crore when national income increases by `100 crore., Compute the increment in autonomous expenditure in this, economy to attain an increase in national income by `, 6,000 crore., (3 marks), [Ans. `1,200 crore]
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Solution of Do it yourself 29, MPS = ∆S/∆Y = 20/100 = 0.2, Value of investment multiplier, k = 1/MPS =, 1/0.2 = 5, Now, Investment multiplier, k = ∆Y/∆I, ∆Y = `6,000 crore (given) and k = 5, Therefore, 5 = 6,000/∆I ⇒ ∆I = 1,200, Since ∆A = ∆I, therefore increase in autonomous, expenditure ∆A = `1,200 crore
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NUMERICAL 30, The consumption function of an economy is given by C = `100, crore + 0.8Y., As a result of increase in autonomous expenditure in this, economy, national income increases by `500 crore. Calculate the, increase in autonomous expenditure in the economy. (3 marks), Solution : (i) We know that the equilibrium level of, income in an economy is determined when: S = I, Substituting S = (–) 10 + 0.20Y and I = 240, we have, –10 + 0.20Y =240, 0.20Y =250, Y = 250/0.20 = 1,250, Equilibrium level of income in the economy = `1,250crore, (ii) From the savings function S = (–) 10 + 0.20Y, MPS = 0.20, Value of investment multiplier, k = 1/MPS = 1/0.20 = 5
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To double of the existing income level (∆Y = 1,250 crore),, suppose additional investments needed = ∆I, k=∆Y/∆I, =1250/∆I, ∆I=1,250/5 = 250, Additional investments needed = `250 crore
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Do it yourself 30, The saving function of an economy is given as: S = (–) 50 +, 0.10 Y, If the ex-ante Investments are `450 crore, calculate the, following:, (i) Equilibrium level of income in the economy., (ii) Additional investments which will be needed to gain an, additional income level of ` 3,000, crore., (CBSE 2019) (6 marks), [Ans. (i) ` 5,000 crore (ii) `300 crore]
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Solution of Do it yourself 30, (i) We know that the equilibrium level of income in an, economy is determined when: S = I, – 50+0.10Y=450 ⇒ 0.10Y=500, Y= `5,000 crore, (ii) MPS = 0.10, k = 1/MPS = 1/0.10 = 10, To gain additional income level (∆Y = 3,000, crore), ∆I = ?, k = ∆Y/∆I ⇒ 10 = 3,000/∆I, ∆I = `300 crore
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NUMERICAL 31, If Marginal Propensity to Consume (MPC) is 0.8 and, increase in autonomous investment is `1,000 crore,, calculate the increase in induced consumption and the, leakages in the economy., (6 marks), Solution : Investment Multiplier k = 1/(1 – MPC), = 1/(1 – 0.8) = 1/0.2 = 5, Also, k = ∆Y/∆I, 5 = ∆Y/1,000, ⇒ ∆Y = 5,000, Thus, increase in final income (∆Y) = `5,000 crore, MPC = 0.8, ⇒ ∆C/∆Y = 0.8, ⇒ ∆C/5,000 = 0.8, ⇒ ∆C = 0.8 × 5,000 = 4,000
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Thus, increase in induced consumption (∆C) = `4,000, crore, Leakages in the economy means the additional savings of, the economy i.e. ∆S = ∆Y – ∆C = 5,000 – 4,000 = `1,000, crore
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Do it yourself 31, If Marginal Propensity to Consume (MPC) is 0.75 and, change in initial investment is `2,000 crore, calculate the, increase in induced consumption and the leakages in the, economy., (6 marks), [Ans. ` 6,000 crore; ` 2,000 crore]
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Solution of Do it yourself 31, Investment Multiplier k = 1/(1 – MPC) = 1/(1 – 0.75), = 1/0.25 = 4, Also, k = ∆Y/∆I ⇒ 4 = ∆Y/2,000 ⇒ ∆Y = 8,000, Thus, increase in final income (∆Y) = `8,000 crore, MPC = 0.75 ⇒ ∆C/∆Y = 0.75 ⇒ ∆C/8,000 = 0.75, ∆C = 0.75 × 8,000 = 6,000, Thus, increase in induced consumption (∆C) = `6,000, crore, Leakages in the economy = Additional savings, ∆S = ∆Y, – ∆C, = 8,000 – 6,000 = `2,000 crore
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Question 1, When an economy decides to save the whole of its, additional income, what will be the value of investment, multiplier?, (1 mark), , HOTs 3.5— Analysing, Evaluating & Creating Type Questions
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Answer 1, When an economy decides to save the whole of its, additional income, i.e. MPS = 1, the value of investment, multiplier will be:, k = 1/MPS = 1/1 = 1, , HOTs 3.5— Analysing, Evaluating & Creating Type Questions
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Question 2, State giving reasons whether the following statements, are true or false:, (4 marks), (a) When marginal propensity to consume is greater, than marginal propensity to save, the value of, investment multiplier will be greater than 5., (b) If the ratio of marginal propensity to consume and, marginal propensity to save is 4 : 1, the value of, investment multiplier will be 4., , HOTs 3.5— Analysing, Evaluating & Creating Type Questions
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Answer 2, (a) False, Reason: Value of investment multiplier will be greater, than 2., Explanation: MPC >MPS, 1 – MPS <MPS, 1 > 2 MPS, 1/MPS >2, k >2, (b) False, Reason:Value of investment multiplier will be 5., HOTs 3.5— Analysing, Evaluating & Creating Type Questions
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Question 3, If in an economy, the consumption and savings curves, are parallel to each other, what will be the value of, investment multiplier? Explain., (3 marks), , HOTs 3.5— Analysing, Evaluating & Creating Type Questions
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Answer 3, Value of investment multiplier = 2, Explanation: When two straight lines are parallel, their, slopes must be equal., Since consumption and savings curves are parallel to each, other, therefore they have the equal slopes., We know that the slope of the consumption curve is, MPC and the slope of the savings curve is MPS., Thus, MPC = MPS, Since MPC + MPS = 1, therefore we have, MPS + MPS = 1, HOTs 3.5— Analysing, Evaluating & Creating Type Questions
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2 MPS = 1, MPS = 1/2 = 0.5, Therefore,Value of investment multiplier, k = 1/MPS, = 1/0.5 = 2, , HOTs 3.5— Analysing, Evaluating & Creating Type Questions
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Question 4, Why does a change in investment cause a multiple, change in income? Explain., (3 marks), , HOTs 3.5— Analysing, Evaluating & Creating Type Questions
Page 1350 :
Answer 4, Since value of investment multiplier is always greater than 1., Explanation, Value of investment multiplier k = 1/(1 – MPC), Minimum value of investment multiplier is 1 when MPC =, 0 since = 1/(1–0) = 1/1 = 1., Maximum value of multiplier can be infinity when MPC =, 1 since k = 1/(1 – MPC) = 1/(1–1) = 1/0 = ∞., However, in reality 0 < MPC < 1, therefore, 1 < k < ∞, ⇒, k>1, ⇒, ∆Y/∆I > 1, ⇒, ∆Y > ∆I, HOTs 3.5— Analysing, Evaluating & Creating Type Questions
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Thus, change in final income is greater than initial change, in investment., , HOTs 3.5— Analysing, Evaluating & Creating Type Questions
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Question 5, How is this money creation by commercial banks likely, to affect the national income? Explain., (3 marks), , HOTs 3.5— Analysing, Evaluating & Creating Type Questions
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Answer 5, Commercial banks create money through the lending of, deposits of the public after keeping legal reserves., Commercial banks lend money mainly to investors. Thus,, more lending by banks means more investment in the, country., The rise in investment in the economy leads to rise in, national income through the investment multiplier, mechanism., , HOTs 3.5— Analysing, Evaluating & Creating Type Questions
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Question 6, Government of India launched ‘Jan-Dhan Yojna' which, aimed at every household in the country to have at least, one bank account. Explain how deposits made under the, plan affect national income of the country., (CBSE 2015) (3 marks), , HOTs 3.5— Analysing, Evaluating & Creating Type Questions
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Answer 6, Opening more bank accounts means more bank deposits., More deposits means increase in the lending capacity of, the commercial banks. Commercial banks lend money, mainly to investors. Thus, more lending by banks means, more investment in the country. The rise in investment in the, economy leads to rise in national income through the, investment multiplier mechanism., , HOTs 3.5— Analysing, Evaluating & Creating Type Questions
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Question 1, If MPC = 1, the value of multiplier is:, (CBSE 2015) (Choose the correct alternative), (a) 0, (b) 1, (c) Between 0 and 1, (d) Infinity, , Objective Type Questions 3.5
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Answer 1, (d) Infinity, , Objective Type Questions 3.5
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Question 2, If MPC = 0, the value of multiplier is:, (CBSE 2015) (Choose the correct alternative), (a) 0, (b) 1, (c) Between 0 and 1, (d) Infinity, , Objective Type Questions 3.5
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Answer 2, (b), , 1, , Objective Type Questions 3.5
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Question 3, The maximum value of investment multiplier can be, __________ when the MPC is assumed to, __________., (Choose the correct alternative), (a) Infinity, zero, (b) Infinity, one, (c) One, infinity, (d) None of these, , Objective Type Questions 3.5
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Answer 3, (b), , Infinity, one, , Objective Type Questions 3.5
Page 1362 :
Question 4, National income will rise with the rise in investment., True/False? Give reason., , Objective Type Questions 3.5
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Answer 4, True: Since production capacity will increase with rise, investment, therefore national income will rise, multiplier times the initial rise in investment., , Objective Type Questions 3.5
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Question 5, If the value of MPC is 0.75, the value of multiplier is, __________., (Fill in the blank), , Objective Type Questions 3.5
Page 1365 :
Answer 5, 4, , Objective Type Questions 3.5
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Question 6, Value of investment multiplier varies between zero and, infinity., (True/False), , Objective Type Questions 3.5
Page 1367 :
Answer 6, False: Investment multiplier, k = 1/(1–MPC), Since 0 < MPC < 1, therefore, value of multiplier, ranges between 1 and ∞., , Objective Type Questions 3.5
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Question 7, When marginal propensity to consume is zero, the value, of investment multiplier will also be zero. (True/False), , Objective Type Questions 3.5
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Answer 7, False:Value of investment multiplier, k = 1/(1–MPC), When MPC = 0, k = 1/(1 – 0) = 1/1 = 1, , Objective Type Questions 3.5
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Question 8, The ratio of the total increment in equilibrium value of, final goods output to the initial increment in, autonomous expenditure is called __________ of the, economy., (Fill in the blank), , Objective Type Questions 3.5
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Answer 8, Investment multiplier, , Objective Type Questions 3.5
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Question 9, What is the value of multiplier, when S = –100 + 0.4Y?, (Choose the correct alternative), (a) 1.5, (b) 1.05, (c) 2.5, (d) 2.05, , Objective Type Questions 3.5
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Answer 9, (c), , 2.5, , Objective Type Questions 3.5
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Question 10, In an economy, when investment decreases national, income decreases at least by an amount equal to, decrease in investment., (True/False), , Objective Type Questions 3.5
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Answer 10, True: Investment multiplier, k = 1/(1 – MPC) Since 0 <, MPC < 1, the value of multiplier will be greater, than 1 (k > 1). Therefore, a change in investment, will cause a multiple change in income. Hence, a, decrease in investment will cause national, income to decrease at least by an amount equal, to decrease in investment., , Objective Type Questions 3.5
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Question 11, If MPS = 1, change in national income will be exactly, equal to change in investment., (True/False), , Objective Type Questions 3.5
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Answer11, True: When MPS = 1, k = 1/MPS = 1/1 = 1, k = DY/DI = 1, DY = DI, Thus, change in national income will be exactly, equal to change in investment., , Objective Type Questions 3.5
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Question 12, If MPC is double the MPS, value of investment multiplier, will be 2., (True/False), , Objective Type Questions 3.5
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Question 13, When MPC is equal to MPS, increase in national income, will be twice the initial increase in investment.(True/False), , Objective Type Questions 3.5
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Answer 13, True: Equality between MPC and MPS signifies that, both of them are equal to 0.5 (as MPC + MPS =, 1). Therefore, value of investment multiplier (k) =, 1/MPS = 1/0.5 = 2. It means that increase in, income in the economy will be twice the initial, increase in investment., , Objective Type Questions 3.5
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Question 14, When investment multiplier is 1, the value of marginal, propensity to consume is zero., (True/False), , Objective Type Questions 3.5
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Answer 14, True: k = 1/(1 – MPC), Since k = 1, therefore, 1 = 1/(1 – MPC), 1 – MPC = 1, MPC = 0, , Objective Type Questions 3.5
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Question 15, A change in initial investment causes a change in final, income by an amplified amount, which is a multiple of, the change in initial investment and depends upon the, value of ____________., (Fill in the blank), , Objective Type Questions 3.5
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Answer 15, MPC; since k = 1/(1 – MPC), , Objective Type Questions 3.5
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Question 16, As MPC rises, value of multiplier increases., True/False? Give reason., , Objective Type Questions 3.5
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Answer 16, True: Because the size of the multiplier (k) depends on, the value of MPC as k = 1/(1 – MPC)., There is a direct/positive relation between MPC, and value of multiplier. Thus, as MPC rises, the, value of multiplier increases., , Objective Type Questions 3.5
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3.6, Problems of Deficient, Demand and Excess, Demand
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Full Employment Equilibrium, Full employment refers to a situation of no involuntary, unemployment., Involuntary unemployment refers to a situation, when a person who is willing and able to work at the, prevailing wage rate, does not get work., Thus, full employment is a situation in which all those, who are able and willing to work at the prevailing wage, rate find work.
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, , Top Tip, , Involuntary unemployment is distinguished from voluntary, unemployment which refers to that part of population which, are able to work but voluntarily prefer not to work. Such, people are not included in the labour force of the country, because labour force comprises of people who are able to, work and willing to work., , Full employment level of income is that level of, income where all the factors of production are fully, employed in the production process., Figure 3.9 shows that the economy is in equilibrium at, point E where the aggregate demand (AD) curve, intersects the 45° line from origin. The corresponding, level of income is OQ, which is full employment level, of income. It must be noted that equilibrium level of
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output determined by the equality, Y = AD does not, necessarily mean the full employment level of output., The equilibrium level of output may be more or less, than the full employment level of output., If it is less than the full employment of output, it is, due to the fact that demand is not enough to, employ all factors of production. This situation is, called the situation of deficient demand., On the other hand, if the equilibrium level of, output is more than the full employment level, it is, due to the fact that the demand is more than the, level of output produced at full employment level., This situation is called the situation of excess, demand.
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Deficient demand and Deflationary, gap, If equilibrium level of income/output is less than the, full employment level of income/output, it is due to, the fact that aggregate demand is not enough to, employ all the factors of production. This situation is, called the situation of deficient demand., When aggregate demand is less than aggregate supply, at full employment, it is a situation of deficient demand., Deficient demand gives rise to a deflationary gap,, which causes the economy’s income, output and, employment to decline, thus pushing the economy, into an underemployment equilibrium.
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Deflationary gap is the amount by which the aggregate, demand falls short of aggregate supply at full employment., The deflationary gap is called deflationary because it, sets in motion forces that cause deflation i.e. a fall in, general price level., When aggregate demand and aggregate supply are, equal at below full employment level, it is called, under-employment equilibrium., Figure 3.10 depicts the situation of deficient demand, and deflationary gap. OQ is the full employment level, of income/output. For the economy to be at full, employment equilibrium, the aggregate demand should be, equal to the full employment level of income/output, i.e., FQ (which is equal to OQ since point F lies on the 45°, line from the origin).
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However, the actual aggregate demand is GQ, which is, less than FQ. This results in a situation of deficient, demand. The resulting deflationary gap created due to, deficient demand is represented by FG in figure 3.10., The deflationary gap is the amount by which the, actual aggregate demand falls short of the level of, aggregate demand required to established the full, employment equilibrium., To correct the situation of deficient demand, the, aggregate demand must be increased by an amount, equal to the deflationary gap FG. This will move the, economy to the full employment equilibrium at point, F., Note that since we are considering only two-sector
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economy, aggregate demand can be increased through, increase in investment, as shown by DI in figure 3.10., (In a two-sector economy, there is no role of the, government.)
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Remedy for deficient demand and, deflationary gap, In order to remedy the problem of deficient demand,, the aggregate demand has to be increased by an, amount equal to the deflationary gap.This will move, the economy to the full employment equilibrium., The aggregate demand may be increased by taking, recourse to fiscal policy, monetary policy or both.
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Fiscal policy measures, Fiscal policy is the expenditure and taxation policy of, the government., (i) Increase in government expenditure: Government, should increase its own expenditure to leave more, personal disposable income. Then, aggregate demand, will increase to correct the deflationary situation. (ii), Decrease in taxes: The government under its fiscal, policy may decrease the rate of taxes (both direct and, indirect taxes). This will ensure greater purchasing, power in the hands of general public. This will help to, increase aggregate demand and remove the, deflationary gap.
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Monetary policy measures – Increase, in money supply, Central bank through its expansionary monetary, policy can increase the money supply in the economy., Central bank can use tools like bank rate, cash reserve, ratio, repo and reverse repo rates etc. to ensure greater, money in the hands of general public which would in, turn increase the aggregate demand in the economy, and be helpful in reducing/removing the deflationary, gap., Central bank should:, • Reduce bank rate, • Reduce statutory liquidity ratio, • Reduce reverse repo rate
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•, , Purchase government securities in the open, market., • Reduce cash reserve ratio, • Reduce repo rate, • Reduce margin requirement on loan, (These were explained under functions of Central Bank, in the Unit 2, Section 2.4. The students are expected to, revise these monetary policy instruments from Unit 2.), , Excess Demand and Inflationary gap, If the equilibrium level of income/output is more than, the full employment level of income/output, it is due, to the fact that the aggregate demand is more than the, level of output produced at full employment level. This, situation is called the situation of excess demand.
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When aggregate demand is more than the aggregate, supply at full employment, it is a situation of excess, demand., Excess demand gives rise to an inflationary gap,, which causes a rise in the general price level or, inflation., The Inflationary gap is the amount by which the, aggregate demand exceeds aggregate supply at full, employment. Inflationary gap is called inflationary, because it sets in motion forces that will cause, inflation or a rise in general price level. (It is called, demand pull inflation, i.e., an aggregate demand, induced rise in the general price level.) Figure 3.11, depicts the situation of excess demand and, inflationary gap. OQ is the full employment level of
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income/output. For the economy to be at full, employment equilibrium, the aggregate demand, should be equal to the full employment level of, income/output, i.e. FQ (which is equal to OQ since, point F lies on the 45° line from the origin)., However, the actual aggregate demand is GQ, which is, greater than FQ. This results in a situation of excess, demand., The resulting inflationary gap created due to excess, demand is represented by GF in figure 3.11., The Inflationary gap is the amount by which the, actual aggregate demand exceeds the level of, aggregate demand required to established the full, employment equilibrium.
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To correct the situation of excess demand, the, aggregate demand must be decreased by an amount, equal to the deflationary gap GF. This will move the, economy to the full employment equilibrium at point, F., Note that since we are considering only two-sector, economy, aggregate demand can be decreased through, decrease in investment, as shown by ∆I in figure 3.11., (In a two-sector economy, there is no role of the, government.)
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Impact of excess demand in the economy, (i) On employment – There will be no change in the, employment as the economy is already working at, the full employment. Thus, there is no further, scope of creation of employment., (ii) On output – Output cannot increase because full, employment level of output is the largest output, that the economy is capable of producing since all, resources are fully employed., (iii)On general price level – Production cannot be, increased beyond the full employment level., Increase in aggregate demand here onwards, will, only increase the general price level., (iv) On income – Excess demand will cause increase
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in nominal income only due to rise in the general price, level. However, real income (i.e. output) remains the, same. It cannot increase because full employment level, of output is the largest output that the economy is, capable of producing when all resources are fully, employed.
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Remedy to correct the situation of excess, demand and inflationary gap, In order to remedy the problem of excess demand, the, aggregate demand has to be reduced by an amount, equal to the inflationary gap. This will keep the, economy at full employment equilibrium but will lower, the price level and thus combat the inflation., The aggregate demand may be reduced by taking, recourse to fiscal policy or to monetary policy.
Page 1408 :
Fiscal policy measures, (i) Decrease in government expenditure: Decrease, in government expenditure will reduce aggregate, demand and remove the inflationary gap. The fall, in government expenditure should be equal to the, inflationary gap., (ii) Increase in taxes: The government may increase, the rate of taxes (both direct and indirect taxes)., This will reduce purchasing power in the hands of, general public. This will help to decrease aggregate, demand and reduce the inflationary gap.
Page 1409 :
Monetary policy measures: Decrease in, money supply:, Central Bank can decrease the money supply in the, economy. Central bank can use tools like bank rate,, cash reserve ratio, repo and reverse repo rates etc. to, ensure lesser money in the hands of general public, which would in turn decrease the aggregate demand in, the economy and be helpful in reducing/removing the, inflationary gap., • Increase bank rate, • Increase cash reserve ratio, • Increase statutory liquidity ratio, • Increase repo rate
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•, Increase margin requirement on loan, •, Sell government securities in the open market., (These were explained under functions of Central Bank, in the Unit 2, Section 2.4. The students are expected to, revise these monetary policy instruments from Unit 2.)
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Key Terms, Full employment – It refers to a situation of no involuntary, unemployment., Involuntary unemployment – It refers to a situation when a, person who is willing and able to work at the prevailing wage rate,, does not get work., Full employment level of income – It is that level of income, where all the factors of production are fully employed in the, production process., Deficient Demand – When aggregate demand is less than, aggregate supply at full employment, it is a situation of deficient, demand., Deflationary gap – It is the amount by which the aggregate, demand falls short of aggregate supply at full employment., Under-employment equilibrium – When aggregate demand and, aggregate supply are equal at below full employment level, it is, called under-employment equilibrium.
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Excess Demand – When aggregate demand is more than the, aggregate supply at full employment, it is a situation of excess, demand., Inflationary gap – It is the amount by which the aggregate, demand exceeds aggregate supply at full employment., Demand pull inflation – An aggregate demand induced rise in the, general price level.
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RECAP, , Full employment refers to a situation of no involuntary, unemployment., Involuntary unemployment refers to a situation when a, person who is willing and able to work at the prevailing wage, rate, does not get work., , Deficient demand and deflationary gap, When aggregate demand is less than the full employment, level of aggregate supply, it is a situation of deficient, demand. Deficient demand gives rise to deflationary gap., Deflationary gap is the amount by which the aggregate, demand falls short of full employment level of aggregate, supply. It is called deflationary because it leads to decline in, prices in the long run., The economy will be operating at under employment, equilibrium level.
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Remedy to correct the situation of deficient demand, and deflationary gap, To tackle the situation of deficient demand, the aggregate, demand must be increased by an amount equal to the, deflationary gap., Fiscal policy measures, (i) Increase in government expenditure: Government, should increase its own expenditure to leave more, personal disposable income. Then, aggregate demand, will increase to correct the deflationary situation., (ii) Decrease in taxes: The government under its fiscal, policy may decrease the rate of taxes (both direct and, indirect taxes). This will ensure greater purchasing, power in the hands of general public. This will help to, increase aggregate demand and remove the deflationary, gap.
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Monetary policy measures – Increase in money supply, Central bank through its expansionary monetary policy can, increase the money supply in the economy., Central bank can use tools like bank rate, cash reserve ratio,, repo and reverse repo rates etc. to ensure greater money in, the hands of general public which would in turn increase the, aggregate demand in the economy and be helpful in, reducing/removing the deflationary gap., , Excess demand and inflationary gap, When aggregate demand is more than the full employment, level of aggregate supply, it is a situation of excess demand., Excess demand gives rise to inflationary gap., Inflationary gap is the amount by which the aggregate, demand exceeds the full employment level of aggregate, supply. It is called inflationary because it leads to rise in
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prices in the long run., Impact of excess demand in the economy:, (i) On employment, output and income – There will be no, change in the employment as the economy is already, working at the full employment. Thus, there is no, further scope of creation of employment., Output cannot increase because full employment level, of output is the largest output that the economy is, capable of producing since all resources are fully, employed., Only nominal income will increase due to rise in general, price level., (ii) On general price level – Production cannot be increased, beyond the full employment level. Increase in aggregate, demand here onwards, will only increase the general, price level.
Page 1417 :
Remedy to correct the situation of excess demand and, inflationary gap, In order to remedy the problem of excess demand, the, aggregate demand has to be reduced by an amount equal to, the inflationary gap., Fiscal policy measures, (i) Decrease in government expenditure: Decrease in, government expenditure will reduce aggregate demand, and remove the inflationary gap. The fall in government, expenditure should be equal to the inflationary gap., (ii) Increase in taxes: The government may increase the rate, of taxes (both direct and indirect taxes)., This will reduce purchasing power in the hands of, general public., This will help to decrease aggregate demand and reduce, the inflationary gap.
Page 1418 :
Monetary policy measures – Decrease in money supply, Central Bank can decrease the money supply in the, economy., Central bank can use tools like bank rate, cash reserve ratio,, repo and reverse repo rates etc. to ensure lesser money in the, hands of general public which would in turn decrease the, aggregate demand in the economy and be helpful in, reducing/removing the inflationary gap.
Page 1419 :
NUMERICAL 32, In an economy, autonomous consumption is `100, crore and autonomous investment is `60 crore. In, this economy, with every increase in income, 80% of, it is spent on consumption. The full employment, level of income is `1000 crore., (a) Calculate the equilibrium level of income., (b)State whether the economy is facing a situation of, excess demand or deficient demand. Give reasons in, support of your answer. Calculate the required, increase/decrease in investment to reach the full, employment equilibrium., (6 marks), Solution: (a) Autonomous consumption C = 100, MPC = b, = 80% = 0.8, Autonomous investment I = 60
Page 1420 :
Consumption function equation C = C + bY = 100 +, 0.8Y, At equilibrium level of income, Y = C + I, Y=, 100 + 0.8Y + 60, ⇒ Y – 0.8Y =, 160 ⇒ 0.2Y = 160 ⇒ Y = 160/0.2, = 800, Therefore, equilibrium level of income = `800 crore, (b) Full employment level of income = `1000 crore, Since equilibrium level of income is less than full, employment level of income, it is a situation of, deficient demand, which gives rise to a deflationary, gap. The economy is operating at under-employment, equilibrium., Required increase in income to combat deflationary, gap or to reach the full employment equilibrium, DY =, 1000 – 800 = `200 crore
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Value of multiplier, k= 1/(1–MPC) = 1/(1–0.8) = 1/0.2 = 5, k = ∆Y/∆I ⇒ 5 = 200/∆I ⇒ ∆I = 40, Hence, increase in investment required to reach the full, employment of level of income = `40 crore
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Do it yourself 32, The consumption function of an economy is given as: C = 10, + 0.8Y, If the planned investment is `100 crore, calculate the, following:, (a) Equilibrium level of income in the economy., (b)Deflationary gap at the full employment level of income, `1,000 crore., (6 marks), [Ans. (a) ` 550 crore (b) ` 90 crore]
Page 1423 :
Solution of Do it yourself 32, C = 10 + 0.8Y and I = 100, (a) Equilibrium level of income in the economy exist, when Y = C + I, Substitute the values of consumption and, investment, we get, Y = 10 + 0.8Y + 100, Y – 0.8Y = 10 + 100 ⇒, 0.2Y = 110, Equilibrium level of income Y = 110/0.2 = `550, crore, (b) At full employment level of income (Y = 1,000), Aggregate demand will be: AD = C + I = 10 + 0.8, (1,000) + 100 = 10 + 800 + 100 = `910 crore, Thus, AD < Y at full employment level of income,
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i.e. a situation of deficient demand in the economy., Deflationary gap = Full employment level of income –, AD at full employment level = 1,000 – 910 = `90 crore
Page 1425 :
NUMERICAL 33, In an economy the equilibrium level of income is, `500 crore whereas the full employment level of, income is ` 800 crore. The marginal propensity to, consume is 0.75. Calculate the decrease in investment, required to combat the inflationary gap. (3 marks), Solution: Since equilibrium level of income is less than, full employment level of income, it is a situation of excess, demand in the economy. Inflationary gap = 800 – 500 =, `300 crore. Thus, required decrease in income ∆Y = (–) `, 300 crore, Investment multiplier, k = 1/(1–MPC) = 1/(1–0.75) = 1/0.25 = 4, k = ∆Y/∆I ⇒ 4 = –300/∆I ⇒ ∆I = –75, , Thus, required decrease in investment required to combat
Page 1427 :
Do it yourself 33, The consumption function of an economy is given as: C =, 250 + 0.75Y, If the planned investment is ` 2,000 crore, calculate the, following:, (a), Equilibrium level of income in the economy., (b)Inflationary gap at the full employment level of income, `5,000 crore., (6 marks), [Ans. ` 9,000 crore; ` 1,000 crore]
Page 1428 :
Solution of Do it yourself 33, Given C = 250 + 0.75Y, I = 2,000, (a), Equilibrium level of income in the economy exist, when Y = C + I, Substitute the values of consumption and investment,, we get, Y = 250 + 0.75Y + 2,000, Y – 0.75Y = 2,250 ⇒ 0.25Y = 2,250, Y = 2,250/0.25, Equilibrium level of income Y = `9,000 crore, (b) At full employment level of income (Y = 5,000), Aggregate demand will be:, AD = C + I ⇒ AD = 250 + 0.75 (5,000) + 2,000, AD = 250 + 3,750 + 2,000
Page 1429 :
AD = 6,000, Thus, AD > Y at full employment level of income, i.e. a, situation of excess demand in the economy., Inflationary gap = AD at full employment level – Full, employment level of income = 6,000 – 5,000 = `1,000, crore
Page 1430 :
Question 1, Giving valid reasons, state whether the following, statements are true or false:, (4 marks), (a) An excess of aggregate demand over full employment, level of aggregate supply represents a situation of, inflationary gap., (b) An economy facing unintended accumulation of, inventories would try to reduce aggregate demand., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1431 :
Answer 1, (a) The given statement is true; an excess of aggregate, demand over full employment level of aggregate, supply represents a situation of inflationary gap,, production cannot be increased beyond this level., Increase in AD here onwards, will increase only the, general price level., (b) The given statement is not correct. The situation of, unintended accumulation of inventories arises when, ex-ante aggregate demand is lesser than the ex-ante, aggregate supply. This would pile up the stock with, the producers, thus to tackle this situation the, economy must increase AD., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1432 :
Question 2, ‘An economy is operating at under-employment level of, income’. What is meant by the given statement? Discuss, one fiscal measure and one monetary measure to tackle, the situation., (CBSE Sample Question Paper 2020) (6 marks), , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1433 :
Answer 2, An economy is said to be operating at under employment, equilibrium level, if the planned aggregate expenditure (i.e., aggregate demand) falls short of available output in the, economy, corresponding to the full employment level. It, refers to a situation of deficient demand, which gives rise, to a deflationary gap., To tackle such a situation the aggregate demand has to be, increased by an amount equal to the deflationary gap., Following measures may be taken for the same., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1434 :
(i) One fiscal measure – Decrease in taxes, The government under its fiscal policy may decrease, the rate of taxes (both direct and indirect taxes). This, will ensure greater purchasing power in the hands of, general public. This will help to increase aggregate, demand and remove the deflationary gap., (ii) One monetary measure – Increase in money, supply Central bank through its expansionary, monetary policy can increase the money supply in, the economy. Central bank can use tools like bank, rate, cash reserve ratio, repo and reverse repo rates, HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1435 :
etc. to ensure greater money in the hands of general, public which would in turn increase the aggregate demand, in the economy and be helpful in reducing/removing the, deflationary gap., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1436 :
Question 3, State which of the following statements are true or false., Give valid reasons., (CBSE 2019) (3 marks), (a) According to Keynesian theory of employment, the, state of full employment is obtained only when the, economy is in equilibrium., (b) According to Keynesian theory of employment, a, state of under-employment can never exist in an, economy., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1437 :
Answer 3, (a) The given statement is false – as per Keynesian, theory of Employment the economy can be in, equilibrium at less than or more than full employment, level also., (b) The given statement is false, according to Keynesian, theory of employment the state of under, employment can exist. This may occur at that level of, income where equilibrium between AD and AS, happens at less than full employment level., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1438 :
Question 4, State the impact of ‘Excess Demand’ under the, Keynesian theory on employment, in an economy., (CBSE 2019) (3 marks), , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1439 :
Answer 4, In case of ‘Excess Demand’ under the Keynesian Theory,, there will be no change in the employment as the, economy is already working at the full employment. Thus,, there is no further scope of creation of employment., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1440 :
Question 5, What does the deflationary gap measure?, , (1 mark), , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1441 :
Answer 5, The deflationary gap is a measure of the amount of, deficiency of aggregate demand., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1442 :
Question 6, What is meant by demand pull inflation?, , (1 mark), , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1443 :
Answer 6, Demand pull inflation is an aggregate demand induced rise, in the price level., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1444 :
Question 7, Why is the inflationary gap so called?, , (1 mark), , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1445 :
Answer 7, The inflationary gap is so called because it sets in motion, forces that will cause inflation or a rise in the price level., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1446 :
Question 8, What is the effect of a decrease in bank rate on, aggregate demand?, (1 mark), , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1447 :
Answer 8, It will increase the level of aggregate demand in the, economy., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1448 :
Question 9, What is the effect of a rise in cash reserve ratio on, aggregate demand?, (1 mark), , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1449 :
Answer 9, It will decrease the level of aggregate demand in the, economy., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1450 :
Question 10, What is the effect of increase in Reverse repo rate on, aggregate demand?, (1 mark), , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1451 :
Answer 10, It will decrease the level of aggregate demand in the, economy., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1452 :
Question 11, Give two measures taken by the government to remove, deflationary gap., (1 mark), , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1453 :
Answer 11, (i), (ii), , Increase in government expenditure, Reduction in the amount of taxes, , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1454 :
Question 12, Give two measures taken by the Central bank to, combat excess demand., (CBSE 2009) (1 mark), , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1455 :
Answer 12, (i), (ii), , Increase in Legal reserves (CRR, SLR), Increase in Bank rate, , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1456 :
Question 13, In the situation of inflation, more credit creation by, commercial banks has negative impact on the economy., How?, , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1457 :
Answer 13, Credit creation by commercial banks in inflationary, situation in the economy increases the money supply and, hence aggregate demand. It creates the situation of excess, demand and inflationary gap if aggregate demand exceeds, the full employment level of output/income., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1458 :
Question 14, Is equilibrium level of income and output always, associated with full-employment? Explain., (3 marks), , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1459 :
Answer 14, The economy will be in full-employment equilibrium if, aggregate demand is equal to aggregate supply at full, employment. However, the equilibrium level of income/output, is not always associated with full employment., • If aggregate demand is less than aggregate supply at full, employment, then it is a situation of deficient demand, in the economy which gives rise to deflationary gap., • On the other hand, if aggregate demand is more than, aggregate supply at full employment, then a situation of, excess demand exists in the economy which gives rise, to inflationary gap., HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1460 :
Question 15, What changes will take place in the economy if, (4 marks), (i) aggregate demand exceeds aggregate supply?, (ii) aggregate demand exceeds aggregate supply at full, employment?, , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1461 :
Answer 15, (i), , (ii), , If aggregate demand exceeds aggregate supply (AD, > AS), this means that consumers would be buying, more goods than firms were producing. This would, lead to an unplanned decrease in inventories. Firms, would then increase output and thus income would, increase. This process of increase in income will, continue until the economy is in equilibrium where, AD = AS., If aggregate demand exceeds the full employment, level aggregate supply, then a situation of excess, demand exists in the economy. Excess demand gives, HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1462 :
rise to an inflationary gap; which causes a rise in the, general price level or inflation., , HOTs 3.6— Analysing, Evaluating & Creating Type Questions
Page 1463 :
Question 1, Aggregate demand can be increased by:, (Choose the correct alternative), (a) increasing bank rate, (b) selling government securities by Reserve Bank of India, (c) increasing cash reserve ratio, (d) none of the above, , Objective Type Questions 3.6
Page 1464 :
Answer 1, (d) none of the above, , Objective Type Questions 3.6
Page 1465 :
Question 2, The remedy to combat deficient demand is .................... ., (Choose the correct alternative), (a) Decrease in bank rate, (b) Increase in cash reserve ratio, (c) Increase in tax rate, (d) All of these, , Objective Type Questions 3.6
Page 1466 :
Answer 2, (a), , Decrease in bank rate, , Objective Type Questions 3.6
Page 1467 :
Question 3, A fiscal policy measure to combat deflationary gap is, .................... ., (Choose the correct alternative), (a) Increase in tax rates, (b) Increase in government expenditure, (c) Increase in price level, (d) Decrease in government expenditure, , Objective Type Questions 3.6
Page 1468 :
Answer 3, (b), , Increase in government expenditure, , Objective Type Questions 3.6
Page 1469 :
Question 4, Increase in cash reserve ratio will lead to:, (Choose the correct alternative), (a) Fall in Aggregate Demand, (b) Rise in Aggregate Demand, (c) No change in Aggregate Demand, (d) None of these, , Objective Type Questions 3.6
Page 1470 :
Answer 4, (a), , Fall in Aggregate Demand, , Objective Type Questions 3.6
Page 1471 :
Question 5, The gap by which actual aggregate demand exceeds the, aggregate demand required to establish full employment, equilibrium is known as ............... ., (Choose the correct alternative), (a) Deficient Demand, (b) Deflationary gap, (c) Inflationary Gap, (d) Excess Demand, , Objective Type Questions 3.6
Page 1472 :
Answer 5, (c), , Inflationary gap, , Objective Type Questions 3.6
Page 1473 :
Question 6, ............ refers to the situation when aggregate demand is, less than aggregate supply corresponding to full, employment level of output in the economy., (Choose the correct alternative), (a) Deficient Demand, (b) Excess Demand, (c) Inflationary Gap, (d) Deflationary gap, , Objective Type Questions 3.6
Page 1474 :
Answer 6, (a), , Deficient Demand, , Objective Type Questions 3.6
Page 1475 :
Question 7, A situation of excess demand in the economy will lead, to ............., (Choose the correct alternative), (a) Increase in the level of employment, (b) Decrease in the level of employment, (c) No change in the level of employment, (d) None of these, , Objective Type Questions 3.6
Page 1476 :
Answer 7, (c), , No change in the level of employment, , Objective Type Questions 3.6
Page 1477 :
Question 8, Deficient Demand indicates:, (Choose the correct alternative), (a) Under employment equilibrium, (b) Deflationary gap, (c) Full employments equilibrium, (d) Both (a) and (b), , Objective Type Questions 3.6
Page 1478 :
Answer 8, (d), , Both (a) and (b), , Objective Type Questions 3.6
Page 1479 :
Question 9, Monetary Policy is the policy of the ................. to control, money supply and credit creation in the economy., (Choose the correct alternative), (a) Central Government, (b) Central Bank, (c) Both (a) and (b), (d) None of these, , Objective Type Questions 3.6
Page 1480 :
Answer 9, (b), , Central Bank, , Objective Type Questions 3.6
Page 1481 :
Question 10, In situation of excess demand, the central bank ................, the margin requirement, (Choose the correct alternative), (a) Decreases, (b) Increases, (c) Removes, (d) Does not change, , Objective Type Questions 3.6
Page 1482 :
Answer 10, (b), , Increases, , Objective Type Questions 3.6
Page 1483 :
Question 11, An increase in the bank rate is effective to combat, inflation., (True/False), , Objective Type Questions 3.6
Page 1484 :
Answer11, True: The bank rate is the rate of interest at which the, Central Bank lends money to the commercial, banks., During inflation, the Central bank, increases the bank rate, which increases the cost, of borrowings from the Central bank. Therefore,, commercial banks also increase their lending, rates. This will discourage people to take loans., This will reduce the money supply and the level, of aggregate demand in the economy to combat, inflation., Objective Type Questions 3.6
Page 1485 :
Question 12, In situation of deficient demand, the central bank raises, cash reserve ratio., (True/False), , Objective Type Questions 3.6
Page 1486 :
Answer 12, False: In situation of deficient demand, the Central, bank decreases the cash reserve ratio (CRR). As, a result,banks are required to hold smaller, fraction of their deposits as cash reserves with, the central bank. Therefore, the lending capacity, of the banks increases. It leads to an increase in, money supply. This will raise the level of, aggregate demand and correct the situation of, deficient demand., , Objective Type Questions 3.6
Page 1487 :
Question 13, The effects of deficient demand in an economy are:, (Choose the correct alternative), (a) Increase in output, income, employment and price, level., (b) Decrease in output, income, employment and price, level., (c) Increase in output, income and employment, but no, change in the price level., (d) Decrease in output, income and employment, but no, change in the price level., Objective Type Questions 3.6
Page 1488 :
Answer 13, (b), , Decrease in output, income, employment and, price level., , Objective Type Questions 3.6
Page 1489 :
Question 14, If the equilibrium level of output is more than the full, employment level, this situation is called the situation of, __________., (Fill in the blank), , Objective Type Questions 3.6
Page 1490 :
Answer 14, excess demand, , Objective Type Questions 3.6
Page 1491 :
Question 15, The level of output determined by the equality of Y and, AD necessarily mean the level of output at which, everyone is employed., True/False? Give reason., , Objective Type Questions 3.6
Page 1492 :
Answer 15, False: The equilibrium level of output determined by, the equality of Y and AD does not necessarily, signify the full employment level of output. The, equilibrium level of output may be greater than, the full employment level of output (the situation, of excess demand) or less than the full, employment level of output (the situation of, deficient demand)., , Objective Type Questions 3.6
Page 1493 :
Question 16, The impact of ‘Excess Demand’ under the Keynesian, theory of income and employment, in an economy are:, (Choose the correct alternative), (a) Decrease in output, income, employment and price, level., (b) Increase in output, income employment and price, level., (c) Rise in the price level and the nominal income but, no change in the output and employment., (d) Increase in output, income and employment; but no, change in the price level., Objective Type Questions 3.6
Page 1494 :
Answer 16, (c) Rise in the price level and the nominal income but, no change in the output and employment., Reason: Since the economy is already working at the, full employment, there is no further scope of creation, of employment. So there is no change in the, employment and hence, the output (real income)., However, excess demand gives rise to an, inflationary gap; which causes a rise in the price, level or inflation (demand pull inflation—an aggregate, demand induced rise in the price level)., Nominal income increases due to rise in the price level., Objective Type Questions 3.6
Page 1495 :
Question 17, _________ is that level of income where all the factors, of production are fully employed in the production, process., (Fill in the blank), , Objective Type Questions 3.6
Page 1496 :
Answer 17, Full employment level of income, , Objective Type Questions 3.6
Page 1497 :
Question 18, Full employment means absence of _________ ., (Fill in the blank), , Objective Type Questions 3.6
Page 1498 :
Answer 18, involuntary unemployment, , Objective Type Questions 3.6
Page 1499 :
Question 19, If the equilibrium level of output is less than the full, employment level of output, this situation is called the, situation of ___________ ., (Fill in the blank), , Objective Type Questions 3.6
Page 1500 :
Answer 19, deficient demand, , Objective Type Questions 3.6
Page 1501 :
Question 20, In situation of excess demand, taxes must be ________, (increased/decreased)., (Fill in the blank with correct option), , Objective Type Questions 3.6
Page 1502 :
Answer 20, decreased, , Objective Type Questions 3.6
Page 1503 :
Self-Assessment Test 1, , Determination and Income and Employment, Time Allowed: 1 hour, , Maximum Marks: 25
Page 1504 :
Question 1, Average Propensity to Consume can never be, ………………………..., (choose the correct alternative) (1 mark), (a) positive, (b) zero, (c) more than one, (d) less than one
Page 1505 :
Answer 1, (b) Zero
Page 1506 :
Question 2, The monetary policy generally targets to, ensure………….……, (Choose the correct alternative) (1 mark), (a) price stability in the economy, (b) employment generation in the country., (c) stable foreign relations., (d) greater tax collections for the government.
Page 1507 :
Answer 2, (a) price stability in the economy.
Page 1508 :
Question 3, In an economy, break-even point and equilibrium, point may lie at the same level of income, if ex-ante, investments are …………………, (Fill up the blank with correct answer) (1 mark)
Page 1509 :
Answer 3, Zero
Page 1510 :
Question 4, In an economy, MPC = 0.75. As a result of multiplier, mechanism, national income increased by `300 crore, caused by an additional investment of .............., (1 mark), (a) `400 crore, (b) ` 225 crore, (c) ` 1200 crore, (d) ` 75 crore
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Question 5, Calculate the value of Marginal Propensity to Consume, (MPC), if in an economy, autonomous consumption is `500, crore, ex-ante investments are ` 4000crore and equilibrium, level of Income of the economy is ` 8,000 crore. (3 marks)
Page 1513 :
Answer 5, We know that consumption function is: C = C +MPC. Y, At equilibrium level of Income in the economy Y = C + I, , Given, Autonomous Consumption (C) = `500 crore, and Ex-ante Investments (I) = `4000 crore, 18,000 = 500 + MPC(18,000) + 4,000, MPC (18,000) = 18000 – 4500 ⇒ MPC =, 13,500/18,000, MPC = 0.75
Page 1514 :
Question 6, Suppose in a hypothetical economy, the savings increase, by ` 20 crore when national income increases by `100, crore. Compute the additional investments needed to, attain an increase in national income by `6,000 crore?, (3 marks)
Page 1515 :
Answer 6, MPS = (Change in Saving/Change in Income) =, (ΔS/ΔY) ) = 20/100 = 0.20, Investment Multiplier (K) = 1/MPC = 1/0.20 = 5, Investment Multiplier (K) = Change in Income /Change, in Investment, = (ΔY/ΔI), 5 = `6,000/Change in Investment (ΔI), Change in Investment (ΔI) = `1,200 crore, Increase in investment by `1,200 crore is required to, attain additional income of ` 6,000 crore.
Page 1516 :
Question 7, Giving valid reasons, state whether the following, statements are true or false:, (3 marks), (a) Ex-post investment means fixed capital with, production units during a particular period of time., (b) Marginal propensity to consume represents the slope, of the consumption function.
Page 1517 :
Answer 7, (a) The given statement is false, as ex-post investment, includes both fixed as well as inventory investment, with the production unit during a period of time, (b) The given statement is true, as it represents change, in consumption due to a given change in income., MPC = (ΔC/ΔY)
Page 1518 :
Question 8, Define inflationary gap. Show inflationary gap using a, well-labelled diagram. Explain any one fiscal measure, and one monetary measure to correct the situation of, inflationary gap., (6 marks)
Page 1519 :
Question 9, What is Effective Demand Principle? Discuss with the help, of an imaginary numerical example., (6 marks)
Page 1520 :
Self-Assessment Test 2, , Determination of Income and Employment, Time Allowed: 1 hour, , Maximum Marks: 25
Page 1521 :
Question 1, According to Keynesian Theory of employment, ex-ante, savings and ex-post savings are always equal., True/False? Give reason. (1 mark)
Page 1522 :
Answer 1, False: as ex-ante savings are those which all the, households plan to make at different levels of, income during a period, whereas, ex-post savings, are the actual amount of savings made in the, economy during a period. So, the two may or may, not be equal.
Page 1523 :
Question 2, In the Keynesian theory of employment, it is assumed that, consumption changes at a constant rate as income, changes. It implies:, (1 mark), (a) Both MPC and MPS are constant, (b) Both the consumption and savings curves have, constant slopes, and are linear curves., (c) Aggregate demand curve is parallel to the, consumption curve, i.e. they have the same slope (i.e.,, MPC)., (d) All of the above
Page 1524 :
Answer 2, (d) All of the above
Page 1525 :
Question 3, If change in investment is ` 1,000 crore and MPC is 0.8, then national income will change by (1 mark), (a) `1,250 crore, (b) ` 2,500 crore, (c) ` 5,000 crore, (d) ` 10,000 crore
Page 1526 :
Answer 3, (c) `5,000 crore
Page 1527 :
Question 4, An excess of aggregate demand over full employment, level of aggregate supply represents a situation of, inflationary gap., (True/False) (1 mark)
Page 1528 :
Answer 4, True: An excess of aggregate demand over full, employment level of aggregate supply represents, a situation of inflationary gap; production cannot, be increased beyond this level. Increase in, aggregate demand here onwards, will increase, only the general price level.
Page 1529 :
Question 5, “An economy facing unintended accumulation of, inventories would try to reduce aggregate demand.” Do, you agree with the given statement? Support your, answer with valid reasons., (3 marks)
Page 1530 :
Answer 5, Yes, the given statement is correct. In a two sector, economy, the firms produce goods and services and, make factors payments to the households. The factor, income earned by the households will be used to buy the, goods and services which would be equal to income of, firms. The aggregate consumption expenditure by the, households in the economy is equal to the aggregate, expenditure on goods and services produced by the, firms in the economy (Income of the producers).
Page 1531 :
Question 6, Estimate the change in final income, if Marginal, Propensity to Consume (MPC) is 0.75 and change in, initial investment is `2,000 crore. (3 marks)
Page 1532 :
Answer 6, Multiplier K = 1/(1 – MPC), When MPC = 0.75, K = 1/(1 – 0.75) = 1/0.25 = 4, Also, K = ∆Y/∆I, 4 = ∆Y/2,000, ∆Y =4 × 2,000 =, 8,000., Change in final income = `8,000 crore
Page 1533 :
Question 7, Giving valid reasons, state whether the following, statements are true or false:, (3 marks), (a) An excess of aggregate demand over full, employment level of aggregate supply represents a, situation of inflationary gap., (b) If the ratio of Marginal Propensity to Consume, (MPC) and Marginal Propensity to Save (MPS) is 4 :, 1, the value of investment multiplier will be 4.
Page 1534 :
Answer 7, (a) The given statement is true; an excess of aggregate, demand over full employment level of aggregate, supply represents a situation of inflationary gap,, production cannot be increased beyond this level., Increase in AD here onwards, will increase only the, general price level., (b) The given statement is false., Let the value of MPS = x, Therefore, MPC = 4x, We know that; MPC + MPS = 1 ⇒ x + 4x = 1 ⇒, 5x = 1, MPS (x) = 1/5 = 0.20
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Substituting the value of MPS in k = 1/MPS = 1/0.20 = 5, Thus, the value of multiplier is 5 and not 4.
Page 1536 :
Question 8, Discuss the working of the adjustment mechanism in the, following situation :, (6 marks), (a) Ex-Ante Aggregate demand is greater than ExAnte Aggregate supply., (b) Ex-Ante/Planned Investments are lesser than ExAnte/Planned Savings.
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Answer 8, 8. (a) When Aggregate Demand is greater than, Aggregate Supply (AD>AS), buyers are planning to,, buy more goods and services than what producers, are planning to produce. It will lead to fall in planned, inventories below the desired level. The producers in, turn will produce more, which will raise the income, level i.e. AS, till AD becomes equal to AS.
Page 1538 :
Question 9, Draw a straight line consumption curve. From it derive, a savings curve explaining the process. Show on this, diagram:, (a) the level of income at which average propensity, to consume is equal to one., (b) a level of income at which average propensity to, save is negative., (CBSE Sample Question Paper 2015) (6 marks)
Page 1539 :
Self-Assessment Test 3, , Determination of Income and Employment, Time Allowed: 1 hour, , Maximum Marks: 25
Page 1540 :
Question 1, If MPS = 0.20 and investment is increased by `100, crore, then total increase in income will be: (1 mark), (a) `80 crore, (b) ` 1000 crore, (c) ` 500 crore, (d) ` 800 crore
Page 1542 :
Question 2, An economy is at full employment and AD is greater, than AS, what will be the impact on price level in such, an economy?, (1 mark), (a) Rise, (b) Fall, (c) no change, (d) both rise and fall
Page 1543 :
Answer 2, (a) Rise
Page 1544 :
Question 3, Which of the following is not true?, (a) APC can be more than 1, (b) APC can be equal to 1, (c) APC rises with increase in income, (d) APC can never be 0, , (1 mark)
Page 1545 :
Answer 3, (c) APC rises with increase in income
Page 1546 :
Question 4, Ex-post investment means fixed capital with production, units during a particular period of time. True/False?, Give reason., (1 mark)
Page 1547 :
Answer 4, False: As ex-post investment includes both, fixed as well as inventory investment, with the production units during a, period of time.
Page 1548 :
Question 5, Value of which of the following can be greater than one, and why?, (3 marks), (a) Marginal Propensity to Consume (MPC), (b) Average Propensity to Consume (APC)
Page 1549 :
Answer 5, (b) The value of Average Propensity to Consume (APC), can be greater than 1., This is because total consumption can be greater than, total income, due to the existence of autonomous, consumption.
Page 1550 :
Question 6, The consumption function of an economy is : C = 40 +, 0.8Y (amount in `crore). Determine that level of income, where average propensity to consume will be one., (3 marks)
Page 1551 :
Answer 6, Given, APC=1, which means that income (Y) is equal to, the consumption (C), i.e. Y = C., C = 40+0.8Y ⇒ Y = 40+0.8Y (since Y = C), Y – 0.8Y = 40 ⇒ 0.2Y = 40 ⇒ Y = `200 crore
Page 1552 :
Question 7, State and discuss the components of Aggregate Demand, in a two sector economy., (3 marks)
Page 1553 :
Answer 7, Components of Aggregate Demand are:, (i) Consumption Expenditure, (C) (ii) Investment Expenditure(I), • Consumption Expenditure (C) – It is that portion of, income which is spent on purchase of goods and, services by the consumers in an economy during the, accounting period., • Investment Expenditure (I)– The addition to the stock, of physical capital and change in inventories of a, firm in an economy.
Page 1554 :
Question 8, The saving function of an economy is given as:, S = (–) 10 + 0.20Y, If the ex-ante investments are `240 crore, calculate the, following:, (i), Equilibrium level of income in the economy., (ii), Additional investments which will be needed to, double the present level of equilibrium income., (6 marks)
Page 1555 :
Answer 8, We know that the equilibrium level of income in an, economy is determined when: S = I ⇒ –10 + 0.20Y =, 240 ⇒ 0.20Y = 250, Y= `1,250 crore, To double of the existing income level (DY = 1,250, crore), k =DY/DI = 1/MPS, 1250/DI = 1/0.2, DI =, `250crore
Page 1557 :
Government budget – meaning, objectives and, , components., , Classification of receipts - revenue receipts and, , capital receipts; classification of expenditure –, revenue expenditure and capital expenditure., , Measures of government deficit–revenue deficit,, , fiscal deficit, primary deficit their meaning.
Page 1558 :
4.1, Meaning and Objectives of, Government Budget
Page 1559 :
Government Budget is a financial statement of budgetary, receipts and budgetary expenditure of the government, during a fiscal year., , Objectives of Government Budget, 1. Reallocation of resources, Reallocation of resources refers to re - distribution of, resources from one use to another. Government through, its budgetary policies tries to reallocate resources to, ensure fulfillment of various socio-economic objectives., The government may influence the allocation of resources, through:
Page 1560 :
(a) Taxation policy, Imposition of heavy taxes: Heavy taxes can be, imposed on production units engaged in producing, harmful products like liquor, cigarettes, tobacco,, etc. Thus, it discourages those occupations which, are not beneficial to the society by imposing taxes, at higher rates., Subsidies and Tax concessions: Subsides and, tax concessions can be given to the private sector, industries to encourage production of those, products which are beneficial to people. For, example, government can give subsidies and tax, concessions to the enterprises who are willing to, undertake electricity generation, especially in
Page 1561 :
backward areas. In this way, budgetary incentives, (tax concessions, subsidies, etc.) can be used to, influence allocation of resources in the country.
Page 1562 :
(b) Expenditure policy (Direct participation in production), There are many non-profitable economic activities, which are not undertaken by the private sector, either due to lack of enough profits or due to huge, investment expenditure involved, e.g. water supply,, sanitation, street lighting, maintaining law and, order, national defence, government administration,, measures to reduce air pollution, etc. These are, called public goods. Therefore, government can, directly produce these goods and services in public, interest in order to create social welfare. For, example, more expenditure by the government on, maintaining law and order raises the sense of, security among the people. Any such expenditure, raises welfare of the people.
Page 1563 :
2. Reduction in income inequalities or, Redistribution of income, Inequalities of income and wealth reflect a section of, society being deprived of even basic necessities. Thus, arises the need for reducing income inequalities in the, society, i.e. reducing the gap between rich and poor., Every government tries to reduce inequality of income, among masses so as to ensure progress of the people, with lesser monetary resources. Inequalities of income, can be reduced either by rationalisation of taxation policy, or regulating the expenditure policy of the government, or both.
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(a) Taxation policy (progressive income taxation), The redistribution objective is sought to be achieved, through progressive income taxation, in which higher, the income, higher is the tax rate. The government, puts a higher rate of taxation on incomes of the rich, people and lower rates of taxation on lower income, groups. This will reduce the inequalities of income, as the difference between personal disposable incomes*, of higher income and lower income groups will fall., , *The national income of the country goes to either the private sector, that is, firms and, households (known as private income) or the government (known as public income)., Out of private income, what finally reaches the households is known as personal, income and the amount that can be spent is the personal disposable income (PDI). PDI, = Personal income – Personal income tax.
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(b) Expenditure policy (transfer payments and subsidies), The amount collected through taxes can be used by, the government for spending on welfare of the poor, people. It can provide them transfer payments and, subsidies. For example:, (i) Providing free services like education and health, to the poor people., (ii) Providing essential items of food grains almost, free to the families living below the poverty line., (iii) Free LPG kitchen gas connections and subsidised, LPG gas to the families living below the poverty, line.
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Increased expenditure by the government on such transfer, payments and subsidies will have twin effects:, First, it will increase their disposable income and thus, will reduce the income inequalities, i.e., the gap between, rich and poor., Secondly, spending on free services to the poor raises, their standard of living and thus increases their welfare.
Page 1567 :
3. Economic stability or Price stability, Economic stability (or price stability) means absence of, large-scale fluctuations in general price level in the, economy. Too much fluctuations in prices is not good, for the economy as they create uncertainties in the economy., Stability in price level in the country is necessary to, create business environment., Government can exercise control over price fluctuations, through its taxation policy and expenditure policy.
Page 1568 :
(a) Under inflationary situations, Inflationary tendencies emerge due to aggregate, demand being higher than aggregate supply under, conditions of high employment. Therefore, during, periods of inflation government may discourage, spending by increasing taxes and reducing its own, expenditure. This will decrease aggregate demand, to correct inflationary situation. To raise aggregate, supply, tax concessions and subsidies for private, sector enterprises can also be used by the government.
Page 1569 :
(b) Under deflationary situations, During periods of recession (or high rate of, unemployment), government can reduce taxes to, encourage demand as well as increase its own, expenditure. Government can also use subsidies to, encourage spending by people. It will increase the, personal disposable income of people and thus, will, raise the level of aggregate demand. It will combat, deflationary situation in the economy.
Page 1570 :
4. Economic growth, Economic growth implies a sustainable increase in real, GDP of an economy, i.e., an increase in volume of goods, and services produced in an economy. Government, budget can be an effective tool to ensure the economic, growth in a country.
Page 1571 :
(a) Taxation policy and subsidies, If the government provides tax rebates and other, budgetary incentives for productive ventures and, projects, it will stimulate savings and investments, in the economy and thus, economic growth. For, example, suppose the government decides to give, tax concessions (or tax rebates) and subsidies to, investors for making investments in backward, regions. Tax concessions aim at reducing cost and, thus, making profits. Similarly, subsidies aim at, reducing prices of products to encourage sales and, earning more profits. Thus, tax concessions and, subsidies both aim at raising profits. When profits, increase, savings and investment will also increase., It will lead to economic growth.
Page 1572 :
(b) Expenditure policy, Spending on infrastructure in the economy promotes, the production activities across different sectors., Government expenditure is a major factor that, generates demand for different types of goods and, services, which induces economic growth in the, country., However, before planning such expenditure, tax, rebates and subsidies, the government should check, the rate of inflation and tax rates. Also, there may, be the risk of debt trap if loans are too high to, finance the expenditure.
Page 1573 :
Key Terms, Government Budget–Government Budget is a financial statement, of budgetary receipts and budgetary expenditure of the government, during a fiscal year., Reallocation of resources– It refers to re-distribution of resources, from one use to another., Public goods – Non-profitable economic activities which are not, undertaken by the private sector either due to lack of enough profits, or huge investment expenditure, e.g. water supply, sanitation,, maintaining law and order, etc. are called public goods., Inequalities of income and wealth – It reflects a section of society, being deprived of even basic necessities., Economic stability (or price stability) –It means absence of largescale fluctuations in general price level in the economy., Economic growth – It implies a sustainable increase in real GDP of, an economy, i.e., an increase in volume of goods and services, produced in an economy.
Page 1574 :
RECAP, , Government Budget is a financial statement of budgetary, receipts and budgetary expenditure of the government, during a fiscal year., , Objectives of Government Budget, , 1. Reallocation of resources: The government may, influence the allocation of resources through:, (a) Taxation policy: Heavy taxes may be imposed on, harmful products, e.g. liquor, cigarettes, tobacco,, etc.to discourage their production. On the other, hand, tax concessions/subsidies may be provided, on the production of socially useful products to, encourage their production., (b) Expenditure policy: Government may directly, undertake production of certain goods and services
Page 1575 :
in the areas where private sector may not be, willing to participate in production activities due, to lack of enough profits and huge investment, expenditure involved, e.g. water supply, sanitation,, law and order, national defence, etc., 2. Reduction in income inequalities or Redistribution, of income: Inequalities of income can be reduced, by government either by rationalisation of taxation, policy or regulating the expenditure policy of the, government or both., (a) Taxation policy: The government puts a higher, rates of taxation on incomes of the rich people, and lower rates of taxation on lower income groups., This will reduce the inequalities of income as, the difference between disposable incomes of
Page 1576 :
higher income and lower income groups will, fall., (b) Expenditure policy: The amount collected through, taxes can be used by the government for spending, on welfare of the poor people. It can provide, them transfer payments and subsidies. For, example, providing free education and health,, providing essential food grains almost free, free, LPG kitchen gas connections and subsidised, LPG gas, etc. It will reduce the income inequalities, and raise their standard of living., 3. Economic stability or Price stability: Government, uses taxation policy and expenditure policy in controlling, the prices.
Page 1577 :
(a) Under inflationary situations:, Inflationary tendencies emerge due to aggregate, demand being higher than aggregate supply., Therefore, government can increase taxes and, decrease its own expenditure. To raise aggregate, supply, tax concessions and subsidies can also, be used., (b) Under deflationary situations:, During deflationary situation, government can, reduce taxes and increase its own expenditure, to leave more disposable income in the hands of, people, thereby increasing aggregate demand to, combat deflationary situation.
Page 1578 :
Question 1, Goods and services provided by the market mechanism,, i.e. by exchange between individual consumers and producers, are called ______________ ., Government provides certain goods and services which, cannot be provided by the market mechanism such as, national defence, roads, government administration etc,, which are referred to as ___________., , (Fill in the blanks), Objective Type Questions 4.1
Page 1579 :
Answer 1, (i) Private goods, (ii) Public goods, , Objective Type Questions 4.1
Page 1580 :
Question 2, Which of the following is not a characteristic of public, goods?, , (Choose the correct alternative), (a) Public goods are non-excludable., (b) It is difficult and sometimes impossible to collect, fees for the public goods., (c) The consumption of public goods by several, individuals is rivalrous., (d) None of the above., Objective Type Questions 4.1
Page 1581 :
Answer 2, (c) The consumption of public goods by several individuals, is rivalrous., , Objective Type Questions 4.1
Page 1582 :
Question 3, _______ means that public goods are financed through, the budget and can be used without any direct payment., Public goods may be produced by the government or the, private sector. When public goods are produced directly, by the government it is called ___________. (Public, provision/Public production), , (Fill in the blanks with correct option), , Objective Type Questions 4.1
Page 1583 :
Answer 3, (i) Public provision, (ii) Public production, , Objective Type Questions 4.1
Page 1584 :
Question 4, The government affects the (i) ________ of households, by making transfers and collecting taxes. It is through, this that the government can change the distribution of, income and bring about a distribution that is considered, ‘fair’ by society. This is the (ii) ___________ function of, (Choose the correct alternative), government Budget., (a) (i) Private income, (ii) allocation, (b) (i) Personal income, (ii) Stabilisation, (c) (i) Personal disposable income, (ii) redistribution, (d) (i) Public income, (ii) redistribution, Objective Type Questions 4.1
Page 1585 :
Answer 4, (c) (i) Personal disposable income, (ii) redistribution, , Objective Type Questions 4.1
Page 1586 :
Question 5, The intervention of the government whether to raise the, level of aggregate demand or reduce it constitutes the, _____________ of government budget., , (Choose the correct alternative), (a), (b), (c), (d), , Allocation function, Redistribution function, Stabilisation function, None of these., , Objective Type Questions 4.1
Page 1587 :
Answer 5, (c) Stabilisation function, , Objective Type Questions 4.1
Page 1588 :
Question 6, Law and order, national defence, sanitation, etc. are, __________., , (Choose the correct alternative), (a), (b), (c), (d), , final goods, intermediate goods, public goods, private goods, , Objective Type Questions 4.1
Page 1589 :
Answer 6, (c) public goods, , Objective Type Questions 4.1
Page 1590 :
Question 7, State giving reason whether the following statement, is true or false:, Provision of public goods is the same as public production., , Objective Type Questions 4.1
Page 1591 :
Answer 7, False: Provision of public goods means that the, public goods like law and order, defence, parks,, roads, etc. are financed through the budget. These, goods may be produced directly by the government or, it can encourage the private sector by giving them tax, concessions and subsides., , Objective Type Questions 4.1
Page 1592 :
Question 8, State giving reason whether the following, statement is true or false:, Through changes in its expenditure and taxes, the, government brings economic stability., , Objective Type Questions 4.1
Page 1593 :
Answer 8, True: In case of deflation (or unemployment), the, government can give tax concession or increase, expenditure to leave more disposable income in the, hands of people. In case of inflation, government, can reduce its own expenditure or increase tax., , Objective Type Questions 4.1
Page 1594 :
Question 9, The government has increased the rate of income tax., The objective of government is to:, , (Choose the correct alternative), (a), (b), (c), (d), , maintain balanced regional development, redistribute income & wealth, reallocate resources, ensure economic stability, , Objective Type Questions 4.1
Page 1595 :
Answer 9, (b) redistribute income & wealth, , Objective Type Questions 4.1
Page 1596 :
Question 10, Match the following:, Column I, 1. Government increases taxes on, very rich people, 2. Government increases its own, expenditure during deflation to, increase aggregate demand, , Column II, (a) Reallocation of, resources, (b) Economic stability, , (c) Reducing in equalities, in income and wealth, , Objective Type Questions 4.1
Page 1597 :
Answer 10, 1 — (c), 2 — (b), , Objective Type Questions 4.1
Page 1598 :
Question 1, “Through its budgetary policy government allocates, resources in accordance with the requirements of the, country.” Do you agree with the given statement?, Support your answer with valid reasons., (CBSE 2019) (3 marks), , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1599 :
Answer 1, The given statement is true., Reallocation of resources refers to re-distribution of, resources from one use to another. The government, reallocates resources with a view to balance the goals of, profit maximisation (by firms) and social welfare (by, government). Production of goods which are injurious to, health is discouraged through taxation. On the contrary,, production of socially useful goods is encouraged through, subsidies. If the private sector does not take initiative in, certain activities, government directly controls them like, water supply, sanitation etc., HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1600 :
Question 2, What is the role of Government Budget in allocation of, resources?, (1 mark), , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1601 :
Answer 2, Government can directly undertake the production of, public goods and services. Alternately, it can encourage, private sector by giving tax concessions and subsidies., , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1602 :
Question 3, How does the government reduce inequalities of income, and wealth?, (1 mark), , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1603 :
Answer 3, Government can reduce inequalities through taxes and, expenditure. It can tax the rich or the goods consumed, by the rich. It can spend the amount so collected on, providing free services to the poor., , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1604 :
Question 4, State one fiscal measure that can be used to reduce the, gap between rich and poor., (CBSE Sample Question Paper 2018) (1 mark), , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1605 :
Answer 4, (a) Increasing government expenditure which will directly, benefit the poor., (b) Increasing the taxes on rich and using the same amount to, benefit the poor. (any one), , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1606 :
Question 5, Name any one step that the government can take through, its budget to check inflation that is causing hardships to, the people., (CBSE 2013) (1 mark), , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1607 :
Answer 5, Government can reduce its own expenditure to leave, less disposable income in the hands of people., , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1608 :
Question 6, Government raises its expenditure on producing public, goods. Which economic value does it reflect? Explain, with an example., (CBSE 2014) (3 marks), , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1609 :
Answer 6, Increased expenditure by government on public goods, like defence, maintaining law and order etc. increases, their availability to the people of the country. For, example, more expenditure on maintaining law and, order raises the sense of security among the people., Any such expenditure raises welfare of the people., , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1610 :
Question 7, Tax rates on higher income group have been increased., Which economic value does it reflect? Explain., (CBSE 2014) (3 marks), , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1611 :
Answer 7, This will reduce the inequalities of income as the, difference between disposable incomes of higher income, and lower income groups will fall. This will also provide, more resource to the government for spending on welfare, of the poor, e.g. free services like education and health to, the poor people., , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1612 :
Question 8, Government has started spending more on providing, free services like education and health to the poor., Explain the economic value it reflects., (3 marks), , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1613 :
Answer 8, Spending on free services to the poor raises their, standard of living and at the same time helps in reduction, in income inequalities. It also helps in raising production, potential of the country by raising the efficiency level of, the working class among the poor., , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1614 :
Question 9, The government decides to give budgetary incentives to, investors for making investments in backward regions., Explain these possible incentives and the reasons for the, same., (CBSE 2015) (6 marks), , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1615 :
Answer 9, Possible Budgetary Incentives: Budgetary incentives refer, to concession in taxation and granting subsidies to those, production units which set up their units in economically, backward areas., • Tax concessions aim at reducing cost and thus raising, profits., • Subsidies aim at reducing prices of products to, encourage sales and earning more profits., Clearly, tax concessions and subsidies both aim at raising, profits. Reasons for giving tax concession and subsidies, by the government:, HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1616 :
(i) Economic Growth: The aim of giving tax rebates, and subsidies for productive ventures and projects is, that it can stimulate savings and investments in the, economy leading to economic growth., (ii) Allocation of resources: Government can influence, allocation of resources by encouraging industries to, produce selected goods by giving tax concessions, and subsidies., , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
Page 1617 :
Question 10, The Government, under Ujjwala Yojana, is providing, free LPG kitchen gas connections to the families ‘below, the poverty line’. What objective the government is, trying to fulfill through the government budget and how?, Explain., (6 marks), , HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
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Answer 10, By providing free LPG kitchen gas connections to the, families ‘below the poverty line’, the objective which the, government is trying to fulfill is ‘Reduction in, inequalities of income and wealth.’, Inequalities of income and wealth reflect a section of the, society being deprived of even basic necessities of life, like food, clothing and housing. Thus arises the need for, reducing inequalities of incomes in the society, i.e.,, reducing the gap between rich and poor. The government, can impose higher taxes on the rich reducing their disposable income. The amount so collected through taxes, HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
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can be used by the government for spending on welfare, of the poor people. It can provide them transfer payments and subsidies., Increased expenditure by the government on such transfer payments and subsidies will have twin effects: First,, it will increase their disposable income and thus will reduce the income inequalities, i.e., the gap between rich and, poor. Secondly, spending on free services to the poor, raises their standard of living and thus increases their, welfare., HOTs 4.1 — Analysing, Evaluating & Creating Type Questions
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4.2, Components of Government, Budget
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Although the Government Budget relates to the budgetary receipts and budgetary expenditure of the government for a particular financial year, the impact of it, will be there in subsequent years. Therefore, there is a, need to have two accounts — the revenue account (also, called revenue budget) and the capital account (also, called capital budget)., Revenue Budget: Those receipts and expenditure that, relate to the current financial year only are included in, the revenue budget. Therefore, revenue budget includes, both revenue receipts and revenue expenditure., Capital Budget: Those receipts and expenditure that, concern the assets and liabilities of the government are, included in the capital budget. Therefore, capital bud-
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get includes both capital receipts and capital expenditure., Thus, major components of Government Budget are:, (i) Revenue Receipts, (ii) Capital Receipts, (iii) Revenue Expenditures (iv) Capital Expenditures
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Capital Receipts, Capital receipts are those receipts of the government, which either create a liability (e.g. borrowings) or lead, to reduction in assets (e.g. recovery of loans, sale of, shares in Public Sector Undertakings, etc.)., Components of capital receipts are:, , 1. Debt creating capital receipts, Debt creating capital receipts are borrowings made by, the government. When government takes fresh loans,, these loans will have to be returned and interest will, have to be paid on these loans. So, borrowings are debt, creating capital receipts of the government. For example,
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(i) loans raised by the government from the public, (called market borrowings),, (ii) borrowing by the government from the Reserve, Bank of India (RBI) and commercial banks and other financial institutions through the sale of treasury bills,, (iii) loans received from foreign monetary authorities, and international organisations like IMF, etc.
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2. Non-debt creating capital receipts, Non-debt creating capital receipts are those capital receipts which are not borrowings and therefore, do not, give rise to debt. For example,, (i) Proceeds from sale of shares in Public Sector Undertakings (PSUs) (This is referred to as PSU disinvestment.), (ii) Recovery of loans, , , , Top Tip, , Other sources of capital receipts are:, (i) Small savings (Post Office Savings Accounts, National Savings, Certificates, etc.), (ii) Provident funds
Page 1626 :
Revenue Receipts, Revenue receipts are those receipts of the government, that neither create a liability nor lead to reduction in assets. For example: income tax, profit of PSU, dividends,, fees and fines etc., Components of revenue receipts: Revenue receipts are, divided into tax and non-tax revenues, , 1. Tax revenue, Tax revenue/tax receipt is the revenue earned by the, government from taxes levied on income, wealth and, commodities. For example, corporation tax, personal, income tax, excise tax, customs duties, etc., Tax revenues are classified into direct and indirect taxes:
Page 1627 :
(i) Direct taxes: Direct taxes are those taxes which, cannot be shifted to the other person/entity. Their monetary burden is borne by those on whom, they are levied. A direct tax is collected directly, from the income earners. For example, personal, income tax falls directly on individuals and corporation tax falls directly on firms. The payer and, bearer of a direct tax is the same person., Other direct taxes include Interest tax, Wealth tax,, Gift tax, Estate duty (now abolished), etc.
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, , Top Tips, , • Asset ↓ or Liability ↑ ⇒ Capital receipts. If NOT, then Revenue, rec-eipts., • A tax is legally compulsory transfer payment made by the people to, the government., • Wealth tax, gift tax are the direct taxes which have insignificant, contribution to tax revenues; so called ‘paper taxes’., , (ii) Indirect taxes: Indirect taxes are those taxes, which can be shifted to another person/entity., Their monetary burden is ultimately borne by, final users of goods and services, rather than the, person on whom the tax is levied. For example,, Goods and services tax (GST), Entertainment tax,, Sales tax, Excise tax, Customs duties, Service tax,, etc.
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2. Non-tax revenues, Non-tax revenues/Non-tax receipts are the revenue earned by the government from sources other than taxes., Examples:, (i) Interest receipts on loans advanced by the Central, Government, (ii) Dividends and profits on investments made by the, Central Government, (iii) Fees and other receipts for services rendered by the, government, (iv) Cash grants in aid from foreign countries and international organisations
Page 1630 :
Capital Expenditure, Capital expenditure is an expenditure of the Government which either leads to creation of assets (e.g. construction of school buildings, hospitals, etc.) or reduces, its liabilities (e.g. repayment of loans). Examples:, (i) Expenditure on the acquisition of land, building,, machinery, equipment, etc., (ii) Investment in shares, (iii) Loans and advances by the central government to, state and union territory governments, PSUs and, other parties, (iv) Construction of school buildings, hospitals, etc., (v) Repayment of loans
Page 1631 :
Revenue Expenditure, Revenue expenditure is that expenditure of the governent that neither creates any asset nor reduces any liability. Examples:, (i) Interest payments on loans, (ii) Grants given to state governments and other parties (even though some of the grants may be meant, for creation of assets)., (iii) Defence services expenditure, (iv) Salaries and pensions, (v) Expenditure on education and health, (vi) Subsidies
Page 1632 :
, , Top Tips, , • Asset ↓ or Liability ↑ ⇒ Capital expenditure. If NOT, then, Revenue expenditure., • Revenue expenditure relates to the expenses incurred for the, normal functioning of the government departments and various services.
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Key Terms, Revenue Budget – Those receipts and expenditure that relate to, the current financial year only are included in the revenue budget., It includes both revenue receipts and revenue expenditure., Capital Budget – Those receipts and expenditure that concern the, assets and liabilities of the government are included in the capital, budget. It includes both capital receipts and capital expenditure., Capital receipts – Those receipts of the government which either, create a liability (e.g. borrowings) or lead to reduction in assets (e.g., recovery of loans, sale of shares in Public Sector Undertakings, etc.)., Debt creating capital receipts – Borrowings made by the governent., Non-debt creating capital receipts – Those capital receipts which are not borrowings and therefore, do not give rise to debt. For, example, PSU disinvestment, recovery of loans., Revenue receipts – Those receipts of the government that neither
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create a liability nor lead to reduction in assets, e.g. income tax,, profit of PSU, dividends, fees and fines etc., Tax revenue/tax receipt – Revenue earned by the government, from taxes levied on income, wealth and commodities, e.g., corporation tax, personal income tax, GST, etc., Tax – Legally compulsory transfer payment made by the people to, the government., Direct taxes – Those taxes which cannot be shifted to the other, person/entity, e.g. income tax, corporation tax, etc., Indirect taxes – Those taxes which can be shifted to another person/entity, e.g. Goods and services tax (GST), Non-tax revenues/Non-tax receipts – Revenue earned by the government from sources other than taxes, e.g. interest receipts, dividends and profits on investments, fees and fines, cash grants in, aid., Capital expenditure – An expenditure of the Government which, either leads to creation of assets (e.g. construction of school buildings, hospitals, etc.) or reduces its liabilities (e.g. repayment of
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loans)., Revenue expenditure – That expenditure of the government that, neither creates any asset nor reduces any liability, e.g. interest payments, subsidies, etc.
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RECAP, , Revenue Budget (or Revenue Account): It includes those receipts and expenditure that relate to the current financial year only (i.e., revenue receipts and revenue expenditure)., Capital Budget (or Capital Account): It includes those, receipts and expenditure that concern the assets and liabilities of the government (i.e., capital receipts and capital, expenditure)., Major components of Government Budget:, (i) Revenue Receipts, (ii) Capital Receipts, (iii) Revenue Expenditures (iv) Capital Expenditures., , Capital Receipts, , Capital Receipts are those receipts of government which, assets. For Example: borrowings, receipts from recovery of, loans, receipts from disinvestment.
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Components of capital receipts are:, 1. Debt creating capital receipts — When govern-ment, takes fresh loans, e.g. market borrowings, borrowing, from RBI and borrowing from abroad, these loans will, have to be returned and interest will have to be paid, on these loans. So, borrowings are debt creating capital, receipts of the govern-ment., 2. Non-debt creating capital receipts — Those receipts, which are not borrowings and therefore, do not give, rise to debt. For example, proceeds from sale of shares, in Public Sector Undertakings (PSUs) which is referred, to as PSU disinvestment and Recovery of loans reduce, the assets of the government., , Revenue Receipts, , Revenue receipts are those receipts of government which, neither lead to increase in its liabilities nor reduction in its, assets. For example: income tax, profit of PSU, dividends,
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assets. For example: income tax, profit of PSU, dividends,, fees and fines etc. It has two components:, 1. Tax revenues: Tax is a compulsory payment made by, the individuals and the firms to the government. Tax, revenue/tax receipt is the revenue earned by the governent from taxes levied on income, wealth and commodities. Tax revenues are classified into direct and indirect, taxes:, (a) Direct taxes: Direct taxes are those taxes which, cannot be shifted to the other person/entity. Their, monetary burden is borne by those on whom they, are levied. A direct tax is collected directly from the, income earners, e.g., Personal income tax, Corporation tax, Interest tax, Wealth tax, Gift tax., (b) Indirect taxes: Indirect taxes are those taxes which, can be shifted to another person/entity. Their mon-
Page 1639 :
etary burden is ultimately borne by final users of, goods and services, rather than the person on whom, the tax is levied, e.g. GST, Entertainment tax, Sales, tax, Excise tax, Customs duties, Service tax, etc., 2. Non-tax revenues: Non- tax revenues/Non-tax receipts, are the revenue earned by the government from sources, other than taxes. Examples: Interest receipts on loans, advanced by the Central Government, Dividends and, profits on investments made by the Central Government, Fees and other receipts for services rendered by the, government, Cash grants in aid from foreign countries, and international organisations, etc., , Capital Expenditure, , Capital Expenditure is that expenditure of the government, which either creates assets or reduces its liabilities, e.g.,, construction of school buildings, hospitals, flyovers etc., r-
Page 1640 :
epayment of loans, investment in shares, loans and advances given to state and UT governments, etc., , Revenue Expenditure, , Revenue expenditure is that expenditure of the government that neither creates any asset nor reduces any liability,, e.g. Interest payments, Grants given to state governments, and other parties (even though some of the grants may be, meant for creation of assets), Defence services expenditure, Salaries and pensions, Expenditure on education and, health, Subsidies, etc.
Page 1641 :
Question 1, Match the following:, Column I, (i) Revenue, receipts, (ii) Capital, receipts, , (a), (b), (c), (d), , Column II, neither create any asset nor reduces any, liability, either creates a liability or reduces an, asset, either creates asset or reduces liability, neither creates a liability nor reduces any, asset, Objective Type Questions 4.2
Page 1642 :
Answer 1, (i) — d, (ii) — b, , Objective Type Questions 4.2
Page 1643 :
Question 2, Although the budget document relates to the planned, receipts and planned expenditure of the government, for a particular financial year, the impact of it will be, there in subsequent years. So there is a need to have, two accounts., Those planned receipts and planned expenditures of, the government that relate to the current financial year, only are included in the ____ of the government, budget and those that concern the assets and liabilities, of the government into the ____., , (Fill in the blanks), Objective Type Questions 4.2
Page 1644 :
Answer 2, (i) Revenue Account (also called Revenue Budget), (ii) Capital Account (also called Capital Budget), , Objective Type Questions 4.2
Page 1645 :
Question 3, ________ (Revenue receipts/Capital receipts) are those, receipts that do not lead to a claim on the government., They are non-redeemable., , (Fill in the blanks with correct option), , Objective Type Questions 4.2
Page 1646 :
Answer 3, Revenue receipts, , Objective Type Questions 4.2
Page 1647 :
Question 4, Match the columns and choose the correct alternative:, Column I, Column II, (i) Tax on the incomes of firms (A) Paper tax, (ii) Duties levied on goods, (B) Corporation tax, produced within the country, (iii) Tax imposed on goods, (C) Excise taxes imported, into and exported out of, India., (iv) Wealth tax and gift tax, (D) Customs duties, , Objective Type Questions 4.2
Page 1648 :
(a), (b), (c), (d), , (i) — (A), (ii) — (D), (iii) — (C), (iv) — (B), (i) — (B), (ii) — (C), (iii) — (D), (iv) — (A), (i) — (B), (ii) — (D), (iii) — (C), (iv) — (A), (i) — (A), (ii) — (B), (iii) — (C), (iv) — (D), , Objective Type Questions 4.2
Page 1649 :
Answer 4, (b) (i) — (B), (ii) — (C), (iii) — (D), (iv) — (A), , Objective Type Questions 4.2
Page 1650 :
Question 5, Which of the following is a capital receipt in a government budget?, , (Choose the correct alternative), (a) Interest receipts on account of loans by the central, government, (b) Dividends and profits on investments made by the, government, (c) Cash grants-in-aid from foreign countries and international organisations, (d) None of the above, Objective Type Questions 4.2
Page 1651 :
Answer 5, (d) None of the above, , Objective Type Questions 4.2
Page 1652 :
Question 6, When the government receives money by way of loans, or from the sale of its assets, such receipts are called, ____________ in a government budget., , (Fill in the blank), , Objective Type Questions 4.2
Page 1653 :
Answer 6, Capital receipts, , Objective Type Questions 4.2
Page 1654 :
Question 7, Sale of shares in public sector undertakings (PSUs),, which is referred to as _______ is a _______ ., , (Fill in the blanks), , Objective Type Questions 4.2
Page 1655 :
Answer 7, (i) PSU disinvestment, (ii) non-debt creating capital receipt., , Objective Type Questions 4.2
Page 1656 :
Question 8, _______ Revenue expenditure/Capital expenditure) is, expenditure incurred for purposes other than creation of, physical or financial assets of the central governme-nt., , (Fill in the blank), , Objective Type Questions 4.2
Page 1657 :
Answer 8, Revenue expenditure, , Objective Type Questions 4.2
Page 1658 :
Question 9, Which of the following is a revenue expenditure in a government budget?, , (Choose the correct alternative), (a) Expenses incurred for the normal functioning of the, government departments and various services., (b) Interest payments on debt incurred by the government, (c) Grants given to a state government for creation of, assets, (d) All of the above, Objective Type Questions 4.2
Page 1659 :
Answer 9, (d) All of the above, , Objective Type Questions 4.2
Page 1660 :
Question 10, Interest payments, defence-services expenditure, subsidies,, salaries and pensions are main items of ________ of the, government. (plan expenditure/non-plan expenditure), , (Fill in the blank), , Objective Type Questions 4.2
Page 1661 :
Answer 10, non-plan expenditure, , Objective Type Questions 4.2
Page 1662 :
Question 11, Match the columns and choose the correct alternative:, Column I, , Column II, , (A) Committed expenditure, (i) Interest payments on market, loans, external loans and from, various reserve funds, (ii) Defence Expenditure, , (B) Under-pricing of public goods, and services like education and, health, , (iii) Implicit subsidies, , (C) Single largest component of, non-plan revenue expenditure, , (iv) Explicit subsidies, , (D) Subsidies on items such as, exports, interest on loans, food, and fertilisers, Objective Type Questions 4.2
Page 1663 :
(a), (b), (c), (d), , (i) — (A), (ii) — (C), (iii) — (D), (iv) — (B), (i) — (A), (ii) — (C), (iii) — (B), (iv) — (D), (i) — (C), (ii) — (A), (iii) — (D), (iv) — (B), (i) — (C), (ii) — (A), (iii) — (B), (iv) — (D), , Objective Type Questions 4.2
Page 1664 :
Answer 11, (d) (i) — (C), (ii) — (A), (iii) — (B), (iv) — (D), , Objective Type Questions 4.2
Page 1665 :
Question 12, Which of the following is an example of capital, expendi-ture of the government?, , (Choose the correct alternative), (a) Expenditure on the acquisition of land, building,, ma-chinery and equipment., (b) Investment in shares, (c) Loans and advances by the central government to, state and union territory governments, PSUs and, other parties, (d) All of the above, Objective Type Questions 4.2
Page 1666 :
Answer 12, (d) All of the above, , Objective Type Questions 4.2
Page 1667 :
Question 13, Loans to State Governments and Union Territory Governments are a part of __________., , (Choose the correct alternative), (a), (b), (c), (d), , Revenue receipts, Capital receipts, Capital expenditure, Plan revenue expenditure, , Objective Type Questions 4.2
Page 1668 :
Answer 13, (c) Capital expenditure, , Objective Type Questions 4.2
Page 1669 :
Question 14, Which of the following is a capital receipt in the context of government budget?, , (Choose the correct alternative), (a), (b), (c), (d), , Interest receipts, External grants, Provident funds, Personal Income tax, , Objective Type Questions 4.2
Page 1670 :
Answer 14, (c) Provident funds, , Objective Type Questions 4.2
Page 1671 :
Question 15, The non-tax revenue in the following is:, , (Choose the correct alternative), (a), (b), (c), (d), , Export duty, Import duty, Dividends, Excise, , Objective Type Questions 4.2
Page 1672 :
Answer 15, (c) Dividends, , Objective Type Questions 4.2
Page 1673 :
Question 16, Which one of the following is a combination of direct, taxes?, , (Choose the correct alternative), (a), (b), (c), (d), , Excise duty and Wealth tax, Service tax and Income tax, Excise duty and Service tax, Corporation tax and Personal income tax, , Objective Type Questions 4.2
Page 1674 :
Answer 16, (d) Corporation tax and Personal income tax, , Objective Type Questions 4.2
Page 1675 :
Question 17, Which of the following is not a revenue receipt?, , (Choose the correct alternative), (a), (b), (c), (d), , Recovery of loans, Foreign grants, Profits of public enterprises, Wealth tax, , Objective Type Questions 4.2
Page 1676 :
Answer 17, (a) Recovery of loans, , Objective Type Questions 4.2
Page 1677 :
Question 18, Direct tax is called direct because it is collected directly, from:, , (Choose the correct alternative), (a), (b), (c), (d), , The producers on goods produced, The sellers on goods sold, The buyers of goods, The income earners, , Objective Type Questions 4.2
Page 1678 :
Answer 18, (d) The income earners, , Objective Type Questions 4.2
Page 1679 :
Question 19, Which one of these is a revenue expenditure?, , (Choose the correct alternative), (a), (b), (c), (d), , Purchase of shares, Loans advanced, Subsidies, Expenditure on acquisition of land, , Objective Type Questions 4.2
Page 1680 :
Answer 19, (c) Subsidies, , Objective Type Questions 4.2
Page 1681 :
Question 20, State giving reason whether the following, statement is true or false:, Construction of flyovers is a revenue expenditure, of the government., , Objective Type Questions 4.2
Page 1682 :
Answer 20, False: It is a capital expenditure since it leads to creation, of physical assets of the government., , Objective Type Questions 4.2
Page 1683 :
Question 21, State giving reason whether the following, statement is true or false:, Defence services expenditure is a capital expenditure., , Objective Type Questions 4.2
Page 1684 :
Answer 21, False: Defence services expenditure is a revenue expenditure because it neither creates any asset nor reduces any, liability of the government., , Objective Type Questions 4.2
Page 1685 :
Question 22, State giving reason whether the following, statement is true or false:, Receipts of Post-office Savings Accounts, National, Savings Certificates, etc. are capital receipts., , Objective Type Questions 4.2
Page 1686 :
Answer 22, True: Small savings of people (Post-office Savings, Accounts, National Savings Certificates, etc.) are capital, receipts for the government because these receipts create a, liability of repayment on government., , Objective Type Questions 4.2
Page 1687 :
Question 23, State giving reason whether the following, statement is true or false:, Personal income tax and corporation tax are indirect, taxes., , Objective Type Questions 4.2
Page 1688 :
Answer 23, False: These are direct taxes which fall directly on, individuals (personal income tax) and firms (corporation, tax). The liability to pay and burden of the tax lie on the, same person, i.e., burden cannot be shifted., , Objective Type Questions 4.2
Page 1689 :
Question 24, State giving reason whether the following, statement is true or false:, PSU disinvestment is an example of non-debt creating, capital receipts., , Objective Type Questions 4.2
Page 1690 :
Answer 24, True: PSU disinvestment, i.e., net proceeds from sale of, shares in PSUs is a capital receipt that reduces the financial assets of the government. However, it does not give, rise to debt. So, it is a non-debt creating capital receipt., , Objective Type Questions 4.2
Page 1691 :
Question 25, Loans to state government are a part of:, , (Choose the correct alternative), (a), (b), (c), (d), , revenue receipts, capital receipts, capital expenditure, plan revenue expenditure, , Objective Type Questions 4.2
Page 1692 :
Answer 25, (c) capital expenditure, , Objective Type Questions 4.2
Page 1693 :
Question 26, Which one of these is revenue expenditure?, , (Choose the correct alternative), (a), (b), (c), (d), , purchase of shares, loan advanced, subsidies, expenditure on acquisition of land, , Objective Type Questions 4.2
Page 1694 :
Answer 26, (c) subsidies, , Objective Type Questions 4.2
Page 1695 :
Question 27, Identify the tax whose burden can’t be shifted., , (Choose the correct alternative), (a), (b), (c), (d), , GST, Income Tax, Sales tax, VAT, , Objective Type Questions 4.2
Page 1696 :
Answer 27, (b) Income Tax, , Objective Type Questions 4.2
Page 1697 :
Question 28, Which of the following is a direct tax?, , (Choose the correct alternative), (a), (b), (c), (d), , Income Tax, GST, excise duty, custom Duty, , Objective Type Questions 4.2
Page 1698 :
Answer 28, (a) Income Tax, , Objective Type Questions 4.2
Page 1699 :
Question 29, Which of the following is a source of capital receipt?, , (Choose the correct alternative), (a), (b), (c), (d), , foreign donations, dividends, disinvestment, indirect taxes, , Objective Type Questions 4.2
Page 1700 :
Answer 29, (c) disinvestment, , Objective Type Questions 4.2
Page 1701 :
Question 30, Gift tax is a paper tax because ____________., , (Choose the correct alternative), (a), (b), (c), (d), , it is an indirect tax, it is a direct tax, it does not have significant revenue yield, it does not have significant capital yield, , Objective Type Questions 4.2
Page 1702 :
Answer 30, (c) it does not have significant revenue yield, , Objective Type Questions 4.2
Page 1703 :
Question 31, Which one of the following statement is incorrect?, , (Choose the correct alternative), (a) Revenue receipts are regular in nature, (b) There is no future obligation to return the amount in, case of revenue receipts., (c) Capital receipts either create an asset or cause a, reduction in the liabilities of the government., (d) Borrowings are treated as capital receipts as they, lead to an increase in liability., Objective Type Questions 4.2
Page 1704 :
Answer 31, (c) Capital receipts either create an asset or cause a, reduction in the liabilities of the government., , Objective Type Questions 4.2
Page 1705 :
Question 32, Fees of the government college is a revenue receipt, because:, , (Choose the correct alternative), (a) it creates liability of the government, (b) it neither creates any liability nor reduces any asset, of the government., (c) it neither creates any asset nor reduces any liability, of the government., (d) it increases assets of the government., Objective Type Questions 4.2
Page 1706 :
Answer 32, (b) it neither creates any liability nor reduces any asset, of the government., , Objective Type Questions 4.2
Page 1707 :
Question 33, Which one of the following is a combination of capital, expenditure?, , (Choose the correct alternative), (a), (b), (c), (d), , Grants and interest payments, Subsidies and construction of roads, Construction of roads and repayment of loans, Defense services expenditure and construction of, school building, , Objective Type Questions 4.2
Page 1708 :
Answer 33, (c) Construction of roads and repayment of loans, , Objective Type Questions 4.2
Page 1709 :
Question 34, Match the following:, Column I, , Column II, , (i) Purchase of metro coaches from, Japan, , (a) revenue expenditure, , (ii) Dividend received by, government from a company, , (b) capital receipts, , (iii) Sale of 40% shares of a PSU to a, private company, , (c) capital expenditure, , (iv) Pension paid to retired, government employees, , (d) revenue receipts, , Objective Type Questions 4.2
Page 1710 :
Answer 34, (i) – c, (ii) – d, (iii) – b, (iv) – a, , Objective Type Questions 4.2
Page 1711 :
Question 1, Why are borrowings a capital receipt?, (CBSE 2009) (1 mark), , HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1712 :
Answer 1, Because it leads to increase in liability of repayment on, government., , HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1713 :
Question 2, Why are taxes received by the government not capital, receipts?, (CBSE 2009) (1 mark), , HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1714 :
Answer 2, Because taxes neither create any liability nor reduce any, asset of the government., , HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1715 :
Question 3, Giving reasons classify the following into direct and, indirect tax:, (i) Personal income tax, (ii) Goods and services tax, (iii) Corporation tax, (CBSE 2010) (3 marks), , HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1716 :
Answer 3, (i) It is a direct tax because it falls directly on individuals. Its impact (liability to pay) and incidence (actual, burden) falls on the same person, i.e., its burden cannot be shifted., (ii) It is an indirect tax because its impact (liability to, pay) and incidence (actual burden) lie on different, persons, i.e., payer and bearer of the tax are different people., (iii) It is a direct tax because it falls directly on firms. Its, impact (liability to pay) and incidence (actual burden), falls on the same person, i.e., its burden cannot be, shifted., , HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1717 :
Question 4, Categorise the following into revenue expenditure and, capital expenditure. Give reasons., (i) Grants to state governments, (ii) Payment of salaries to staff of government hospitals, (iii) Purchase of cranes for the construction of flyovers, (iv) Repayment of loan from IMF, (4 marks), , HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1718 :
Answer 4, (i) It is a revenue expenditure because it neither creates, any asset nor reduces liability of the government., (ii) It is a revenue expenditure because it neither creates, any asset nor reduces any liability of the government., (iii) It is a capital expenditure because it increases asset of, the government., (iv) It is a capital expenditure because it reduces the liability of the government., , HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1719 :
Question 5, Categorise the following into revenue expenditure and, capital expenditure. Give reasons., (i) Investment in shares, (ii) Subsidies, (iii) Construction of school building, (iv) Defence services expenditure, (v) Repayment of loan with interest, (vi) Grants to state governments for creation of assets, (6 marks), HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1720 :
Answer 5, (i) It is a capital expenditure because it creates asset of, the government., (ii) It is a revenue expenditure because it neither creates, any asset nor reduces any liability of the government., (iii) It is a capital expenditure because it creates asset of, the government., (iv) It is a revenue expenditure because it neither creates, any asset nor reduces any liability of the government., (v) Repayment of the principal amount of loan is a capital expenditure because it reduces liability of the government. But interest amount will be a revenue expHOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1721 :
enditure because it neither creates any asset nor reduces any liability of the government., (vi) It is a revenue expenditure because it neither creates, any asset nor reduces liability of the Central Government (since grants are given for creation of assets of, state governments)., , HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1722 :
Question 6, In the Government of India’s budget, the Finance Minister proposed to raise the excise duty on cigarettes. He also, proposed to increase income tax on individual earn-ing, more than `one crore per annum. Identify and expla-in, the types of taxes proposed by the Finance Minister. Was, the objective only to earn revenue for the govern-ment?, What possible welfare objectives could the Gover-nment, be considering?, (6 marks), , HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1723 :
Answer 6, Excise duty — Indirect tax, Indirect tax is a tax where the payer and the bearer of the, tax are different people., Income tax — Direct tax, Direct tax is a tax where the payer and bearer of the tax is, the same person., Besides the objective of raising more revenue, the proposals also serve some welfare objectives:, (i) Allocation of resources: Raising excise duty on, cigarett-es will make them more expensive. The, price, rise, is, HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1724 :
expected to discourage cigarette smoking, which will, positively impact the health of people and raise their, welfare., (ii) Redistribution of income: Raising income tax on, inco-me above `1 crore will reduce the gap between, the rich and poor people. In other words, income, inequ-alities will reduce., The revenue raised from these proposals could be, spent on health, education, etc. to improve the welfare of the poor., HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1725 :
Question 7, Classify the following statements as revenue receipts or, capital receipts. Give valid reasons in support of your, answer., (a) Financial help from a multinational corporation for, victims in a flood affected area., (b) Sale of share of a Public Sector Undertaking (PSU), to a private company, Y Ltd., (c) Dividends paid to the Government by the State, Bank of India., (d) Borrowings form International Monetary Fund (IMF)., (CBSE 2019) (4 marks), HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1726 :
Answer 7, (a) Revenue receipt of the government, as it is neither, creating any liability nor reducing any assets for the, government., (b) Capital receipt of the government, as it is reducing, the assets of the government., (c) Revenue receipt of the government, as it is neither, creating any liability nor reducing any assets for the, government., (d) Capital receipt, as it is increasing the liability of the, Government., HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1727 :
Question 8, Do ‘disinvestment’ and ‘loan proceeds from abroad’, constitute revenue receipts of the government? Give, reason., (CBSE 2019) (4 marks), , HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1728 :
Answer 8, (i) No, Disinvestment are capital receipts of the government as it leads to reduction in assets., (ii) No “loan proceeds from abroad” are capital recei-pts, of the government as it increases the liabilities of the, Government., , HOTs 4.2 — Analysing, Evaluating & Creating Type Questions
Page 1729 :
4.3, Measures of Government, Deficit – Revenue Deficit,, Fiscal Deficit and Primary, Deficit
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The government may spend an amount equal to the, revenue it collects. This is known as a balanced budget., If it needs to incur higher expenditure, it will have to, raise the amount through taxes in order to keep the budget balanced., When tax collection exceeds the required expenditure,, it is called a surplus budget., The most common feature of government budget is the, situation when expenditure exceeds revenue. This is, known as a deficit budget., When a government spends more than it collects by, way of revenues, it incurs a budget deficit. More formally, it refers to the excess of total expenditure (both, revenue and capital) over total receipts (both revenue
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and capital)., There are various measures that capture government, deficit and they have their own implications for the, economy., Table 4.1: The government budget of a, hypothetical economy (2020-21), Items, 1. Revenue Receipts (a + b), (a) Tax revenue (net of states’ share), (b) Non-tax revenue, 2. Revenue Expenditure, (a) Interest payments, (b) Defence expenditure, (c) Other expenditures (salary, subsidies,, etc.), 3. Revenue Deficit (2 – 1), , (` in lakh crore), 70, 60, 10, 100, 50, 20, 30, 30
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4. Capital Receipts (a + b + c), (a) Borrowings, (b) Recovery of loans, (c) Other receipts (mainly PSU, disinvestment), 5. Capital Expenditure, 6. Total Expenditure (2 + 5), 7. Fiscal Deficit [4(a) = 6 – {1 + 4(b) + 4(c)}], 8. Primary Deficit [7 – 2(a)], , 165, 120, 40, 5, 135, 235, 120, 70
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Revenue Deficit, Meaning, Revenue deficit refers to excess of government’s revenue expenditure over its revenue receipts., Revenue deficit = Revenue expenditure – Revenue receipts, , The revenue deficit indicates that the government will, not be able to meet its revenue expenditure from its current income (i.e., revenue receipts).
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Implications, When the government incurs a revenue deficit, it implies that the government is dissaving and is using up, the savings of the other sectors of the economy to finance a part of its consumption expenditure. This situation means that the government will have to borrow, not only to finance its investment but also its consumption requirements. This will increase borrowings of, the government and the burden of interest liabilities,, and eventually force the government to cut expenditure. Since a major part of revenue expenditure is committed expenditure (mainly interest payments and defence expenditure), it cannot be reduced.
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Often the government reduces productive capital expenditure, (e.g., expenditure on the acquisition of land,, building, machinery, equipment, etc.) or welfare expenditure (e.g. subsidies though under-pricing of essential goods, and services like education and health)., This would mean lower growth and adverse welfare implications.
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Fiscal Deficit, Meaning, Fiscal deficit is the difference between the Government’s budgetary expenditure and its budgetary receipts, excluding borrowings., Fiscal deficit = Total expenditure – Total receipts net of borrowings, , Since total expenditure includes both revenue expenditure and capital expenditure, and total receipts net of, borrowings is the sum total of revenue receipts and, non-debt creating capital receipts, therefore:, Fiscal deficit = (Revenue expenditure + Capital expenditure), –(Revenue receipts+Non-debt creating capital receipts)
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Fiscal deficit indicates the total borrowing, requirements of the government from all, sources., The fiscal deficit will have to be financed through borrowings. Therefore, Fiscal Deficit = Borrowings, From the financing side:, Fiscal Deficit = Net borrowing at home* + Borrowing, from RBI + Borrowing from abroad, Thus, it indicates the total borrowing requirements of, the government from all sources., *Net borrowing at home includes that directly borrowed from the public through debt, instruments (for example, the various small savings schemes) and indirectly from, commercial banks through Statutory Liquidity Ratio (SLR).
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Relationship between the revenue deficit, and the fiscal deficit, Revenue deficit is a part of fiscal deficit., Explanation:, Fiscal deficit = Total expenditure – Total receipts, excluding borrowings, = (Revenue expenditure + Capital, expenditure) – (Revenue receipts +, Non-debt creating capital receipts), = (Revenue expenditure – Revenue, receipts) + Capital expenditure – Nondebt creating capital receipts, = Revenue deficit + Capital expenditure –, Non-debt creating capital receipts
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Clearly, revenue deficit is a part of fiscal deficit. Thus, a, large share of revenue deficit in fiscal deficit indicates, that a large part of borrowings is being used to meet, the government’s consumption expenditure needs rather than investment.
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Implications of Fiscal Deficit, 1. A large fiscal deficit means large amount of borrowings. This creates a large burden of interest payment and repayment of loans in the future., 2. Fiscal deficit equals borrowings of the government., Such borrowings are generally financed by issuing, new currency which may lead to inflation. However,, if the borrowings are for infrastructural development this may lead to capacity building and may not, be inflationary., Thus, fiscal deficit is a key variable in judging the, financial health of the public sector and the stability, of the economy.
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Primary Deficit, Meaning, Primary deficit is the difference between fiscal deficit, and the interest payments made by the government., Primary deficit = Fiscal deficit – Interest payments, , Implications, Primary deficit indicates borrowing requirements, of the government other than to make interest payments on past debts., Explanation: Fiscal deficit is nothing but total, borrowings of the government during the current, year. Total borrowings also includes borrowing on
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account of interest payments. Therefore, out of total borrowings requirement (i.e. fiscal deficit) if we, deduct borrowing on account of interest payments,, we get the primary deficit, which indicates borrowing requirements of the government other than to, make interest payments., Thus, Fiscal Deficit = Primary Deficit + Interest, Payments, If primary deficit in a government budget is zero, it, means fiscal deficit is equal to interest payment., Explanation: Primary deficit = Fiscal deficit – Interest, payments, If primary deficit is zero, then, 0 = Fiscal deficit – Interest payments
Page 1743 :
⇒ Fiscal deficit = Interest payments, It implies that the government has to borrow only, on account of interest payments., , , , Top Tips, , • To obtain an estimate of borrowing on account of current, expenditures exceeding revenues, we need to calculate the, primary deficit., • The goal of measuring primary deficit is to focus on present, fiscal imbalances., • Gross primary deficit = Gross fiscal deficit – Net interest, liabilities, where net interest liabilities consist of interest payments, minus interest receipts by the government on net domestic, lending.
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Key Terms, Balanced Budget – When the government's budgetary expenditure is equal to the revenue it collects, this is known as a balanced, budget., Surplus Budget – When tax collection exceeds the required, expenditure, it is called a surplus budget., Deficit Budget – When the government's budgetary expenditure, is more than budgetary receipts, this is known as a deficit budget., Budget Deficit – When a government spends more than it collects, by way of revenues, it incurs a budget deficit., Revenue deficit – It refers to excess of government’s revenue, expenditure over its revenue receipts., Fiscal deficit – It is the difference between the Government’s, budgetary expenditure and its budgetary receipts excluding, borrowings., Primary deficit – It is the difference between fiscal deficit and the, interest payments made by the government.
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RECAP, , Revenue Deficit, , Revenue deficit refers to excess of government’s revenue, expenditure over its revenue receipts., Revenue deficit = Revenue expenditure –, Revenue receipts, It indicates that government will not be able to meet its, revenue expenditure from its revenue receipts. It implies, that government is dissaving and borrowing to meet consumption expenditure. The government may have to cut, productive capital expenditure or welfare expenditure, which could have lower growth and adverse welfare implicateons., , Fiscal Deficit, , Fiscal deficit is the difference between the Government’s, budgetary expenditure and its budgetary receipts exclude-
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ng borrowings., Fiscal deficit = Total expenditure – Total receipts net, of borrowings, = (Revenue expenditure + Capital expenditure) – (Revenue receipts + Non-debt creating capital receipts), = Revenue deficit + Capital expenditure –, Non debt creating capital receipts, Clearly, revenue deficit is a part of fiscal deficit. So, a large, share of revenue deficit in fiscal deficit indicates that a, large part of borrowings is being used to meet the government’s consumption expenditure needs rather than investment., Fiscal deficit indicates total borrowing requirements of the, government from all sources. From the financing side:, Fiscal Deficit = Net borrowing at home + Borrowing from, RBI + Borrowing from abroad.
Page 1747 :
Primary Deficit, , Primary deficit is the difference between fiscal deficit and, the interest payments made by the government., Primary deficit = Fiscal deficit – Interest payments, Since fiscal deficit is nothing but total borrowings of the, government, therefore, primary deficit indicates borrowings other than to make interest payments.
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Question 1, Match the following:, Column I, 1. Fiscal deficit, 2. Primary deficit, , (a), (b), , 3. Revenue deficit (c), (d), , Column II, Total expenditure – Total receipts, Revenue expenditure – Revenue, receipts, Total expenditure – Total receipts, excluding borrowings, Fiscal deficit – Interest payment, Objective Type Questions 4.3
Page 1749 :
Answer 1, (i) – c, (ii) – d, (iii) – b, , Objective Type Questions 4.3
Page 1750 :
Question 2, Match the following:, Column I, (i) When government expenditure, equals the revenue it collects., (ii) Tax collection exceeds the, required expenditure., (iii) When government expenditure, exceeds the revenue., , Column II, (A) Deficit Budget, (B) Surplus Budget, (C) Balanced Budget, , Objective Type Questions 4.3
Page 1751 :
Answer 2, (i) – (C), (ii) – (B), (iii) – (A), , Objective Type Questions 4.3
Page 1752 :
Question 3, If the government needs to incur higher expenditure, it, will have to _______ taxes in order to keep the budget, balanced. (increase/decrease), , (Fill in the blanks with correct option), , Objective Type Questions 4.3
Page 1753 :
Answer 3, increase, , Objective Type Questions 4.3
Page 1754 :
Question 4, The ______ includes only such transactions that affect, the current income and expenditure of the government., , (Choose the correct alternative), (a), (b), (c), (d), , Budget deficit, Revenue deficit, Fiscal deficit, Primary deficit, , Objective Type Questions 4.3
Page 1755 :
Answer 4, (b) Revenue deficit, , Objective Type Questions 4.3
Page 1756 :
Question 5, Which of the following is not true for revenue deficit?, A revenue deficit:, , (Choose the correct alternative), (a) implies that the government is dissaving and is, using up the savings of the other sectors of the, economy., (b) means that the government will have to borrow n-ot, only to finance its investment but also its consumption expenditure requirements., (c) focuses on present fiscal imbalances., (d) leads to build up of stock of debtObjective, and Type, interest, liaQuestions 4.3
Page 1757 :
bilities; and forces the government, eventually, to, cut productive capital expenditure or welfare, expendit-ure. This would mean lower growth and, adverse welfare implications., , Objective Type Questions 4.3
Page 1758 :
Answer 5, (c) focuses on present fiscal imbalances., , Objective Type Questions 4.3
Page 1759 :
Question 6, Which of the following is not true for fiscal deficit?, , (Choose the correct alternative), (a) Fiscal deficit= Total expenditure – Revenue, receipts –Non debt creating capital receipts, (b) Fiscal deficit= Net borrowing at home+ Borrowing, from RBI + Borrowing from abroad, (c) Fiscal deficit = Primary deficit + Interest payments, on accumulated debt, (d) None of the above, Objective Type Questions 4.3
Page 1760 :
Answer 6, (d) None of the above, , Objective Type Questions 4.3
Page 1761 :
Question 7, Fiscal deficit = Total expenditure – (Revenue receipts +, _______________________), , (Fill in the blank), , Objective Type Questions 4.3
Page 1762 :
Answer 7, Non debt creating capital receipts., , (Those capital receipts which are not borrowings and, therefore, do not give rise to debts, e.g. proceeds from sale, of PSUs, and recovery of loans i.e. PSU disinvestment), , Objective Type Questions 4.3
Page 1763 :
Question 8, Fiscal deficit will have to be financed through _______., , (Choose the correct alternative), (a), (b), (c), (d), , Primary deficit, Revenue deficit, Borrowing, Taxes, , Objective Type Questions 4.3
Page 1764 :
Answer 8, (c) Borrowing, , Objective Type Questions 4.3
Page 1765 :
Question 9, Fiscal deficit indicates the total borrowing requirements, of the government from all sources., , True/False? Give reason., , Objective Type Questions 4.3
Page 1766 :
Answer 9, True: Fiscal deficit is financed through borrowings., From the financing side:, Fiscal deficit = Net borrowing at home + Borrowing from, RBI + Borrowing from abroad, , Objective Type Questions 4.3
Page 1767 :
Question 10, _______ is a key variable in judging the financial health, of the public sector and the stability of the economy., , (Choose the correct alternative), (a), (b), (c), (d), , Revenue deficit, Fiscal deficit, Primary deficit, None of the above., , Objective Type Questions 4.3
Page 1768 :
Answer 10, (b) Fiscal deficit, , Objective Type Questions 4.3
Page 1769 :
Question 11, Revenue deficit is a part of fiscal deficit., , True/False? Give reason., , Objective Type Questions 4.3
Page 1770 :
Answer 11, True: Revenue deficit is a part of fiscal deficit, Fiscal deficit = Total expenditure – Total receipts, excluding borrowings, = Revenue expenditure + Capital expenditure, – (Revenue receipts + Non debt creating capital receipts), = Revenue expenditure – Revenue receipts, + Capital expenditure – Non debt creating capital receipts, = Revenue deficit + capital expenditure, – Non debt creating capital receipts, Objective Type Questions 4.3
Page 1771 :
Question 12, A large share of __________ in fiscal deficit indicates, that a large part of borrowing is being used to meet the, government’s consumption expenditure needs rather, than investment., , (Fill in the blank), , Objective Type Questions 4.3
Page 1772 :
Answer 12, revenue deficit, , Objective Type Questions 4.3
Page 1773 :
Question 13, The goal of measuring ________ is to focus on present, fiscal imbalances., , (Choose the correct alternative), (a), (b), (c), (d), , Revenue deficit, Fiscal deficit, Primary deficit, None of the above, , Objective Type Questions 4.3
Page 1774 :
Answer 13, (c) Primary deficit, , Objective Type Questions 4.3
Page 1775 :
Question 14, To obtain an estimate of borrowing on account of, current expenditure exceeding revenues, we need, to calculate __________., , (Choose the correct alternative), (a), (b), (c), (d), , Revenue deficit, Fiscal deficit, Primary deficit, None of the above, , Objective Type Questions 4.3
Page 1776 :
Answer 14, (c) Primary deficit, , Objective Type Questions 4.3
Page 1777 :
Question 15, Primary deficit = Fiscal deficit – Net interest liabilities., , True/False? Give reason., , Objective Type Questions 4.3
Page 1778 :
Answer 15, True: Primary deficit = Fiscal deficit – Net interest, liabilities, Net interest liabilities consist of interest payments, minus interest receipts by the government on net, domestic lending., , Objective Type Questions 4.3
Page 1779 :
Question 16, Fiscal deficits are always inflationary., , True/False? Give reason., , Objective Type Questions 4.3
Page 1780 :
Answer 16, False: Fiscal deficit equals borrowings of the, government. Such borrowings are generally financed by, issuing new currency which may lead to inflation., However, if the borrowings are for infrastructure, development, this may lead to capacity building and may, not be inflationary., , Objective Type Questions 4.3
Page 1781 :
Question 17, Primary deficit in a government budget will be zero, when, __________., , (Choose the correct alternative), (a), (b), (c), (d), , Revenue deficit is zero, Fiscal deficit is zero, Total borrowing is equal to interest payments, Net interest payments is zero., , Objective Type Questions 4.3
Page 1782 :
Answer 17, (c) Total borrowing is equal to interest payments, , Objective Type Questions 4.3
Page 1783 :
Question 18, Which of the following is a revenue receipt?, , (Choose the correct alternative), (a) Sale of shares of a public sector undertaking (PSU), to a private company, Y Ltd., (b) Financial help from a multinational corporation for, victims in a flood affected area., (c) Dividends paid to the government by the State Bank, of India., (d) Both (b) and (c), Objective Type Questions 4.3
Page 1784 :
Answer 18, (d) Both (b) and (c), Fiscal deficit = Total expenditure – (Revenue, receipts + Non debt creating capital receipts), = [(iv)+(v)]-[(i)+(ii)]-(iii), = (1500 + 480)-(1,000 + 150)-50, = 1,980 –1,150 -50 = ` 780 crore, , Objective Type Questions 4.3
Page 1785 :
Question 19, Fiscal Deficit – Interest payments = __________., , (Choose the correct alternative), (a), (b), (c), (d), , Revenue Deficit, Budget Deficit, Primary Deficit, None of these, , Objective Type Questions 4.3
Page 1786 :
Answer 19, (c) Primary Deficit, , Objective Type Questions 4.3
Page 1787 :
Question 20, _________ indicates that the government will have to, borrow not only to finance its investments but also its, consumption expenditure., , (Choose the correct alternative), (a), (b), (c), (d), , Revenue deficit, Fiscal deficit, Primary deficit, Budget deficit, , Objective Type Questions 4.3
Page 1788 :
Answer 20, (a) Revenue deficit, , Objective Type Questions 4.3
Page 1789 :
Question 21, Fiscal deficit is financed through __________., , (Choose the correct alternative), (a), (b), (c), (d), , market borrowings, borrowings from the Central Bank, borrowings from foreign governments, All of these, , Objective Type Questions 4.3
Page 1790 :
Answer 21, (d) All of these, , Objective Type Questions 4.3
Page 1791 :
Question 22, Which of the following statement is not true for fiscal, deficit?, A fiscal deficit:, , (CBSE SQP 2015) (Choose the correct alternative), (a) represents the borrowing of the government., (b) is the difference between total expenditure and total, receipts of the government, (c) is the difference between total expenditure and total, receipts other than borrowing, (d) increases the future liability of the government, Objective Type Questions 4.3
Page 1792 :
Answer 22, (b) is the difference between total expenditure and, total receipts of the government, , Objective Type Questions 4.3
Page 1793 :
Question 23, Borrowing in government budget is:, , (CBSE SQP 2016) (Choose the correct alternative), (a), (b), (c), (d), , Revenue deficit, Fiscal deficit, Primary deficit, Deficit in taxes, , Objective Type Questions 4.3
Page 1794 :
Answer 23, (b) Fiscal deficit, , Objective Type Questions 4.3
Page 1795 :
Question 24, Which of the following statements is true?, , (Choose the correct alternative), (a) Fiscal deficit is the difference between total expenditure and total receipts., (b) Primary deficit is the difference between total receipt and interest payments., (c) Fiscal deficit is the sum of primary deficit and interest payment., (d) None of the above, Objective Type Questions 4.3
Page 1796 :
Answer 24, (c) Fiscal deficit is the sum of primary deficit and interest payment., , Objective Type Questions 4.3
Page 1797 :
Question 25, Which of the following statement is true?, , (CBSE SQP 2016) (Choose the correct alternative), (a) Loans from IMF is a Revenue Receipt., (b) Higher revenue deficit necessarily leads to higher fiscal deficit., (c) Borrowing by a government represents a situation of, fiscal deficit., (d) Revenue deficit is the excess of capital receipts over, the revenue receipts., Objective Type Questions 4.3
Page 1798 :
Answer 25, (c) Borrowing by a government represents a situation of, fiscal deficit., , Objective Type Questions 4.3
Page 1799 :
Question 26, Primary deficit in a government budget equals:, , (Choose the correct alternative), (a), (b), (c), (d), , Interest payments, Interest payments less borrowings, Borrowings less interest payments, None of these, , Objective Type Questions 4.3
Page 1800 :
Answer 26, (c) Borrowings less interest payments, , Objective Type Questions 4.3
Page 1801 :
Question 27, State giving reason whether the following statement, is true or false:, Increase in revenue deficit will always lead to higher, fiscal deficit., , Objective Type Questions 4.3
Page 1802 :
Answer 27, False: Fiscal deficit = Revenue deficit + Capital expenditure, – Non-debt creating capital receipts. Therefore, increase in, revenue deficit may not lead to higher fiscal deficit because, fiscal deficit is also influenced by non-debt creating capital, receipts and capital expenditure of the government in, addition to revenue deficit., , Objective Type Questions 4.3
Page 1803 :
Question 28, State giving reason whether the following statement, is true or false:, Primary deficit equals revenue deficit less interest payments., , Objective Type Questions 4.3
Page 1804 :
Answer 28, False: Primary deficit equals fiscal deficit less interest, payments., , Objective Type Questions 4.3
Page 1805 :
Question 29, Primary deficit is borrowing requirement of government, for making, , (Choose the correct alternative), (a), (b), (c), (d), , interest payment, other than interest payment, payments off public debts, payment off borrowing from RBI, , Objective Type Questions 4.3
Page 1806 :
Answer 29, (b) other than interest payment, , Objective Type Questions 4.3
Page 1807 :
Question 30, Zero primary deficit means:, , (Choose the correct alternative), (a) no liabilities with government, (b) the government has to resort to borrowing only to, meet interest payments, (c) no interest payments, (d) no current liabilities, , Objective Type Questions 4.3
Page 1808 :
Answer 30, (b) the government has to resort to borrowing only to, meet interest payments, , Objective Type Questions 4.3
Page 1809 :
Question 31, In a situation of Inflation, the government should adopt:, , (Choose the correct alternative), (a), (b), (c), (d), , Balanced Budget, Deficit budget, Surplus Budget, None of these, , Objective Type Questions 4.3
Page 1810 :
Answer 31, (c) Surplus Budget, , Objective Type Questions 4.3
Page 1811 :
Question 1, Suppose you are a member of the “Advisory Committee, to the Finance Minister of India”. The finance Minister is, concerned about the rising Revenue Deficit in the budget., Suggest any one measure to control the rising Revenue, deficit of the government., (CBSE 2019) (1 mark), , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1812 :
Answer 1, Measure to Control Revenue deficit: (any one), (a) To reduce government administrative expenses., (b) To reduce the burden of subsidy., (c) To increase taxation., , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1813 :
Question 2, State whether the following statement is true or, false. Support your answer with reason., Revenue deficit increase when government fails to recover loans forwarded to different nations., (CBSE 2019) (1 mark), , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1814 :
Answer 2, The given statement is false, because recovery of loans is, a capital receipt. It does not affect the revenue receipts., , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1815 :
Question 3, "Fiscal deficit indicates the total borrowing requirements, of the government from all sources." Elucidate., (4 marks), , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1816 :
Answer 3, Fiscal deficit is the difference between the Government’s, budgetary expenditure and its budgetary receipts excluding borrowings., The fiscal deficit will have to be financed through borrowings. Therefore, Fiscal Deficit = Borrowings, From the financing side:, Fiscal Deficit = Net borrowing at home + Borrowing, from RBI + Borrowing from abroad, Thus, it indicates the total borrowing requirements of the, government from all sources., HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1817 :
Question 4, ‘‘A large fiscal deficit leads to a higher revenue deficit in, future. ’’Do you agree with the statement? Give reasons, in support of your answer., (3 marks), , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1818 :
Answer 4, Yes, a large fiscal deficit leads to a higher revenue deficit, in future., Reason: A large fiscal deficit means large amount of borrowings. This creates a large burden of repayment of loans in future and interest payments. More interest payments will increase revenue expenditure. Hence, revenue deficit in future will increase., , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1819 :
Question 5, “Governments across nations are too much worried about the term fiscal deficit”. Do you think that fiscal deficit is necessarily inflationary in nature? Support your, answer with valid reasons., (CBSE Sample Question Paper 2016) (3 marks), , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1820 :
Answer 5, The term fiscal deficit is the difference between the government’s total expenditure and its total receipts (excluding, borrowing). Such borrowings are generally financed by, issuing new currency which may lead to inflation., However, if the borrowings are for the infrastructural, development-al purposes this may lead to capacity, building and may not be inflationary., , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1821 :
Question 6, Explain the relationship between revenue deficit and, fiscal deficit., (4 marks), , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1822 :
Answer 6, Revenue deficit is a part of fiscal deficit., Explanation: Fiscal deficit = Total expenditure – Total, receipts excluding borrowings, = (Revenue expenditure + Capital expenditure) – (Revenue receipts + Non-debt creating capital receipts), = (Revenue expenditure – Revenue receipts) + Capital, expenditure – Non-debt creating capital receipts, = Revenue deficit + Capital expenditure – Non-debt creating capital receipts, Clearly, revenue deficit is a part of fiscal deficit., HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1823 :
Thus, a large share of revenue deficit in fiscal deficit, indic-ates that a large part of borrowings is being used to, meet the government’s consumption expenditure needs, rather than investment., , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1824 :
Question 7, Can there be a fiscal deficit without revenue deficit?, Explain., (4 marks), , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1825 :
Answer 7, Fiscal deficit = Total expenditure – Total receipts excluding borrowings, = (Revenue expenditure + Capital expenditure) – (Revenue receipts + Non-debt capital receipts), = (Revenue expenditure – Revenue receipts) – (Capital, expenditure – Non-debt capital receipts), Yes, there can be a fiscal deficit in a government budget, without a revenue deficit in the following situations:, (i) When revenue budget is balanced (i.e., revenue expenditure = revenue receipts) and capital budget shows, HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1826 :
a deficit (i.e., capital expenditure > non-debt capital, receipts)., (ii) When there is a surplus in the revenue budget (i.e.,, revenue receipts > revenue expenditure) but the deficit in capital budget is greater than this surplus., , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1827 :
Question 8, What will be the effect of a deficit budget on the level, of aggregate demand?, (3 marks), , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1828 :
Answer 8, When the government’s total expenditure (both revenue, and capital) exceeds its total receipts (both revenue and, capital), it incurs a budget deficit. Increased government, expenditure will raise the level of aggregate demand in economy since government expenditure is a component of, aggregate demand., A budget deficit is financed through borrowings, mainly, Central Bank Borrowing, which issues new currency to, the government. The government then pays for its expenses with this money. The money thus ultimately comes, into the hands of the general public and becomes a part, HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1829 :
of money supply. That is, money supply in the economy, increases. As a result, aggregate demand in the economy, increases., , HOTs 4.3 — Analysing, Evaluating & Creating Type Questions
Page 1830 :
NUMERICAL 1, From the following data calculate Fiscal Deficit., (CBSE Sample Question Paper 2018) (1 mark), Items, , (` in billion), , (i) Capital receipts net of borrowings, , 95, , (ii) Capital Receipt, , 68, , (iii) Revenue Expenditure, , 160, , (iv) Interest Payment, , 20, , (v) Borrowings, , 32, , (vi) Tax Revenue, , 50, , (vii) Non-tax Revenue, , 10, , Solution: Fiscal deficit = Borrowings = `32 billion
Page 1831 :
Do it yourself 1, In a government budget, revenue deficit is`50000 crore and, borrowings are `75000 crore. How much is the fiscal deficit?, (1 mark), [Ans. `75000 crore]
Page 1832 :
Solution of Do it yourself 1, Fiscal deficit = Borrowings = ` 75000 crore
Page 1833 :
NUMERICAL 2, A government budget shows a primary deficit of `400, crore. The revenue expenditure on interest payment is `, 400 crore. How much is the fiscal deficit?, (1 mark), Solution:, Primary deficit = Fiscal deficit – Interest payment, Therefore, Fiscal deficit, = Primary deficit+ Interest payment, = 4400 + 400 = `4800 crore
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Do it yourself 2, A government budget shows a primary deficit of `3,500 crore. The interest payment is `500 crore. How much is the, fiscal deficit?, (1 mark), [Ans. `4,000 crore]
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Solution of Do it yourself 2, Fiscal deficit = Primary deficit + Interest payment, = 3,500 + 500 = `4,000 crore
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NUMERICAL 3, In a government budget, if revenue receipts are `100 crore,, capital receipts are ` 50 crore and revenue deficit is ` 25, crore, how much is the revenue expenditure?, (1 mark), Solution:, Revenue deficit = Revenue expenditure – Revenue receipts, 25 = Revenue expenditure – 100, Revenue expenditure = 25 + 100 = `125 crore
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Do it yourself 3, In a government budget, if tax revenue receipts are `80, crore, non-tax revenues are ` 20 crore and revenue deficit is, ` 50 crore, how much is the revenue expenditure?, (1 mark), [Ans. `150 crore]
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Solution of Do it yourself 3, Revenue deficit = Revenue expenditure – Revenue, receipts (tax and non-tax revenues), 50 = Revenue expenditure – (80 + 20), Revenue expenditure = 50 + 100 = `150 crore
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NUMERICAL 4, From the following data about a government budget find, (a) Revenue deficit, (b)Fiscal deficit and(c) Primary deficit:, (CBSE Sample Question Paper 2018) (1 mark), Items, , (` in billion), , (i) Tax revenue, , 47, , (ii) Capital receipts, , 34, , (iii) Non-tax revenue, , 10, , (iv) Borrowings, , 32, , (v) Revenue expenditure, , 80, , (vi) Interest payments, , 20, , Solution: (a) Revenue deficit = Revenue expenditure –, Revenue receipts (Tax revenue + Non-tax revenue), = 80 – (47 + 10) = 80 – 57 = ` 23 arab
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(b) Fiscal deficit = Borrowings = ` 32 arab, (c) Primary deficit = Fiscal deficit – Interest payments =, 32 – 20 = ` 12 arab
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Do it yourself 4, From the following data about a government budget find (a), Fiscal deficit and (b) Primary deficit :, (4 marks), Items, , (` in arab), , (i) Revenue expenditure, , 70000, , (ii) Borrowings, , 15000, , (iii) Revenue receipts, , 50000, , (iv) Interest payments, , 25% of revenue deficit, , [Ans. (a) ` 15000 crore (b) ` 10,000 crore]
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Solution of Do it yourself 4, (a) Fiscal deficit = Borrowings = ` 15000 crore, (b) Primary deficit = Fiscal deficit – Interest payments, = 15000 – 5000 = ` 10000 crore, Note: Revenue deficit = Revenue expenditure –, Revenue receipts = 70000 – 50000 = ` 20000 crore., Therefore, interest payments = 25% of 20000, = ` 5000 crore
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NUMERICAL 5, From the following data about a government budget find:, (a) Revenue deficit (b) Fiscal deficit (c) Primary deficit, (6 marks), S. No. Items, , (` in billion), , (i), , Tax revenue, , 1037, , (ii), , Revenue expenditure, , 2811, , (iii), , Interest receipts by the government on, net domestic lending, , 400, , (iv), , Dividends and profits on investments, , 600, , (v), , Recovery of loans, , 135, , (vi), , Capital expenditure, , 574, , (vii), , Proceeds from sale of shares in PSUs, , 100, , (viii), , Interest payments on accumulated debts, , 1013
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Solution:, (a) Revenue deficit = Revenue expenditure – Revenue, receipts = 2811 – 2037 = ` 774 crore, Note: Revenue receipts = Tax revenue + Non- tax, revenues (Interest receipts + Dividends and profits), = 1037 + (400 + 600) = ` 2037 crore, (b) Fiscal deficit = Total expenditure – Total receipts, excluding borrowings, = (Revenue expenditure + Capital expenditure) –, (Revenue receipts + Non-debt capital receipts), = (2811 + 574) – (2037 + 235) = 3385 – 2272 = ` 1113 crore, Note: Non-debt creating capital receipts = (vii) + (v) =, 100 + 135 = ` 235 crore, (c) Primary deficit = Fiscal deficit – Net interest payments, (viii – iii) = 1113 – (1,013 – 400) = ` 500 crore
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Do it yourself 5, Find out (a) Revenue deficit, (b) Fiscal deficit and, (c) Primary deficit :, (CBSE 2011) (4 marks), S. No. Items, , (` in arab), , (i), , Capital receipts net of borrowings, , 95, , (ii), , Revenue expenditure, , 100, , (iii), , Interest payments, , 10, , (iv), , Revenue receipts, , 80, , (v), , Capital expenditure, , 110, , [Ans. (a) ` 20 arab (b) ` 35 arab (c) ` 25 arab]
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Solution of Do it yourself 5, (a) Revenue deficit = Revenue expenditure, – Revenue receipts = 100 – 80, = ` 20 arab, , (b) Fiscal deficit = Total Expenditure – Total receipts, excluding borrowings, = (Revenue expenditure + Capital expenditure) –, (Revenue receipts, + Capital receipts net of borrowings), = (100 + 110) – (80 + 95) = 210 – 175 = ` 35 arab, , (c) Primary deficit = Fiscal deficit – Interest payments, = 35 – 10 = ` 25 arab
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NUMERICAL 6, From the following data about a government budget calculate Primary deficit:, (CBSE Sample Question Paper 2018) (1 mark), S. No. Items, , (` in billion), , (i), , Revenue deficit, , 40, , (ii), , Non-debt creating capital receipts, , 190, , (iii), , Tax revenue, , 125, , (iv), , Capital expenditure, , 220, , (v), , Interest payments, , 20, , Solution: Fiscal deficit = Revenue deficit + Capital, expenditure – Non-debt creating capital receipts = 40 +, 220 – 190 = ` 70 arab. Therefore, Primary deficit = Fiscal, deficit – Interest payments = 70 – 20 = ` 50 arab
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Self-Assessment Test 1, , Government Budget and the Economy, Time Allowed: 1 hr., , Maximum Marks: 25
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Question 1, The formula to calculate Primary deficit is _____., (Fill up the blank with correct answer) (1 mark), , Self Assessment Test-1
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Answer 1, Primary Deficit = Fiscal Deficit – Interest, Payments, , Self Assessment Test-1
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Question 2, Government expenditure on Mid-Day Meal scheme running in government (state run) schools is a, type of _____ expenditure in government budget., (Fill up the blank with correct answer) (1 mark), , Self Assessment Test-1
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Answer 2, Revenue, , Self Assessment Test-1
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Question 3, Which of the following is not a Capital expenditure?, (Choose the correct alternative) (1 mark), (a) Loan advanced by World Bank, (b) Construction of school buildings, (c) Repayment of loans, (d) Tax Receipts, , Self Assessment Test-1
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Answer 3, (d) Tax Receipts, OR, (a) Loan advanced by World Bank, , Self Assessment Test-1
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Question 4, State the meaning of Revenue Deficit., (1 mark), , Self Assessment Test-1
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Answer 4, Revenue deficit refers to excess of government’s, revenue expenditure over its revenue receipts., , Self Assessment Test-1
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Question 5, If an economy, the Estimated Receipts of the government during a year are lesser than the Estimated, Expenditure, the budget would be called ________, budget., (Fill up the blank with correct answer) (1 mark), , Self Assessment Test-1
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Answer 5, deficit, , Self Assessment Test-1
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Question 6, How a capital expenditure different from revenue, expenditure? Discuss briefly., (4 marks), , Self Assessment Test-1
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Answer 6, (d) All of the above are methods of data collection, , Self Assessment Test-1
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Question 7, Classify the following statements as revenue receipts or capital receipts. Give valid reasons in suport of your answer., (4 marks), (a) Financial help from a multinational corporation for victims in a flood affected area., (b) Sale of share of a Public Sector Undertaking, (PSU) to a private company, Y Ltd., (c) Dividends paid to the Government by the State Bank of India., Self Assessment Test-1
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(d) Borrowings form International Monetary Fund (IMF)., , Self Assessment Test-1
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Answer 7, (a) Revenue receipt of the government, as it is neither creating any liability nor reducing any, as-sets for the government., (b) Capital receipt of the government, as it is reducing the assets of the government., (c) Revenue receipt of the government, as it is, nei-ther creating any liability nor reducing any, as-sets for the government., (d) Capital receipt, as it is increasing the liability, of the Government., Self Assessment Test-1
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Question 8, Given the following data estimate the values of (i), Revenue Deficit, and (ii) Fiscal Deficit: (4 marks), S. No., (i), (ii), (iii), (iv), (v), (vi), , Items, Tax Revenue, Non-Tax Revenue, Net Borrowings by Government, Disinvestments Proceeds, Revenue Expenditure, Capital Expenditure, , (` in billion), 1,000, 150, 780, 50, 1,500, 480, Self Assessment Test-1
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Answer 8, (i) Revenue Deficit = Total Revenue expenditure Total revenue Receipt, = Revenue Expenditure - (Tax revenue + Non Tax, revenue), = 1500 – (1000 + 150 ) = `350 crore, (ii) Fiscal deficit = Total expenditure – (Revenue Receipt + Disinvestment proceeds), = (1500+480)–(1000+150+50) = 780 crore, Alternately, fiscal deficit = Net Borrowings by, Gov-ernment = `780 crore, Self Assessment Test-1
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Question 9, “Through its budgetary policy government allocates resources in accordance with the requirements, of the country.” Do you agree with the given statement? Support your answer with valid reasons., (4 marks), , Self Assessment Test-1
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Question 10, Elaborate the objective of ‘reallocation of resources’, in the government budget., (4 marks), , Self Assessment Test-1
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Self-Assessment Test 2, , Government Budget and the Economy, Time Allowed: 1 hr., , Maximum Marks: 25
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Question 1, Primary deficit in a government budget will be zero,, when _____________., (Choose the correct alternative) (1 mark), (a) Revenue deficit is zero., (b) Net interest payments are zero., (c) Fiscal deficit is zero., (d) Fiscal deficit is equal to interest payment., , Self Assessment Test-2
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Answer 1, (d) Fiscal Deficit is equal to interest payment, , Self Assessment Test-2
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Question 2, What is meant by revenue deficit?, , Self Assessment Test-2
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Question 3, Which the following is a capital receipt in the Government Budget?, (Choose the correct alternative) (1 mark), (a) Income tax, (b) Interest receipt, (c) Sale of shares of a Public Sector Undertaking, (PSU) to X Limited (Private Company), (d) Dividends from a Public Sector Undertaking, (PSU), Self Assessment Test-2
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Answer 3, (c) sale of shares of a Public sector undertaking, (PSU) to X Limited (Private Company), , Self Assessment Test-2
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Question 4, Dividends received from public sector Undertakings (PSUs) are a part of the government’s ____., (Choose the correct alternative) (1 mark), (a) Non-tax Revenue Receipts, (b) Tax receipts, (c) Capital receipts, (d) Capital expenditure, , Self Assessment Test-2
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Answer 4, (a) Non-tax Revenue Receipts, , Self Assessment Test-2
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Question 5, State any two items of revenue expenditure in a, Government budget., (1 mark), , Self Assessment Test-2
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Answer 5, Expenditure of the government on salaries, pensions, subsidies, grants etc., , Self Assessment Test-2
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Question 6, Explain how the government can use the budgetary policy in reducing inequality of income in the, econ-omy., (4 marks), , Self Assessment Test-2
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Question 7, How are capital receipts different from revenue, receipts? Discuss briefly., (4 marks), , Self Assessment Test-2
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Question 8, Is the following revenue expenditure or capital, exp-enditure in the context of government budget?, Give reason., (4 marks), (i) Expenditure on collection of taxes, (ii) Expenditure on purchasing computers, (iii) Expenditure on scholarships, (iv) Expenditure on building a bridge, Self Assessment Test-2
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Answer 8, (i) Expenditure on collection of taxes is revenue, expenditure because it neither creates any asset nor reduces any liability of the government., (ii) Expenditure on purchasing computers is capital expenditure because it creates assets of the, government., (iii) Expenditure on scholarships is revenue expenditure because it neither creates any asset nor, Self Assessment Test-2
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reduces any liability of the government., (iv) Expenditure on building a bridge is capital, expenditure because it leads to creation of, assets of the government., , Self Assessment Test-2
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Question 9, From the following data about a Government budget, find out (a) Revenue deficit, (b) Fiscal deficit, and (c) Primary deficit:, (4 marks), S. No., (i), (ii), (iii), (iv), (v), , Items, Capital receipts net of borrowings, Revenue expenditure, Interest payments, Revenue receipts, Capital expenditure, , (` in billion), 95, 100, 10, 80, 110, Self Assessment Test-2
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Answer 9, (a) Revenue deficit = Revenue expenditure – Revenue receipts = 100 – 80 = ` 20 arab, (b) Fiscal deficit = Total Expenditure – Total receipts excluding borrowings, = (Revenue expenditure+ Capital expenditure), – (Revenue receipts + Capital receipts net of, borrowings), = (100 + 110) – (80 + 95) = 210 – 175, = ` 35 arab, Self Assessment Test-2
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(c) Primary deficit = Fiscal deficit – Interest payments = 35 – 10 = `25 arab, , Self Assessment Test-2
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Question 10, "Fiscal deficit indicates the total borrowing requirements of the government from all sources." Elucidate., (4 marks), , Self Assessment Test-2
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Self-Assessment Test 3, , Government Budget and the Economy, Time Allowed: 1 hr., , Maximum Marks: 25
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Question 1, State any two examples of non-tax revenue receipts, of the government., (1 mark), , Self Assessment Test-3
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Answer 1, Fees, Fines, Penalties, Escheat etc., , Self Assessment Test-3
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Question 2, State whether the following statement is true, or false. Support your answer with reason., Taxation is an effective tool to reduce the inequalities of income., (1 mark), , Self Assessment Test-3
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Answer 2, The given statement is true. Generally, the governments collect higher taxes from the rich people, and spend it on the welfare of the poor. Thereby,, reducing the inequalities of income., , Self Assessment Test-3
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Question 3, Which of the alternatives best describes the following?, The receipts of the government which creates burden of repayment of loans and interest thereon in, future. (Choose the correct alternative) (1 mark), (a) Non-debt creating capital receipts, (b) Debt creating capital receipts, (c) Fiscal deficit, (d) Both (a) and (b), Self Assessment Test-3
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Answer 3, (d) Both (a) and (b), , Self Assessment Test-3
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Question 4, Which of the following is/are capital receipt(s) in, a government budget?, (Choose the correct alternative) (1 mark), (a) Financial help from a multinational corporation for victims in a flood affected area., (b) Sale of share of a public sector undertaking, (PSU) to a private company., (c) Dividends paid to the Government by the State Bank of India., Self Assessment Test-3
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(d) Borrowings from International Monetary Fund (IMF)., , Self Assessment Test-3
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Answer 4, (b) and (d), , Self Assessment Test-3
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Question 5, _______ is the difference between the Government, budgetary expenditure and its budgetary receipts, excluding borrowings., (Fill up the blank with correct answer) (1 mark), , Self Assessment Test-3
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Answer 5, Fiscal deficit, , Self Assessment Test-3
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Question 6, From the following data about a government budget find (a) Revenue deficit, (b) Fiscal deficit and, (c) Primary deficit:, (4 marks), S. No., (i), (ii), (iii), (iv), (v), (vi), , Items, Tax revenue, Capital receipts, Non-tax revenue, Borrowings, Revenue expenditure, Interest payments, , (` in arab), 47, 34, 10, 32, 80, 20, Self Assessment Test-3
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Answer 6, (a) Revenue deficit, = Revenue expenditure – Revenue receipts, (Tax revenue + Non-tax revenue), = 80 – (47 + 10) = 80 – 57 = ` 23 arab, (b) Fiscal deficit = Borrowings = ` 32 arab, (c) Primary deficit = Fiscal deficit – Interest payments = 32 – 20 = ` 12 arab, , Self Assessment Test-3
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Question 7, Categorise the following government receipts into, revenue and capital receipts., (4 marks), (i) Profits and dividend received from public sector undertakings, (iii) Tax receipts, (iii) Recovery of loans granted by the Central government, (iv) Cash grants-in-aid from foreign countries and, international organisations, Self Assessment Test-3
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Answer 7, (i) It is a revenue receipt as it neither creates a liability nor reduces any asset of the government., (ii) It is a revenue receipt as it neither creates a, liability nor reduces any asset of the government., (iii) It is a capital receipt as it reduces assets of the, Central Government., (i) It is a revenue receipt as it neither creates a liability nor reduces any asset of the government., Self Assessment Test-3
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Question 8, Discuss briefly the role of the government budget, in influencing “allocation of resources” in the economy., (4 marks), , Self Assessment Test-3
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Question 9, Distinguish between revenue receipts and capital, receipts of the government., (4 marks), , Self Assessment Test-3
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Question 10, Define 'revenue receipts' in a government budget., Do ‘disinvestment’ and ‘loan proceeds from abroad’, constitute revenue receipts of the government? Give, reason., (4 marks), , Self Assessment Test-3
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Answer 10, (i) No, Disinvestment are capital receipts of the, government as it leads to reduction in assets., (ii) No “loan proceeds from abroad” are capital, receipts of the government as it increases the, liabilities of the Government., , Self Assessment Test-3
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Balance of payments account – meaning, , and components, Foreign exchange rate – meaning of fixed, and flexible rates and managed floating
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5.1, , Balance of Payments: Meaning and, Components, , Meaning of Balance of Payments, Balance of Payments (BoP) is defined as the statement, of accounts of a country’s inflows and outflows of, foreign exchange in a fiscal year. (Foreign exchange or, foreign currency refers to any currency other than the, domestic currency.), There are two main accounts in the BoP – the current, account and the capital account. Current account is, the record of trade in goods and services and transfer, payments, whereas capital account records all, international transactions of assets, e.g. money, stocks,
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bonds, government debt, etc., Since it is difficult to record all international economic, transactions accurately, therefore we have a third, element of BoP (apart from the current and capital, accounts) called errors and omissions which reflects, this.
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Debit Side, Any international transaction which results in outflow, of foreign exchange is recorded on the debit side in the, balance of payments accounts (the current account and, or capital account). It is given a negative sign., For example, payments for imports of goods and services,, purchase of financial assets (e.g. shares, debentures,, bonds, etc.) in a foreign country, etc., , Top Tip, Buying, foreign goods (i.e. import) is expenditure from our country, , and it becomes the income of that foreign country. Hence, it is a, debit item of the current account of balance of payments., Note that imports decrease the domestic demand for goods and, services in our country.
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Credit Side, Any international transaction which leads to inflow of, foreign exchange is recorded on the credit side in the, balance of payments accounts (the current account or, the capital account). It is given a positive sign., For example, receipts on account of exports of goods, and services, foreign investments, factor income earned, from abroad, loans and grants from abroad, etc., , , , Top Tips, , Selling of domestic goods to foreign nationals, i.e. export,, brings income to our country. Hence, it is a credit item of, the current account of balance of payments. Note that, exports add to the aggregate domestic demand for goods, and services in our country.
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Foreign investments lead to inflow of foreign exchange., Hence, it is recorded on the credit side of the capital, account since it is an international transactions of assets., Note that foreign investments are divided into Foreign, Direct Investment (FDI) and Portfolio investment. While FDI, involves foreign investors taking a controlling and lasting, stake in productive enterprises, portfolio investments, represent holdings of minor equity (without management, control) or debt through the stock markets by foreign, investors for the purpose of earning return on investment.
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Current Account of BoP, Current Account is the record of trade in goods and, services and transfer payments., , Components of the Current Account, 1. Trade in goods: It includes (i) exports of goods, and (ii) imports of goods., For example, export or import of machinery., 2. Trade in services: Services trade includes both, net factor income and net non-factor income, transactions., (i) Net factor income: Net factor income, includes net international earnings of factors, of production (like labour, land and capital).
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Examples:, • Net income from compensation of employees, • Net investment income, i.e., interest, profits and, dividends on our assets abroad minus the income, foreigners earn on assets they own in India., (ii) Net non-factor income: Net non-factor income is, net sale of service products like shipping, banking,, tourism, software services, etc., 3. Transfer payments: Foreign transfers are the, receipts which the residents of a country get for, ‘free’, without having to provide any goods or, services in return. They consist of gifts, remittances, and grants. They could be given by the government, or by private citizens living abroad.
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Balance on Current Account, Balance on Current Account has two components: (i), Balance of Trade or Trade Balance and (ii) Balance on, Invisibles., 1. Balance of Trade (BoT)/Trade Balance: It is the, difference between the value of exports and imports, of goods of a country during a year., Balance of Trade (BoT) = Value of exports of goods –, Value of imports of goods, , , , Top Tips, , Exports and imports of goods is also called visible trade.
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Export of goods is entered as a credit item in BoT as it, leads to inflows of foreign exchange whereas import, of goods is entered as a debit item in BoT as it results, in outflow of foreign exchange., BoT is said to be in balance when exports of goods, are equal to the imports of goods., Surplus BoT or Trade surplus will arise if the total, value of country’s exports of merchandise (goods), is more than value of its imports of the, merchandise during a year., Deficit BoT or Trade deficit will arise if the total, value of country’s imports of merchandise (goods), is more than value of its exports of the merchandise, during a year.
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2. Balance on Invisibles: Net invisibles is difference, between the value of exports and imports of, invisibles of a country in a given period of time., Invisibles include services, transfers and flows of, income., Current account is in balance when receipts on, current account are equal to the payments on the, current account., Current Account Surplus (CAS) refers to excess, of receipts from value of export of visible items,, invisible items and unilateral transfers over, payments for value of import of visible items,, invisible items and unilateral transfers.
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CAS is relatively broader concept as compared to, trade surplus., CAS signifies that the nation is a lender to the, rest of the world., Current Account Deficit (CAD) arises when the, value of exports of visible items, invisible items, and unilateral transfers is less than the value of, imports of visible items, invisible items and, unilateral transfers., CAD is relatively broader concept as compared, to trade deficit., CAD signifies that the nation is a borrower from, the rest of the world.
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, , Top Tip, , Difference between Balance on Trade Account and, Balance on Current Account, • 'Balance on Trade Account' is the difference between, value of exports of goods and imports of goods. In other, words, it is the difference between visible inflows and, visible outflows of foreign exchange., • 'Balance on Current Account' is the sum total of balance, of trade and balance on invisibles. In other words, it is the, difference between the sum of both visibles and invisibles, inflows and outflows of foreign exchange.
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Capital Account of BoP, Capital account records all international transactions of, assets. An asset is any one of the forms in which wealth, can be held, for example, money, stocks, bonds,, government debt, etc., Capital inflows such as receipt of loans from, abroad, sale of assets or shares in foreign, companies, etc. are recorded on the credit side of, the capital account as there is inflow of foreign, exchange in India., Capital outflows such as repayment of loans,, purchase of assets or shares in foreign countries,, etc. are recorded on the debit side of the capital, account as it results in outflow of foreign exchange.
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Components of Capital Account, There are three components of the capital account —, Foreign Investments, External Borrowings and External, Assistance., 1. Foreign Investments: Foreign investments may be, of two kinds:, (a) Direct Investment, e.g. Foreign Direct, Investments (FDIs), Equity Capital, Reinvested, Earnings and other Direct Capital Flows., (b) Portfolio Investment, e.g. Foreign Institutional, Investments (FIIs), Offshore Funds, etc., 2. External Borrowings: Examples: External Commercial, Borrowings, Short-term Debt, etc.
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3. External Assistance: Examples: Government Aid,, Inter-governmental, Multilateral and Bilateral Loans.
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Balance on Capital Account, Balance on Capital Account is the sum total of net, foreign investments, net external borrowings and net, external assistance., Capital account is in balance when capital inflows, (like receipt of loans from abroad, sale of assets or, shares in foreign companies) are equal to capital, outflows (like repayment of loans, purchase of, assets or shares in foreign countries)., Surplus in capital account arises when capital, inflows are greater than capital outflows., Deficit in capital account arises when capital, inflows are lesser than capital outflows.
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Key Term, Foreign exchange — Any currency other than the domestic, currency., Balance of Payments (BoP) — The statement of accounts of a, country’s inflows and outflows of foreign exchange in a fiscal year., Debit — Any international transaction which results in outflow of, foreign exchange is entered as a debit in BoP accounts., Credit — Any international transaction which results in inflow of, foreign exchange is entered as a credit in BoP accounts., Current Account — The record of trade in goods and services and, transfer payments., Capital Account — The record of all international transactions of, assets, e.g. money, stocks, bonds, government debt, etc., Factor income — Net international earnings on factors of, production (like labour, land and capital)., Non-factor income — Net sale of service products like shipping,, banking, tourism, software services, etc.
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Balance of Trade (BoT) — The difference between the value of, exports and imports of goods of a country in a given period of time., Invisibles — Services, transfers and flows of income that take, place between different countries., Current Account Surplus (CAS) — A situation that arises when, the receipts on current account are more than the payments on, current account., Current Account Deficit (CAD) — A situation that arises when the, receipts on current account are less than the payments on, current account., Balance on Current Account — Sum total of balance of trade and, balance on invisibles., Balance on Capital Account — Sum total of net foreign investments,, net external borrowings and net external assistance., Foreign Investments—Foreign Direct Investments (FDIs), Portfolio, Investment, e.g. Foreign Institutional Investments (FIIs)., External Borrowings — External Commercial Borrowings, Shortterm Debt.
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External Assistance — Government Aid, Inter-governmental,, Multilateral and Bilateral Loans., Surplus in capital account — Capital inflows (like receipt of loans, from abroad, sale of assets or shares in foreign companies) are, greater than capital outflows (like repayment of loans, purchase, of assets or shares in foreign countries).
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RECAP, , Balance of Payments, Balance of Payments is defined as the statement of, accounts of a country’s inflows and outflows of foreign, exchange in a fiscal year. Foreign exchange refers to any, currency other than the domestic currency., There are two main accounts in the BoP – the current, account and the capital account. Current Account is the, record of trade in goods and services and transfer, payments. Capital Account records all international, transactions of assets, e.g. money, stocks, bonds,, government debt, etc., Any transaction which results in outflow of foreign, exchange is recorded on the debit side in the balance of, payments accounts (the current account and the capital, account), e.g. imports.
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Any transaction which leads to inflow of foreign exchange, is recorded on the credit side in the balance of payments, accounts, e.g. exports., , Components of Current Account, 1. Trade in goods: It includes:, (i) exports of goods and (ii) imports of goods., 2. Trade in services: Services trade includes both factor, income and non-factor income transactions., Factor income includes net international earnings on, factors of production (like labour, land and capital)., For example, net income from compensation of, employees and net investment income, e.g., profits, from investments made abroad., Non-factor income is net sale of service products like, shipping, banking, tourism, software services, etc.
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3. Transfers payments: The receipts which the residents of, a country get for ‘free’, e.g. gifts, remittances and grants., , Components of Balance on Current Account, 1. Balance of Trade/Trade Balance: The difference between, the value of exports and imports of goods of a country, during a year., Trade surplus will arise if the total value of country’s, exports of merchandise (goods) is more than value of, its imports of the merchandise during a year., Trade deficit will arise if the total value of country’s, imports of merchandise (goods) is more than value of, its exports of the merchandise during a year., 2. Balance on Invisibles: The difference between the value, of exports and imports of invisibles of a country in a given, period of time. Invisibles include services, transfers and, flows of income.
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Balance on Current Account, Current Account Surplus (CAS) refers to excess of receipts, from value of export of visible items, invisible items and, unilateral transfers over payments for value of import of visible, items, invisible items and unilateral transfers. It is relatively, broader concept as compared to trade surplus. CAS signifies, that the nation is a lender to the rest of the world., Current Account Deficit (CAD) arises when the value of, exports of visible items, invisible items and unilateral transfers, is less than the value of imports of visible items, invisible items, and unilateral transfers. It is relatively broader concept as, compared to trade deficit. CAD signifies that the nation is a, borrower from the rest of the world., , Capital Account, Capital Account records all international transactions of, assets, e.g. money, stocks, bonds, government debt, etc.
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It has three components:, 1. Foreign Investments: (i) Direct Investment, e.g. Foreign, Direct Investments (FDIs) (ii) Portfolio Investment, e.g., Foreign Institutional Investments (FIIs)., 2. External Borrowings, e.g. External Commercial, Borrowings, Short-term Debt., External Assistance, e.g. Government Aid, Intergovernmental, Multilateral and Bilateral Loans., , Balance on Capital Account, Surplus in capital account arises when capital inflows (like, receipt of loans from abroad, sale of assets or shares in, foreign companies) are greater than capital outflows (like, repayment of loans, purchase of assets or shares in foreign, countries)., Deficit in capital account arises when capital inflows are, lesser than capital outflows.
Page 1934 :
Question 1, What does the Balance of payments (BoP) accounts record?, (a) Transactions in goods, services and assets between, residents of a country with the rest of the world, during a fiscal year., (b) Transactions in foreign exchange assets and liabilities, during a fiscal year., (c) Inflows and outflows of foreign exchange during a, fiscal year., (d) None of these, Objective Type Questions 5.1
Page 1935 :
Answer 1, (c) Inflows and outflows of foreign exchange during a, fiscal year., , Objective Type Questions 5.1
Page 1936 :
Question 2, ________ of Balance of payments (BoP) is the record, of trade in goods and services and transfer payments., (Current Account/Capital Account), (Fill in the blank with correct option), , Objective Type Questions 5.1
Page 1937 :
Answer 2, Current Account, , Objective Type Questions 5.1
Page 1938 :
Question 3, Which of the following is true for Transfer Payments in, the Current Account of Balance of Payments?, (Choose the correct alternative), (a) Transfer payments are the receipts which the, residents of the country get for free, without having, to provide any goods and services in return., (b) They consist of gifts, remittances and grants., (c) They could be given by the government or by, private citizen living abroad., (d) All of these, Objective Type Questions 5.1
Page 1939 :
Answer 3, (d) All of these, , Objective Type Questions 5.1
Page 1940 :
Question 4, “Domestic demand for goods and demand for domestic, goods are one and the same thing.”, True/False? Give reason., , Objective Type Questions 5.1
Page 1941 :
Answer 4, False: In an open economy, aggregate demand for, domestic goods equals domestic demand for goods, (consumption investment and government spending), plus exports and minus imports., Purchase of foreign goods (i.e. imports) decreases the, domestic demand for goods of our country; whereas, exports adds to the demand for domestic goods., , Objective Type Questions 5.1
Page 1942 :
Question 5, Which of the following is not a component of the current, account of Balance of Payments?, (Choose the correct alternative), (a) Exports and imports of goods and services, (b) Remittances given by private citizens living abroad, (c) Net international income from compensation of, employees, (d) None of the above, , Objective Type Questions 5.1
Page 1943 :
Answer 5, (d) None of the above, , Objective Type Questions 5.1
Page 1944 :
Question 6, Current Account Deficit (CAD) means:, (Choose the correct alternative), (a) The value of exports of goods and services is less, than the value of imports of goods and services., (b) The nation is a borrower from other countries., (c) Both (a) and (b), (d) The nation is a lender to other countries., , Objective Type Questions 5.1
Page 1945 :
Answer 6, (c) Both (a) and (b), , Objective Type Questions 5.1
Page 1946 :
Question 7, Current Account Surplus (CAS) means:, (Choose the correct alternative), (a) The value of exports of goods is more than the, value of imports of goods., (b) The nation is a lender to the rest of the world, (c) Both (a) and (b), (d) The nation is a borrower from other countries., , Objective Type Questions 5.1
Page 1947 :
Answer 7, (b) The nation is a lender to the rest of the world, , Objective Type Questions 5.1
Page 1948 :
Question 8, _____________ is the difference between the value of, exports and value of imports of goods of a country in a, given period of time., (Fill in the blank), , Objective Type Questions 5.1
Page 1949 :
Answer 8, Balance of Trade (BoT) or Trade Balance, , Objective Type Questions 5.1
Page 1950 :
Question 9, Exports of goods is entered as a _____ item in Balance, of Trade (BoT), whereas import of goods is entered as a, ______ item in BoT. (debit/credit), (Fill in the blanks with correct option), , Objective Type Questions 5.1
Page 1951 :
Answer 9, (i) credit, (ii) debit, , Objective Type Questions 5.1
Page 1952 :
Question 10, __________ will arise if a country imports more goods, than what it exports. Whereas, ___________ will arise if, the country exports more goods than what it imports., (Fill in the blanks), , Objective Type Questions 5.1
Page 1953 :
Answer 10, (i) Deficit BoT or Trade Deficit, (ii) Surplus BoT or Trade Surplus, , Objective Type Questions 5.1
Page 1954 :
Question 11, __________ is the difference between the value of, exports and value of imports of services, transfers and, flows of income of a country in a given period of time., (Choose the correct alternative), (a), (b), (c), (d), , Balance of Trade, Net invisibles, Trade Surplus, Current Account Surplus, , Objective Type Questions 5.1
Page 1955 :
Answer 11, (b) Net invisibles, , Objective Type Questions 5.1
Page 1956 :
Question 12, _______________ of Balance of Payments records all, international transactions of assets., (Fill in the blank), , Objective Type Questions 5.1
Page 1957 :
Answer 12, Capital Account, , Objective Type Questions 5.1
Page 1958 :
Question 13, Capital Account of BoP records all international, transactions of assets. Which of the following is, not included in assets?, (Choose the correct alternative), (a), (b), (c), (d), , Money, Stocks and bonds, Machinery, Government debt, , Objective Type Questions 5.1
Page 1959 :
Answer 13, (c) Machinery, , Objective Type Questions 5.1
Page 1960 :
Question 14, If an Indian buys a UK Car Company, it enters ________, (Current Account/Capital Account) of Balance of, Payments as a _________ (debit/credit) item., (Fill up the blanks with correct option), , Objective Type Questions 5.1
Page 1961 :
Answer 14, (i) Capital Account (since it is an international, transaction of assets), (ii) Debit (as foreign exchange is flowing out of India), , Objective Type Questions 5.1
Page 1962 :
Question 15, Sale of share, of an Indian Company to a Chinese, customer is a ___________ (debit/credit) item on, the _______________ (Current Account/Capital, Account) of Balance of Payments., (Fill in the blank with correct option), , Objective Type Questions 5.1
Page 1963 :
Answer 15, (i) credit (as it leads to inflow of foreign exchange into, the country), (ii) Capital account (since it is an international transaction, of assets), , Objective Type Questions 5.1
Page 1964 :
Question 16, Which of the following is not included in the capital, account of the Balance of Payments?, (Choose the correct alternative), (a), (b), (c), (d), , Foreign Direct Investments (FDIs), Foreign Institutional Investments (FIIs), External assistance, None of the above, , Objective Type Questions 5.1
Page 1965 :
Answer 16, (d) None of the above, , Objective Type Questions 5.1
Page 1966 :
Question 17, Foreign Investments include:, (Choose the correct alternative), (a) Direct Investment, e.g. FDI, Equity Capital, Reinvestment, earnings and other Direct Capital Flows:, (b) Portfolio Investment, e.g. FII, off share Funds, (c) Both (a) and (b), (d) Neither (a) nor (b), , Objective Type Questions 5.1
Page 1967 :
Answer 17, (c) Both (a) and (b), , Objective Type Questions 5.1
Page 1968 :
Question 18, ___________ in capital account arises when capital, inflows (like receipt of loans from abroad, sale of assets, or share in foreign companies) are greater than capital, outflows (like repayment or loans, purchase of assets or, shares in foreign countries), whereas, __________ in, capital account arises when capital inflows are lesser than, capital outflows. (Deficit/Surplus), (Fill in the blank with correct option), , Objective Type Questions 5.1
Page 1969 :
Answer 18, (i) Surplus, (ii) deficit, , Objective Type Questions 5.1
Page 1970 :
Question 19, Receipts of loans from abroad is recorded as a ________, (debit/credit) item in the _____ (Current account/capital, account) of Balance of Payments., (Fill in the blank with correct option), , Objective Type Questions 5.1
Page 1971 :
Answer 19, (i) Credit, (ii) Capital account, , Objective Type Questions 5.1
Page 1972 :
Question 20, Which of the following is not recorded in the Capital, Account of Balance of Payments?, (Choose the correct alternative), (a) Equity capitals, (b) Gifts, Remittances and Grants, (c) Government Aid, (d) Offshore Funds, , Objective Type Questions 5.1
Page 1973 :
Answer 20, (b) Gifts, Remittances and Grants, , Objective Type Questions 5.1
Page 1974 :
Question 21, Which of the following is recorded in the capital account, of Balance of Payments?, (Choose the correct alternative), (a) Reinvested Earnings, (b) Inter-governmental multilateral and bilateral loans, (c) Short term debt, (d) All of these, , Objective Type Questions 5.1
Page 1975 :
Answer 21, (d) All of these, , Objective Type Questions 5.1
Page 1976 :
Question 22, It is difficult to record all international transactions, accurately. Thus, a third element of BoP (apart from the, current and capital accounts), called ______________, reflects this., (Fill in the blank), , Objective Type Questions 5.1
Page 1977 :
Answer 22, Errors and omissions, , Objective Type Questions 5.1
Page 1978 :
Question 23, An increase in foreign income improves the trade balance., True/False? Give reason., , Objective Type Questions 5.1
Page 1979 :
Answer 23, True: An increase in foreign income leads to increased, exports., Thus, trade balance (= exports of goods – imports of, goods) increases., , Objective Type Questions 5.1
Page 1980 :
Question 24, _________ is the sum of the balance of merchandise, trade, services and net transfers received from the rest, of the world., True/False? Give reason., , Objective Type Questions 5.1
Page 1981 :
Answer 24, Current Account balance, , Objective Type Questions 5.1
Page 1982 :
Question 25, If inflation is higher in country A than in country B, and the, exchange rate between the two countries is fixed what is, likely to happen to the trade balance between two, countries?, (Choose the correct alternative), (a) Trade balance of country A will share a deficit whereas, trade balance of country B will show a surplus., (b) Trade balance of country A will show a surplus, whereas trade balance of country B will show a deficit., (c) Balance of trade of both the countries will be in, balance, (d) None of the above, Objective Type Questions 5.1
Page 1983 :
Answer 25, (a) Trade balance of country A will share a deficit whereas, trade balance of country B will show a surplus., Hint: Effect on trade balance of country A, Since prices of goods in country A are more than that, in country B, it exports will decrease an imports will, increase. Thus, trade balance (= exports of goods –, imports of goods) will show a deficit., Effect on trade balance of country B, Its exports of goods will increase and imports of, goods will decrease. Thus, trade deficit will show a, surplus., Objective Type Questions 5.1
Page 1984 :
Question 26, Interest on loan received from Nepal is recorded on, the _____________ (debit side/credit side) of the, __________ (current account/capital account) of the, Balance of Payments., , Objective Type Questions 5.1
Page 1985 :
Answer 26, (i) Credit side, (ii) Current account, Hint:, Credit side; as brings foreign exchange into the country, Current account; as it is a part of net factor income, (net investment income)., , Objective Type Questions 5.1
Page 1986 :
Question 27, Import of mobile phones from China is recorded on, the ____________ (debit side/credit side) of the, __________ (current account/capital account) of the, Balance of Payments., , Objective Type Questions 5.1
Page 1987 :
Answer 27, (i) Debit side, (ii) Current account, Hint:, Debit side; as it represents outflow of the foreign, exchange from the country, Current account; as it is an import of goods/visibles., , Objective Type Questions 5.1
Page 1988 :
Question 28, A company located in India receives a loan from a company, located abroad. How is this transaction recorded in India’s, balance of payments account?, (CBSE 2017) (Choose the correct alternative), (a), (b), (c), (d), , Credit side of current account, Debit side of current account, Credit side of capital account, Debit side of capital account, , Objective Type Questions 5.1
Page 1989 :
Answer 28, (c) Credit side of capital account, , Objective Type Questions 5.1
Page 1990 :
Question 29, An Indian company located in India invests in a company, located abroad. This transaction is entered in India’s, balance of payments account on:, (CBSE 2017) (Choose the correct alternative), (a), (b), (c), (d), , credit side of current account, debit side of current account, credit side of capital account, debit side of capital account, , Objective Type Questions 5.1
Page 1991 :
Answer 29, (d) debit side of capital account, , Objective Type Questions 5.1
Page 1992 :
Question 30, Which of the following will be entered as a Credit item, in the Balance of Payments of a country?, (Choose the correct alternative), (a), (b), (c), (d), , Imports of goods and services, Portfolio investments, Purchase of foreign securities, Transfer payments, , Objective Type Questions 5.1
Page 1993 :
Answer 30, (b) Portfolio investments, , Objective Type Questions 5.1
Page 1994 :
Question 31, Which of the following items is not included in the current, account of the Balance of Payments of a country?, (Choose the correct alternative), (a) Interest, profits and dividends on assets abroad, (b) Income from software services, (c) Remittances from abroad, (d) Foreign direct investment, , Objective Type Questions 5.1
Page 1995 :
Answer 31, (d) Foreign direct investment, , Objective Type Questions 5.1
Page 1996 :
Question 32, State, giving reason, whether the following, statement is true or false:, Difference between value of exports and imports of, goods and services is called trade balance., , Objective Type Questions 5.1
Page 1997 :
Answer 32, False: Trade balance is the difference between value of, exports of goods and imports of goods only. It does not, include exports and imports of services., , Objective Type Questions 5.1
Page 1998 :
Question 33, State, giving reason, whether the following, statement is true or false:, External assistance is recorded in the current account of, the Balance of Payments., , Objective Type Questions 5.1
Page 1999 :
Answer 33, False: External assistance (e.g. Government aid, Intergovernmental, Multi-lateral and Bilateral Loans) is recorded, in the capital account of the Balance of Payments., , Objective Type Questions 5.1
Page 2000 :
Question 34, State, giving reason, whether the following, statement is true or false:, Export and import of machines are recorded in capital, account of the balance of payments account., , Objective Type Questions 5.1
Page 2001 :
Answer 34, False: Export and import of machines is the export and, import of goods. Therefore, it is recorded in the Current, account of the Balance of Payments account., , Objective Type Questions 5.1
Page 2002 :
Question 35, State, giving reason, whether the following, statement is true or false:, Foreign investments are recorded in the capital account of, balance of payments., , Objective Type Questions 5.1
Page 2003 :
Answer 35, True: Foreign investments, e.g., foreign direct investment, are the international transactions of assets during a fiscal, year. Therefore, foreign investments are recorded in the, capital account of balance of payments., , Objective Type Questions 5.1
Page 2004 :
Question 36, State, giving reason, whether the following, statement is true or false:, In balance of payments, repayment of loans by Indian, government to US Government will be recorded on, the credit side of current account., , Objective Type Questions 5.1
Page 2005 :
Answer 36, False: It will be recorded in the capital account since, loan from US Government is an international liability., The repayment of loans results in outflow of foreign, exchange. Therefore, it will be recorded on the debit, side., , Objective Type Questions 5.1
Page 2006 :
Question 37, In the context of balance of payments of a country,, state whether the following statement is true or, false. Give reason for your answer., Profits received from investments abroad is recorded in, capital account., , Objective Type Questions 5.1
Page 2007 :
Answer 37, False: Profits received from investments abroad is, recorded in the current account since it is an investment, income (factor income). Factor income includes net, international earning of factors of production., It will be recorded on the credit side of the current, account since it leads to inflow of foreign exchange., , Objective Type Questions 5.1
Page 2008 :
Question 38, In the context of balance of payments of a country,, state whether the following statement is true or, false. Give reason for your answer., Import of machines is recorded in current account., , Objective Type Questions 5.1
Page 2009 :
Answer 38, True: All imports and exports of goods are recorded in, the current account. Import of machines is simply import, of a good., , Objective Type Questions 5.1
Page 2010 :
Question 39, The current account of BoP includes transactions related, to:, (Choose the correct alternative), (a) Financial assets, (b) Borrowing from foreign countries, (c) Export and import of invisible items, (d) Foreign investment, , Objective Type Questions 5.1
Page 2011 :
Answer 39, (c) Export and import of invisible items, , Objective Type Questions 5.1
Page 2012 :
Question 40, Which one is the component of current account of BoP?, (Choose the correct alternative), (a) Invisibles, (b) Foreign Direct Investment, (c) Banking Capital, (d) Loans, , Objective Type Questions 5.1
Page 2013 :
Answer 40, (a) Invisibles, , Objective Type Questions 5.1
Page 2014 :
Question 41, Which of the following items are included in current, account BoP?, (Choose the correct alternative), (a) Foreign Investment, (b) External Borrowings, (c) External Assistance, (d) Non-factor income, , Objective Type Questions 5.1
Page 2015 :
Answer 41, (d) Non-factor income, , Objective Type Questions 5.1
Page 2016 :
Question 42, Borrowing and lending money in international money, market is a part of current account in BoP., True/False? Give reason., , Objective Type Questions 5.1
Page 2017 :
Answer 42, False: Borrowing and lending money in international, money market is a part of capital account in BoP., , Objective Type Questions 5.1
Page 2018 :
Question 43, Purchase of shares of a foreign company are included, in credit side of Capital account., True/False? Give reason., , Objective Type Questions 5.1
Page 2019 :
Answer 43, False: It is recorded on the debit side of capital account, of BoP as there will be outflow of foreign exchange., , Objective Type Questions 5.1
Page 2020 :
Question 1, “A country with trade deficit cannot have current account, surplus in its Balance of Payments”. Do you agree with, given statement? Discuss with reason., (CBSE 2019) (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2021 :
Answer 1, No, trade deficit occurs when value of goods/visibles, imported is more than the value of goods/visibles, exported., Trade deficit = Value of imports(Vm) < Value of, exports (Vx), Trade Surplus in this situation will arise when the, deficit on trade account is less than the surplus on, account of invisibles., , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2022 :
Question 2, State on which side of capital account/current account, will the following transactions be recorded and why:, (i) Interest on loan received from Nepal, (ii) Import of mobile phones from China, (CBSE 2019) (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2023 :
Answer 2, (i) Interest on Loan received from Nepal - It will be, recorded on the credit side of the current account, as it brings in funds to the country., (ii) Import of mobile phones from China - It will be, recorded in the debit/payment side of the current, account as it is represents outflow of the foreign, currency through visible imports., , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2024 :
Question 3, Distinguish between Balance of Trade and Balance of, Payments., (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2025 :
Answer 3, Balance of Trade (or trade balance) is the difference, between value of exports and imports of goods. Its, scope is narrower since it records transactions in, goods only., Balance of payments is an account which records the, transactions in goods, services, incomes, transfers and, assets between residents of a country with the rest of, the world. It reveals the true picture of a country’s, international transactions., , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2026 :
Question 4, Where will sale of machinery to abroad be recorded in, the Balance of Payments Accounts? Give reasons., (CBSE 2015) (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2027 :
Answer 4, Sale of machinery to abroad is export of goods and thus, recorded in the Current Account. Sale of machinery to, abroad brings in foreign exchange and thus recorded on, the credit side., , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2028 :
Question 5, In which sub-account and on which side of balance of, payments account, will foreign investments in India be, recorded? Given reasons., (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2029 :
Answer 5, Foreign investment will be recorded in the capital account, of the balance of payments account because these give, rise to foreign exchange liabilities., Foreign investment will be recorded on the credit side, because these bring in foreign exchange to the economy., , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2030 :
Question 6, In which sub-account and on which side of balance of, payments account, will Profits received from investments, abroad be recorded? Given reasons., (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2031 :
Answer 6, Profits received from investments abroad is recorded in, the current account since it is an investment income, (factor income).Factor income includes net international, earning of factors of production., It will be recorded on the credit side of the current, account since it leads to inflow of foreign exchange., , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2032 :
Question 7, Where will (a) import of machinery and (b) charity to, foreign countries be recorded in the Balance of Payments?, Give reasons., (4 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2033 :
Answer 7, (a) Imports of Machinery is recorded as visible items in, the current account, because it is simply import of a, good. It is recorded as a debit item because it leads to, outflow of foreign exchange., (b) Charity to foreign countries is recorded in the current, account of BoP because it is a transfer payment. It is, recorded on the debit side because it leads to outflow, of foreign exchange., , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2034 :
Question 8, Where will (a) Remittances from family members from, abroad and (b) Borrowings from abroad be recorded in, the Balance of Payments? Give reasons., (4 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2035 :
Answer 8, (a) Remittances from family members from abroad is, accounted for under unilateral transfers of the current, account. It is recorded on the credit side because it, brings in foreign exchange into the country., (b) ‘Borrowings from abroad’ is recorded in the ‘capital, account’ of BoP because it increases international, liability of the country. It is recorded on the credit side, because it brings in foreign exchange into the country., , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2036 :
Question 9, Are the following entered (i) on the credit side or the, debit side and (ii) in the current account or capital, account in the Balance of Payments? You must give, reason for your answer., (a) Transfer of funds to relatives abroad., (b) Imports of Petroleum, Oil and Lubricants (POL), (4 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2037 :
Answer 9, (a) It is a transfer payment which results into outflow of, foreign exchange from the country, so it is recorded, on the debit side of the Current account of Balance, of Payments (BoP)., (b) Imports of Petroleum, Oil and Lubricants (POL) is, the imports of goods, which involve outflow of, foreign exchange from the country, so it is recorded, on the debit side of the Current account of BoP., , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2038 :
Question 10, In the context of balance of payments account, state, whether the following statements are true or false. Give, reasons for your answer., (CBSE 2015) (4 marks), (a) Profits received from investments abroad is recorded, in capital account., (b) Import of machines is recorded in current account., , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2039 :
Answer 10, (a) False: Profits received from investments abroad is, recorded in the current account since it is an, investment income (factor income). Factor income, includes net international earning of factors of, production., It will be recorded on the credit side of the current, account since it leads to inflow of foreign exchange., (b) True: All imports and exports of goods are recorded, in the current account, because it is simply import/, export of a good., HOTS — Analysing, Evaluating & Creating Type Questions
Page 2040 :
Question 11, Giving reason explain how the following will be entered, in (i) current account or capital account and (ii) on, credit side or debit side of balance of payments:, (CBSE 2018) (6 marks), (a) Imports of machinery, (b) Investments from abroad, , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2041 :
Answer 11, (a) Imports of Machinery, (i) Recorded as visible items in the current account,, because it is simply an import of a good., (ii) Recorded on debit side because it leads to, outflow of foreign exchange., (b) Investments from abroad, (i) Recorded in capital account because it is a, transaction in assets., (ii) Recorded on credit side because it leads to inflow, of foreign exchange., HOTS — Analysing, Evaluating & Creating Type Questions
Page 2042 :
Question 12, Given the exchange rate, what is the effect of fall in, domestic prices on aggregate demand?, (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2043 :
Answer 12, If prices of domestic goods fall, exports become cheaper., So, domestic exports will increase. Since exchange rate, remains constant, imports remain unchanged. As a result,, net exports (i.e., exports – imports) will increase. Since, net exports is a component of aggregate demand,, therefore, aggregate demand will increase., , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2044 :
Question 13, If inflation is higher in country A than in country B, and, the exchange rate between the two countries is fixed,, what is likely to happen to the trade balance between, the two countries? Explain., (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2045 :
Answer 13, Effect on trade balance of country A: Since prices of, goods in country A are more than that in country B, its, exports to country B will decrease and imports from, country B will increase., Thus, trade balance (i.e., value of exports of goods –, value of imports of goods) will show a deficit., Effect on trade balance of country B: Since price of goods, in country B are relatively less than that in country A, its, exports to country A will increase and imports from, country A will decrease. Thus, trade balance will show a, surplus., HOTS — Analysing, Evaluating & Creating Type Questions
Page 2046 :
Question 14, What will be the effect of the following on the Balance, of Payments of India?, (a) ‘Make in India’ Programme, (b) Import of Pulses, (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2047 :
Answer 14, (a) ‘Make in India’ will increase supply (inflow) of, foreign exchange in India, causing improvement in, the balance of payments position., (b) Import of pulses will lead to outflow of foreign, exchange from the country, causing adverse effect, on balance of payment position., , HOTS — Analysing, Evaluating & Creating Type Questions
Page 2048 :
NUMERICAL 1, If the value of exports of goods of a country is `1,000 crore, and the value of imports of goods is `1,650 crore, calculate, the trade balance of the country., (1 mark), Solution: Trade balance or Balance of trade, = Value of exports of goods – Value of imports of goods, = 1,000 – 1,650 = (–)`650 crore, Thus, there is a trade deficit of `650 crore., , Do it yourself 1, If the value of exports of merchandise of a country is `800, crore and the value of imports of merchandise is `650 crore,, calculate the trade balance of the country., (1 mark), [Ans. Trade surplus of `150 crore]
Page 2049 :
NUMERICAL 2, If the balance of trade of a country is showing a deficit of `400, crore and the value of imports of goods is `1,100 crore, then, what is the value of exports of goods?, (1 mark), Solution: Trade balance or Balance of trade = Value of exports, of goods – Value of imports of goods, Since there is trade deficit of `400 crore, trade balance = (–), `400 crore and value of imports of goods = `1,100 crore,, therefore, (–) `400 crore = Value of exports of goods – `1,100, crore Value of exports of goods = – 400 + 1,100 = `700 crore, , Do it yourself 2, If a country has trade surplus of `200 crore and the value of, exports of goods is `700 crore, then what is the value of, imports of goods? [Ans. `500 crore], (1 mark)
Page 2050 :
5.2, , Foreign Exchange Rate – Fixed and, Flexible Rates and Managed Floating, , Foreign exchange or foreign currency refers to any, currency other than the domestic currency., The market in which national currencies are traded for, one another is known as the foreign exchange market., The major participants in the foreign exchange market, are commercial banks, foreign exchange brokers and, other authorised dealers and monetary authorities., It is important to note that although participants, themselves may have their own trading centres , the, market itself is world-wide. There is a close and, continuous contact between the trading centres and, the participants deal in more than one market.
Page 2051 :
Foreign Exchange Rate, Foreign Exchange Rate (also called 'Forex Rate') is the, price of one currency in terms of another. It links the, currencies of different countries and enables comparison, of international costs and prices. For example, if we have, to pay 70 rupees for one dollar, then the exchange rate is, `70/$., Foreign exchange rate is the rate at which one currency, can be converted into another currency., Different countries have different methods of determining, their currency’s exchange rate. It can be determined through, Flexible Exchange Rate, Fixed Exchange Rate or Managed, Floating Exchange Rate.
Page 2052 :
Flexible (or Floating) Exchange Rates, An exchange rate determined by the forces of demand, and supply in the foreign exchange market is flexible or, floating exchange rate., In a completely flexible exchange rate system (i.e. clean, floating), the central banks do not intervene in the, foreign exchange market., A central bank does not maintain any reserves of foreign, currency as the market automatically adjusts to determine, the market driven exchange rate. Therefore, there are no, official reserve transactions.
Page 2053 :
Demand for Foreign Exchange in the foreign, exchange market, People demand foreign exchange because of the following, reasons. These are sources of demand because these lead, to outflow of foreign exchange., (i) Imports: Importers need foreign exchange for, making payments for buying goods and services, from abroad., (ii) Foreign transfer payments: For transfer payments, to any other country in the form of gifts, grants or, remittances, etc. foreign currency is needed., (iii) Investments abroad: For investment in other, countries, e.g. purchase of financial assets like shares,, bonds, etc. abroad, foreign currency is needed.
Page 2054 :
(iv) Tourism abroad: Foreign currency is needed for, foreign travel, for example, Indian people visiting, abroad on a vacation say, for sight-seeing etc., (v) Foreign exchange speculation: Another reason for, the demand for foreign exchange is for speculative, purposes. Foreign exchange is demanded for the, possible gains from appreciation of the foreign, currency. If speculators believe that the British, pound is going to increase in value relative to the, rupee, they will want to hold pounds. For instance,, if the current exchange rate is `90/£ and investors, believe that the pound is going to appreciate by, the end of the month and will be worth `95 (i.e.,, exchange rate will rise to `95/£), investors think if, they took `90000 and bought 1000 pounds, at the
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end of the month, they would be able to exchange, the pounds for `95000, thus making a profit of, `5000. This expectation would increase the demand, for pounds in the foreign exchange market.
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Inverse/Negative Relationship between, Foreign exchange rate and demand for, Foreign exchange, A rise in price of foreign exchange causes decrease in, demand for foreign exchange and vice-versa., Explanation: A rise in price of foreign exchange will, increase the cost (in terms of rupees) of purchasing a, foreign good. For example, if rupee-dollar exchange rate, rises from `70/$ to `75/$, Indians have to pay more, rupees to import US goods. This reduces demand for, imports of foreign goods (US goods). This results in less, outflow of foreign exchange from India. Therefore,, demand for foreign exchange (Dollars) decreases, other, things remaining constant.
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Sources of supply of foreign exchange in the, foreign exchange market, Foreign currency flows into the home country due to the, following reasons. These are sources of supply because these, lead to inflow of foreign exchange., (i) Exports: All exports of goods and services by domestic, residents bring foreign exchange into the country., (ii) Foreign Investments: Foreign Direct Investment, (FDI), Portfolio Investments, e.g. Foreign Institutional, Investment (FII) add to the supply of foreign exchange, as these bring in foreign exchange into the country., (iii) Foreign tourism: Foreign tourists coming to India,, say to visit Vrindavan bring foreign currency into the, country.
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(iv) Other sources of supply of foreign exchange:, Factor income earned from abroad, Remittances, from abroad, e.g. NRIs send gifts or make, transfers, Loans and grants from abroad, Interest, received on loans to abroad, etc. are also received, in foreign currency.
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Direct/Positive Relationship between, Foreign exchange rate and demand for, Foreign exchange, A rise in price of foreign exchange causes increase in, supply of foreign exchange and vice-versa., Explanation: A rise in price of foreign exchange will, reduce the foreigners’ cost (in terms of foreign, currency) while purchasing goods from India, other, things remaining constant. For example, if rupee-dollar, exchange rate rises from `70/$ to `75/$, US dollars can, now buy more of domestic goods. That is, exported, goods become cheaper in the international market, giving a competitive edge for the goods of domestic, country (India). As exported goods become cheaper,
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this increases exports of India. This results in more, inflow of foreign exchange. Therefore, supply of foreign, exchange (Dollars) increases, other things remaining, constant., , , , Top Tip, , Link between the balance of payments accounts and the, transactions in the foreign exchange market:, Outflow of foreign exchange on account of imports of goods, and services, investments made abroad, etc. (total debits in, the BoP accounts) represent the demand for foreign, exchange in the foreign exchange market., Conversely, total credits in the BoP accounts, e.g., inflow of, foreign exchange for all exports of goods and services,, external borrowings, foreign investments, etc. represent the, supply of foreign exchange in the foreign exchange market.
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Fixed Exchange Rates, Under fixed exchange rate system, the Government fixes, the exchange rate at a particular level. The Central Bank, actively uses its foreign exchange reserves to maintain the, officially determined exchange rate., An exchange rate between the two currencies fixed at, government level is called fixed exchange rate., The market determined exchange rate is `70/$. However,, let us suppose that for some reason the Indian, Government wants to encourage exports for which it, needs to make rupee cheaper for foreigners it would do so, by fixing a higher exchange rate, say `75 per dollar from, the current exchange rate of `70 per dollar. At this, exchange rate, the supply of dollars exceeds the demand
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for dollars. The RBI intervenes to purchase the dollars, for rupees in the foreign exchange market in order to, absorb this excess supply which has been marked as, AB in the figure. Thus, through intervention, the, Government can maintain any exchange rate in the, economy. But it will be accumulating more and more, foreign exchange so long as this intervention goes on., On the other hand, if the government was to set an, exchange rate at a lower level, there would be an excess, demand for dollars in the foreign exchange market. To, meet this excess demand for dollars, the government, would have to withdraw dollars from its past holdings, of dollars. If it fails to do so, a black market for dollars, may come up.
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, , Top Tips, , Official reserve transactions are more relevant under a, regime of fixed exchange rates than when exchange rates, are floating., , Devaluation of domestic currency, In a fixed exchange rate system, when the government, increases the exchange rate (thereby, making domestic, currency cheaper in terms of a foreign currency) is called, Devaluation of domestic currency. In other words,, devaluation of domestic currency is reduction in the, value of domestic currency by the government with, respect to a given foreign currency.
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Revaluation of domestic currency, In a fixed exchange rate system, when the government, decreases the exchange rate (thereby, making domestic, currency costlier in terms of a foreign currency) is called, Revaluation of domestic currency., , Managed Floating Exchange Rates, Without any formal international agreement, the world, has moved on to what can be best described as a managed, floating exchange rate system., In a system of managed floating exchange rates, the, exchange rate is determined by the combined forces of, demand and supply of foreign exchange, but the Central, Bank may intervene to buy or sell foreign currencies in, order to control the exchange rate fluctuations. Official
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reserve transactions are, therefore, not equal to zero., Managed floating exchange rate is the floating (or flexible), exchange rate which can be influenced by the intervention, of the Central Bank in the foreign exchange market., Thus, managed floating exchange rate system is the, amalgamation of the flexible exchange rate system and, the fixed exchange rate system because managed, floating exchange rate is decided by market forces (the, float part) but remains within a specific range as, decided by central bank (the managed part)., , , , Top Tips, , Managed floating exchange rate system is also called 'dirty floating', as the clean floating rate is influenced by the intervention of the, Central Bank in the foreign exchange market.
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Key Terms, , Foreign exchange market – The market in which national, currencies are traded for one another is known as the foreign, exchange market., Foreign exchange rate – Foreign Exchange Rate (also called, 'Forex Rate') is the rate at which one currency can be, converted into another currency., Flexible (or Floating) Exchange Rates – An exchange rate, determined by the forces of demand and supply in the, foreign exchange market is flexible or floating exchange rate., Equilibrium exchange rate – Equilibrium exchange rate is, the rate at which market demand and supply of foreign, exchange are equal., Fixed exchange rate – An exchange rate between the two, currencies fixed at government level is called fixed exchange, rate.
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Devaluation of domestic currency – In a fixed exchange rate, system, when some government action increases the exchange, rate (thereby, making domestic currency cheaper) is called, Devaluation of domestic currency., Revaluation of domestic currency – In a fixed exchange rate, system, when some government action decreases the, exchange rate (thereby, making domestic currency costlier) is, called Revaluation of domestic currency., Managed floating exchange rate (also called 'dirty floating') –, Managed floating exchange rate is the floating (or flexible), exchange rate which can be influenced by the intervention of, the Central Bank in the foreign exchange market.
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Question 1, ___________ links the currencies of different countries, and enables comparison of international costs and prices., (Fill in the blank), , Objective Type Questions 5.2
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Answer 1, Foreign Exchange Rate (also called Forex Rate), , Objective Type Questions 5.2
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Question 2, The market in which national currencies are traded for, one another is known as the ____________., (Fill in the blank), , Objective Type Questions 5.2
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Answer 2, Foreign exchange market, , Objective Type Questions 5.2
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Question 3, Which of the following is a major participant in the foreign, exchange market?, (Choose the correct alternative), (a) Commercial banks, (b) Foreign exchange brokers and other authorised dealers, (c) Monetary authorities, (d) All of the above, , Objective Type Questions 5.2
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Answer 3, (d) All of the above, , Objective Type Questions 5.2
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Question 4, People demand foreign exchange because:, (Choose the correct alternative), (a) They want to import goods and services., (b) They want to purchase financial assets from abroad, (c) They want to send gifts abroad, (d) All of the above, , Objective Type Questions 5.2
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Answer 4, (d) All of the above, , Objective Type Questions 5.2
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Question 5, Which of the following is not a source of supply of foreign, exchange?, (Choose the correct alternative), (a) Exports, (b) Speculation, (c) Transfer receipts, (d) Foreign Direct Investment (FDI), , Objective Type Questions 5.2
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Answer 5, (b) Speculation, , Objective Type Questions 5.2
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Question 6, Match the columns:, Column I, , Column II, , (i) This exchange rate is determined, by the market forces of demand, and supply, , (a) Fixed exchange rate, , (ii) This exchange rate is determined, by the market forces of demand, and supply, with central bank, intervention to buy and sell, foreign currencies in an attempt, to moderate exchange rate, movements., , (b) Flexible exchange rate, , (iii) This exchange rate is fixed by the, Government at a particular level., , (c) Managed floating exchange rate, Objective Type Questions 5.2
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Answer 6, (i) – (b), (ii) – (c), (iii) – (a), , Objective Type Questions 5.2
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Question 7, Under managed floating official reserve transactions are, equal to zero., True/False? Give reason., , Objective Type Questions 5.2
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Answer 7, False: In case of managed floating, central banks intervene, to reduce fluctuations in the exchange rate., Official reserve transactions are, therefore not equal to, zero. However, under clean floating, the exchange rate is, market determined without any central bank intervention., So, official reserve transactions are equal to zero., , Objective Type Questions 5.2
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Question 8, Without any formal international agreement the world, had moved on to what can be best described as a, _______________ exchange rate system. (flexible/fixed, /managed floating)., (Fill in the blank with correct option), , Objective Type Questions 5.2
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Answer 8, managed floating, , Objective Type Questions 5.2
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Question 9, Why does the central bank need to intervene in a, managed floating system?, (Choose the correct alternative), (a), (b), (c), (d), , To reduce fluctuations in the exchange rate., To maintain the exchange rate at the specified level., To cover the surplus and deficits in the BoP., None of the above, , Objective Type Questions 5.2
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Answer 9, (a) To reduce fluctuations in the exchange rate., , Objective Type Questions 5.2
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Question 10, Managed floating exchange rate system is a mixture of a, flexible exchange rate system and a fixed rate system., True/False? Give reason., , Objective Type Questions 5.2
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Answer 10, True: Under managed floating exchange rate system, the, exchange rate is determined by the market forces of, demand and supply of foreign exchange (the float part), but the central banks need to intervene to buy and sell, foreign currencies in an attempt to moderate exchange, rate movements whenever they feel that such actions are, appropriate (the managed part)., , Objective Type Questions 5.2
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Question 11, If there is a deficit in the BoP, governments will have to, intervene to take care of the gap by use of its official, reserves. Which of the following exchange rate system, has been described above?, (Choose the correct alternative), (a), (b), (c), (d), , Flexible exchange rate system, Fixed exchange rate system, Managed floating exchange rate system, Both (b) and (c), Objective Type Questions 5.2
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Answer 11, (d) Both (b) and (c), , Objective Type Questions 5.2
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Question 12, _____________ (Fixed/Floating) exchange rates system, automatically takes care of the surplus and deficits in the, BoP., (Fill in the blank with correct option), , Objective Type Questions 5.2
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Answer 12, Floating, , Objective Type Questions 5.2
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Question 13, In a ____________ the central banks do not intervene, in the foreign exchange market., (Choose the correct alternative), (a) Completely flexible exchange rate system, i.e. clean, floating, (b) Fixed exchange rate system, (c) Both (a) and (b), (d) Managed floating exchange, , Objective Type Questions 5.2
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Answer 13, (a) Completely flexible exchange rate system, i.e. clean, floating, , Objective Type Questions 5.2
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Question 14, In a fixed exchange rate system, when some government, action increases the exchange rate, it is called _________., (Choose the correct alternative), (a) Depreciation, (b) Appreciation, (c) Devaluation, (d) Revaluation, , Objective Type Questions 5.2
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Answer 14, (c) Devaluation, , Objective Type Questions 5.2
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Question 15, __________ is said to occur, when the Government, decreases the exchange rate in a fixed exchange rate, system., (Choose the correct alternative), (a) Depreciation, (b) Appreciation, (c) Devaluation, (d) Revaluation, , Objective Type Questions 5.2
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Answer 15, (d) Revaluation, , Objective Type Questions 5.2
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Question 16, Suppose the market determined exchange rate is `70/$., However, the Indian Government fixes a higher exchange, rate of `75/$ for some reason. The is called ________ of, Rupee. The purpose of the Indian Government may be, ___________., (Fill in the blanks), , Objective Type Questions 5.2
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Answer 16, Devaluation, to encourage domestic exports to US for, which it needs to make rupee cheaper for foreigners., , Objective Type Questions 5.2
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Question 17, The market determined exchange rate is `65/$. However,, to encourage exports the RBI devalued rupee by fixing a, higher exchange rate `75/$. How will the RBI intervene, to maintain the fixed exchange rate of `75/$?, (Choose the correct alternative), (a) The RBI will withdraw dollars from its past holdings, of dollars to meet the excess demand for dollars in, the foreign exchange market., (b) The RBI will purchase the dollars for rupees in the, foreign exchange market in order to absorb the, excess supply of dollars, Objective Type Questions 5.2
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(c) The RBI will follow the managed floating exchanges, rate system, (d) None of the above
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Answer 17, (b) The RBI will purchase the dollars for rupees in the, foreign exchange market in order to absorb the, excess supply of dollars, , Objective Type Questions 5.2
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Question 18, When the market determined exchange rate is higher, than the exchange rate fixed by the government there, will be ___________ (excess demand/ excess supply) of, foreign exchange in market. The government will ______, (buy/sell) foreign exchange from its resources. If it fails to, do so, a black market for foreign exchange may come up., When people know that the amount of reserves is, inadequate, they would begin to doubt the ability of the, government to maintain the fixed exchange rate. This may, give rise to _____________. When this belief translates, into aggressive buying of one currency thereby forcing, Objective Type Questions 5.2
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the government to devalue, it is said to constitute a, speculative attack on a currency., (Fill in the blank with correct option)
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Answer 18, (i) excess demand, (ii) sell, (iii) Speculation of devaluation, , Objective Type Questions 5.2
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Question 19, Excess demand of foreign exchange implies there is ____, in the BOP. Thus, the Central Bank will have to intervene, to take care of the gap by ______________., (Fill in the blanks), , Objective Type Questions 5.2
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Answer 19, (i) deficit, (ii) use of its official reserves of foreign exchange, , Objective Type Questions 5.2
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Question 20, __________ (Fixed/Flexible) exchange rate system gives, the government more flexibility and they do not need to, maintain large stock of foreign exchange reserves., (Fill in the blank with correct option), , Objective Type Questions 5.2
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Answer 20, Flexible, , Objective Type Questions 5.2
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Question 21, The flexible exchange rate system is also called ________, because exchange rate movements automatically take care, of the surpluses and deficits in the BOP. The Central Banks, do not have to intervene to maintain exchange rate which, are automatically taken care of by the market., On the other hand, the managed floating exchange rate, system is also called ____________ as central banks, intervene to buy and sell foreign currencies to moderate, exchange rate movements in the foreign exchange market., (Fill in the blanks), Objective Type Questions 5.2
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Answer 21, (i) Clean floating, (ii) Dirty Floating, , Objective Type Questions 5.2
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Question 22, Which of the following is a source of supply of foreign, currency?, (Choose the correct alternative), (a) Investments made abroad, (b) Loans and grants from abroad, (c) Imports of goods and services, (d) Tourists going abroad, , Objective Type Questions 5.2
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Answer 22, (b), , Loans and grants from abroad, , Objective Type Questions 5.2
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Question 23, State giving reason, whether the following, statement is true or false:, The official reserve transactions are relevant under, fixed exchange rate system., , Objective Type Questions 5.2
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Answer 23, True: Under fixed/pegged exchange rate system, the, Central Bank actively uses its foreign exchange reserves, to maintain the officially determined exchange rate. Thus,, the official reserve transactions are relevant under a, regime of pegged or fixed exchange rates., , Objective Type Questions 5.2
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Question 24, Price of one currency in relation to foreign currencies is, determined by forces of demand and supply is known as:, (Choose the correct alternative), (a) Equilibrium Rate, (b) Fixed exchange Rate, (c) Exchange Rate, (d) Flexible exchange Rate, , Objective Type Questions 5.2
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Answer 24, (d) Flexible exchange Rate, , Objective Type Questions 5.2
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Question 25, Occasional intervention by the central bank to influence, the exchange rate is known as:, (Choose the correct alternative), (a) Managed floating, (b) Hedging, (c) Appreciation, (d) Depreciation, , Objective Type Questions 5.2
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Answer 25, (a) Managed floating, , Objective Type Questions 5.2
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Question 26, Which of the following is a source of supply of foreign, exchange?, (Choose the correct alternative), (a) Current transfers to abroad, (b) Speculation, (c) Portfolio investment, (d) None of these, , Objective Type Questions 5.2
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Answer 26, (c) Portfolio investment, , Objective Type Questions 5.2
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Question 27, The component of demand for foreign exchange are:, (Choose the correct alternative), (a) Repayment of international debts, (b) Imports, (c) Exports, (d) Remittances from abroad, , Objective Type Questions 5.2
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Answer 27, (b) Imports, , Objective Type Questions 5.2
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5.3, , Exchange Rate in a Free Market:, Effects of Change in Demand and, Supply, , Effects of Increase in Demand for Foreign, Exchange, Increase in demand for foreign exchange may be due, to the following reasons:, (i) Rise in imports of foreign goods and services, for, example, due to increased international travelling, by Indians,, (ii) Purchasing more financial assets abroad,, (iii) Increase in demand for foreign exchange for, speculative purposes,
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(iv) Increase in transfer payments to foreign countries,, etc., , Effect on the exchange rate, Due to increase in demand for foreign exchange, the, , demand curve shirts upward and right to the original, demand curve., Supply of foreign exchange remaining same, increase, in demand will cause excess demand of foreign, currency at the prevailing foreign exchange rate., As a result, a new equilibrium rate of foreign exchange, rate will be determined which will be higher than the, prevailing foreign exchange rate.
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Thus, there will be a rise in the foreign exchange rate, , (say from `70/$ to `75/$), other things remaining, unchanged., Rise in the price of foreign exchange, say `70/$ to, `75/$ implies ‘depreciation’ of domestic currency, (rupees)., Depreciation is the fall in the value of domestic currency, in relation to a foreign currency caused by rise in foreign, exchange rate in the foreign exchange market under the, flexible exchange rate system., Depreciation of rupee indicates that the value of rupees, in terms of dollars has fallen. Clearly, a rise in exchange, rate from `70/$ to `75/$ means that we need to pay more, rupees for a dollar now.
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Effect of depreciation of domestic currency, on exports and imports, Depreciation of domestic currency (rupees) normally, increases exports from a country, as exports become, cheaper for the foreign nationals and foreign currency, can now buy more of domestic goods, i.e., the international, competitiveness of the goods and services of the nation, gets better., On the other hand, Depreciation of domestic currency, (rupees) will increase the cost (in terms of rupees) of, purchasing a foreign good. Indians will have to pay more, rupees to import foreign goods. This reduces demand for, imports of foreign goods. Thus, imports fall.
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Effect on national income, , Since exports rise and imports fall, therefore, Net Exports, (= Exports – Imports) will increase. An increase in Net, Exports will increase the national income, other things, remaining unchanged., , , , Top Tips, , 1. Effects of decrease in demand for foreign exchange, Due to decrease in demand for foreign exchange, the demand curve, shifts leftwards to the original demand curve. Supply of foreign, exchange remaining same, decrease in demand will cause excess supply, of foreign currency at the prevailing foreign exchange rate. As a result, a, new equilibrium rate of foreign exchange rate will be determined which, will be lower than the prevailing foreign exchange rate. Thus, foreign, exchange rate is likely to fall, leading to appreciation of domestic, currency. (Appreciation will be discussed next.), 2. Depreciation of domestic currency implies appreciation of the foreign, currency.
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Effects of Increase in Supply for Foreign, Exchange, Increase in supply for foreign exchange may be due to, the following reasons:, (i) Rise in exports of goods and services,, (ii) Increase in foreign investments(e.g. Foreign Direct, Investment, Portfolio Investments, etc.),, (iii) More foreign tourists coming to India, etc
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Effect on the exchange rate, Due to increase in supply of foreign exchange, the supply, , , , , , , , , curve shifts rightwards to the original supply curve., Demand for foreign exchange remaining same,, increase in supply will cause excess supply of foreign, currency at the prevailing foreign exchange rate., As a result, a new equilibrium rate of foreign exchange, rate will be determined which will be lower than the, prevailing foreign exchange rate., Thus, there will be a fall in the foreign exchange rate, (say from `70/$ to `68/$), other things remaining, unchanged., Fall in the price of foreign exchange, say `70/$ to `68/$, implies ‘appreciation’ of domestic currency (rupees).
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In a flexible exchange rate system, when the price of, foreign currency (say, dollars) in terms of domestic, currency (rupees) falls, the value of domestic currency, in terms of foreign currency increases, it is called, appreciation of domestic currency., Appreciation of domestic currency means that we need, to pay fewer rupees in exchange for one dollar., For example, a fall in the exchange rate (say, from `70/$, to `68/$) indicates that the value of rupee relative to, dollar has increased since we need to pay only 68, rupees in exchange for one dollar.
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Effect of appreciation of domestic currency, on exports and imports, Appreciation of domestic currency decreases exports, since domestic goods become costlier for the foreign, nationals. This is so because one unit of foreign currency, can now buy less of domestic goods, i.e. the international, competitiveness of the goods and services of the nation, gets worse., On the other hand, due to appreciation of domestic, currency, the importers have now to pay less domestic, currency to import one unit worth of foreign currency, goods. Imports thus become cheaper. This raises demand, for imports.
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Effect on national income, , Since exports decrease and imports increase, therefore, Net, Exports (= Exports – Imports) will decrease. A decrease in, Net Exports will decrease the national income, other things, remaining unchanged., , , , Top Tips, , 1. Effects of decrease in supply of foreign exchange, Due to decrease in supply of foreign exchange, the supply curve, shifts leftwards to the original supply curve. Demand for foreign, exchange remaining same, decrease in supply will cause excess, demand of foreign currency at the prevailing foreign exchange rate., As a result, a new equilibrium rate of foreign exchange rate will be, determined which will be higher than the prevailing foreign exchange, rate. Thus, foreign exchange rate is likely to rise, leading to depreciation, of domestic currency., 2. Appreciation of domestic currency implies depreciation of foreign, currency.
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Key Terms, , Depreciation of domestic currency – Depreciation is the fall in, the value of domestic currency in relation to a foreign currency, caused by rise in foreign exchange rate in the foreign exchange, market under the flexible exchange rate system., Appreciation of domestic currency – In a flexible exchange, rate system, when the price of foreign currency (say, dollars) in, terms of domestic currency (rupees) falls, the value of, domestic currency in terms of foreign currency increases, it is, called appreciation of domestic currency.
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RECAP, , Depreciation of domestic currency, It means fall in the value of domestic currency in terms of a foreign, currency caused by a rise in the exchange rate under the flexible, exchange rate system., Depreciation of home currency implies fall in the purchasing, power of domestic currency in terms of foreign currency., Depreciation of home currency implies fall in the price of, domestic goods for the foreign buyers., Depreciation encourages exports as domestic goods become, cheaper for the foreign nationals, i.e., the international competitiveness, of the goods of the nation gets better., However, depreciation will make imports of foreign goods costlier., So, imports fall., Since exports rise and imports fall, therefore, Net Exports (Exports, – Imports) will increase., Therefore, national income is likely to rise.
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Appreciation of domestic currency, It means a rise in the value of domestic currency in terms of a, foreign currency caused by a fall in the exchange rate under the, flexible exchange rate system., Appreciation of home currency implies that purchasing, power of home currency in terms of a foreign currency has, gone up., Appreciation makes foreign goods cheaper for the domestic, buyer., Appreciation decreases exports since domestic goods become, costlier for the foreign nationals., However, it will make imports cheaper for the Indian residents, since they have to pay less domestic currency to buy imported, goods. So, imports rise., Since exports fall and imports rise, therefore, Net Exports, (Exports – Imports) will decrease., Therefore, national income is likely to fall.
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Question 1, A rise in price of foreign exchange will increase demand, for imports., True/False? Give reason., , Objective Type Questions 5.3
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Answer 1, False: A rise in price of foreign exchange will increase, the cost (in terms of rupees) of purchasing a foreign, good. This reduces demand for imports,; other things, remaining constant., , Objective Type Questions 5.3
Page 2139 :
Question 2, A rise in price of foreign exchange increases India’s, exports., True/False? Give reason., , Objective Type Questions 5.3
Page 2140 :
Answer 2, True: A rise in price of foreign exchange will reduce, the foreigner’s cost (in terms of USD) while purchasing, products from India other things remaining constant, this increase India’s exports., , Objective Type Questions 5.3
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Question 3, What will be the likely effects of increased international, travelling by Indians?, (Choose the correct alternative), (a) Depreciation of Rupee, (b) Increase in exports, (c) Both (a) and (b), (d) Increase in imports, , Objective Type Questions 5.3
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Answer 3, (c) Both (a) and (b), , Objective Type Questions 5.3
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Question 4, In a flexible exchange rate regime, when the price of, domestic currency (rupees) in terms of foreign currency, (Dollars) decrease, it is called _____________ of the, domestic currency (rupees) in terms of foreign currency, (dollars)., (Choose the correct alternative), (a) Depreciation, (b) Appreciation, (c) Devaluation, (d) Revaluation, Objective Type Questions 5.3
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Answer 4, (b) Appreciation, , Objective Type Questions 5.3
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Question 5, Suppose the Rupee-Dollar exchange rate is `70/$. Indian, investors believe that USD is going to appreciate by the, end of the month and will be worth `75. The investors, think if they gave the dealer `70,000 and bought 1,000, dollars, at the end of the month, they would be able to, exchange the dollars for `75,000, thus making a profit of, `5,000., What will be the likely effect of this speculation or, expectation on the exchange rate in the present?, (Choose the correct alternative), Objective Type Questions 5.3
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(a), (b), (c), (d), , The exchange rate will increase., The exchange rate will decrease., The exchange rate will remain unchanged., None of the above., , Objective Type Questions 5.3
Page 2147 :
Answer 5, (a) The exchange rate will increase., , Objective Type Questions 5.3
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Question 6, A rise in the interest rates at home leads to ________, of the domestic currency. (depreciation/appreciation), (Fill in the blank with correct option), , Objective Type Questions 5.3
Page 2149 :
Answer 6, appreciation, , Objective Type Questions 5.3
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Question 7, It government bonds in country A pay 8 per cent of, interest whereas equally safe bonds in country B yield, 10 percent, what will be the likely effect on country A’s, currency?, (Choose the correct alternative), (a) Depreciation, (b) Appreciation, (c) Devaluation, (d) No effect, Objective Type Questions 5.3
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Answer 7, (a) Depreciation, Hint: Due to interest rate differential of 2 per cent,, investors from country A will be attracted by the high, interest rates in country B and will buy the currency, of country B selling their own currency to make, investment in country B. So, demand for currency of, country B increases, causing depreciation of currency, of country A., , Objective Type Questions 5.3
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Question 8, If there is increase in income in the home country, the, domestic currency will be ___________. (depreciating, /appreciating), (Fill in the blank with correct option), , Objective Type Questions 5.3
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Answer 8, Depreciating, Hint: When income increases, consumers spending, increases. Spending on imported goods is also likely to, increase. When imports increase, the demand for foreign, exchange increases. The exchange rate thus, is likely to, rise.There is a depreciation of the domestic currency., , Objective Type Questions 5.3
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Question 9, If there is an increase in income abroad the domestic, currency will be ________________. (depreciating/, appreciating), (Fill in the blank with correct option), , Objective Type Questions 5.3
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Answer 9, appreciating, Hint: Due to an increases in income abroad, domestic, exports will rise and hence the supply of foreign, currency will increase. The exchange rate is likely to fall., There is appreciation of domestic currency., , Objective Type Questions 5.3
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Question 10, If income increases in the home country as well as, abroad, what is the likely effect on the value of domestic, currency., (Choose the correct alternative), (a) Domestic currency will be depreciating, (b) Domestic currency will be appreciating, (c) Domestic currency may be depreciating or, appreciating, (d) None of the above, Objective Type Questions 5.3
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Answer 10, (c) Domestic currency may be depreciating or appreciating, Hint: with increase in income, demand for imported, goods and hence demand for foreign exchange increases., With increase in income abroad as well, domestic exports, and hence supply of foreign exchange also increase., On balance, the domestic currency may be depreciating, or appreciating, – If imports are growing faster than exports, domestic, currency will be depreciating, – If exports are growing faster than imports, domestic, currency will be appreciating, Objective Type Questions 5.3
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Question 11, Suppose a shirt costs $20 in the US and `1000 in India,, What will be the effect on exports of India if the, rupee-dollar exchange rate is `70/$?, (Choose the correct alternative), (a), (b), (c), (d), , Exports will increase, Exports will decrease, Exports will remain unchanged, None of the above, , Objective Type Questions 5.3
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Answer 11, (a) Exports will increase, Hint: At the exchange rate `70/$, it costs `1,400 (=, `20) in the US but only `1,000 in India. Being cheaper,, exports of shirts from India will increase., , Objective Type Questions 5.3
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Question 12, Other things remaining unchanged when in a country, the price of domestic currency rises, national income, is:, (Choose the correct alternative), (a), (b), (c), (d), , Likely to rise, Likely to fall, Not affected, Likely to rise and fall both, , Objective Type Questions 5.3
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Answer 12, (b) Likely to fall, Reason: When the price of domestic currency rises, it, denotes appreciation of domestic currency. So, imports, will rise and exports will fall, i.e. net exports will fall. So,, aggregate demand and hence national income will fall,, other things remaining unchanged., , Objective Type Questions 5.3
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Question 13, Suppose the present foreign exchange rate is of `70/$. It, rises to `75/$ leading to rise in prices of imports of, essential goods. How can the RBI help in bringing down, the foreign exchange rate which is very high?, (Choose the correct alternative), (a) The RBI should withdraw dollars to sell them in the, foreign exchange market., (b) The RBI should purchase the dollars for rupees in, the foreign exchange market., (c) The RBI should fix the exchange rate at lower level., (d) None of the above, Objective Type Questions 5.3
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Answer 13, (a) The RBI should withdraw dollars to sell them in the, foreign exchange market., Hint: Selling dollars will cause increase in supply of, dollars in the foreign exchange market. It will lead, to a fall in the exchange rate., , Objective Type Questions 5.3
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Question 14, A fall in the external value of a currency as notified by the, government of the country is called _______________,, whereas a fall in the external value of a currency due to, the change in demand and supply of the currency in the, foreign exchange market is called _______________., (Fill in the blanks), , Objective Type Questions 5.3
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Answer 14, (i) Devaluation of currency, (ii) Depreciation of currency, , Objective Type Questions 5.3
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Question 15, “Indian rupee (`) plunged to all time low of `74.48 against, the US Dollar ($).” What will be effect on National, Income of India, other things remaining the same?, (Choose the correct alternative), (i) National Income will rise., (ii) National Income will fall., (ii) National Income may or may not fall., (iv) National Income may or may not rise., , Objective Type Questions 5.3
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Answer 15, (i) National Income will rise., Hint: Depreciation of Rupee will encourage exports, while discourage imports. Net exports (= Exports Imports) will increase. Hence, national income will rise,, other things remaining the same., , Objective Type Questions 5.3
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Question 16, “USA has accused China of currency devaluation to, promote its exports.” Is it true that by devaluating its, currency, China can promote its exports?, True/False? Give reason., , Objective Type Questions 5.3
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Answer 16, True: Devaluation of currency makes Chinese goods, cheaper in the international market. Thus, it promotes, exports of Chinese goods and may adversely impact the, production and sale of importing country.(USA), , Objective Type Questions 5.3
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Question 17, What is the likely impact of foreign exchange speculation, on the exchange rate?, (Choose the correct alternative), (a) Exchange rate is likely to fall, (b) Exchange rate is likely to rise, (c) Exchange rate remains unchanged, (d) None of these, , Objective Type Questions 5.3
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Answer 17, (b) Exchange rate is likely to rise, , Objective Type Questions 5.3
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Question 18, Which of the following is likely to raise the foreign, exchange rate?, (Choose the correct alternative), (a), (b), (c), (d), , Government gives incentives for exports., Government doubled the import duty on gold., Government promotes foreign direct investment., Visits to foreign countries by people increase., , Objective Type Questions 5.3
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Answer 18, (d) Visits to foreign countries by people increase., , Objective Type Questions 5.3
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Question 19, A rise in the interest rates at home leads to ________., (Choose the correct alternative), (a) Depreciation of foreign currency, (b) Depreciation of domestic currency, (c) Rise in exchange rate, (d) None of these, , Objective Type Questions 5.3
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Answer 19, (a) Depreciation of foreign currency, , Objective Type Questions 5.3
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Question 20, Other things remaining the same, when in a country, the price of foreign currency rises, national income is, likely:, (Choose the correct alternative), (a) to rise, (b) to fall, (c) to rise or to fall, (d) to remain unaffected, , Objective Type Questions 5.3
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Answer 20, (a) to rise, , Objective Type Questions 5.3
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Question 21, An increase in demand for imported goods raises the, foreign exchange rate., (True/False), , Objective Type Questions 5.3
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Answer 21, True: Demand for foreign exchange will increase in, order to make the payment for imported goods. Supply, of foreign exchange remaining unchanged, increase in, demand will cause the exchange rate to rise., , Objective Type Questions 5.3
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Question 22, How can increase in foreign direct investment, other, things remaining the same affect the foreign exchange, rate:, (Choose the correct alternative), (a) Exchange rate will fall, (b) Exchange rate will rise, (c) No change in exchange rate, (d) None of these, , Objective Type Questions 5.3
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Answer 22, (a) Exchange rate will fall, , Objective Type Questions 5.3
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Question 23, When the exchange rate rises under managed floating,, it is called ______________ of domestic currency., (Choose the correct alternative), (a) Devaluation, (b) Appreciation, (c) Depreciation, (d) Revaluation, , Objective Type Questions 5.3
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Answer 23, (c) Depreciation, , Objective Type Questions 5.3
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Question 24, When there is depreciation of foreign currency, the supply, of foreign currency in domestic economy will:, (Choose the correct alternative), (a) Increase, (b) Not change, (c) Either increase or decrease, (d) Decrease, , Objective Type Questions 5.3
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Answer 24, (d) Decrease, , Objective Type Questions 5.3
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Question 1, What is the role of a Central Bank in the following, exchange rate?, (CBSE Sample Question Paper 2015) (3 marks), (a) Fixed exchange, (b) Floating exchange, (c) Managed floating, , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 1, The role of the Central Bank in maintaining the foreign, exchange rates under different regimes is:, (a) Fixed exchange rate system: A Central Bank, actively uses its foreign currency reserves to, maintain the officially determined exchange rate, (b) Floating exchange rate system: A Central, Bank does not maintain any reserves of foreign, currency as the market automatically adjusts to, determine the market driven exchange rate, , HOTS — Analysing, Evaluating & Creating Type Questions
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(c) Managed Floating: A Central Bank enters the, foreign exchange market to buy/sell foreign currency, in order to control fluctuations and volatility in the, market., , HOTS — Analysing, Evaluating & Creating Type Questions
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Question 2, ‘Devaluation and Depreciation of currency are one and, the same thing’. Do you agree? How do they affect the, exports of a country?, (CBSE Sample Question Paper 2018) (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 2, Depreciation and Devaluation both imply a fall in external, value of a currency; however the term depreciation is used, under the floating exchange rate system that is when the, exchange rate system is determined by the combined, market forces of demand and supply. A currency loses or, gains value because of fluctuations in demand and supply., The term devaluation is used in system of fixed exchange, rates. In this system, the exchange value of a currency is, decided by the government. Devaluation of currency is the, deliberate value of currency decided by the government., Devaluation of currency is the deliberate action of the, government., HOTS — Analysing, Evaluating & Creating Type Questions
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Depreciation and devaluation of a currency normally, encourages exports from a country, as exports become, cheaper for the foreign nationals and foreign currency can, now buy more of domestic goods, i.e., the international, competitiveness of the goods and services of such a, nation gets better., , HOTS — Analysing, Evaluating & Creating Type Questions
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Question 3, “Foreign Institutional Investors (FIIs) remained net seller, in the Indian capital markets over the last few weeks.”, – The Economic Times, State and discuss the likely effects of the given statement, on foreign exchange rate with reference to the Indian, Economy., (CBSE Sample Question Paper 2020) (4 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 3, Selling of securities by Foreign Institutional Investors, (FII’s) in Indian capital market will lead to fall in the, supply of foreign currency in the economy. This situation, might lead to excess demand of foreign currency at the, prevailing foreign exchange rate., As a result, a new equilibrium rate of foreign exchange, will be determined which will be higher than the, prevailing foreign exchange rate, leading to depreciation, of domestic currency., , HOTS — Analysing, Evaluating & Creating Type Questions
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Question 4, "Many large Multinational Corporations (MNCs) have, recently shifted their investments from China and have, started their production in India, thereby boosting the, Make in India plans of the Government." Presuming, other factors being constant, discuss the effects of the, given statement on Foreign Exchange rates with, reference to the Indian Economy., (CBSE Sample Question Paper 2020) (4 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 4, Investments by large multinational corporations (MNCs), in India will ensure greater inflow of foreign exchange,, leading to an increase in the supply of foreign currency., This situation may result into excess supply of foreign, currency in the economy at the prevailing foreign, exchange rate., As a result, a new equilibrium rate of foreign exchange, will be determined which will be lower than the, prevailing foreign exchange rate, leading to appreciation, of domestic currency., HOTS — Analysing, Evaluating & Creating Type Questions
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Question 5, ‘‘Indian rupee (`) plunged to all time low of `74.48, against the US Dollar ($)’’. –The Economic Times, In the light of the above report, discuss the impact of the, situation on Indian Imports, Exports and BoP position of, India., (4 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 5, Indian rupee plunged to all time low of `74.48 against US, dollar. It is called depreciation in the value of Indian Rupees., It may lead to fall in imports as foreign goods will become, costlier for the domestic consumers. Fall in imports less, outflow of foreign exchange from the country., Also, depreciation of rupee causes increase in exports of, India since international competitiveness of Indian goods, gets better. So, there will be more inflow of foreign, exchange into the country. Thus, net inflow of foreign, exchange increases which has favourable effect on the, Balance of Payments position., HOTS — Analysing, Evaluating & Creating Type Questions
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Question 6, “Government of India doubled the import duty on gold.”, State and discuss the likely effects of the given statement, on foreign exchange rate with reference to the Indian, Economy., (4 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 6, Increasing import duty on gold will make imports of gold, costly. It will reduce demand for import of gold and, consequently of foreign exchange. This situation may result, into excess supply of foreign currency in the economy at, the prevailing foreign exchange rate., As a result, a new equilibrium rate of foreign exchange will, be determined which will be lower than the prevailing, foreign exchange rate, leading to appreciation of domestic, currency., Thus, foreign exchange rate is likely to fall., HOTS — Analysing, Evaluating & Creating Type Questions
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Question 7, “Visits to foreign countries for sightseeing etc. by the, people of India is on the rise.”, Presuming other factors being constant, discuss the effects, of the given statement on Foreign Exchange rates with, reference to the Indian Economy., (4 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 7, It will raise demand for foreign exchange for spending the, same in foreign countries. This situation might lead to, excess demand of foreign currency at the prevailing, foreign exchange rate. As a result, a new equilibrium rate, of foreign exchange will be determined which will be, higher than the prevailing foreign exchange rate, leading to, depreciation of domestic currency. Thus, foreign exchange, rate likely to rise., , HOTS — Analysing, Evaluating & Creating Type Questions
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Question 8, “Government of India is giving incentives for exports.”, State and discuss the likely effects of the given statement, on foreign exchange rate with reference to the Indian, Economy., (4 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 8, Incentives for exports are aimed at increasing exports., Increase in exports will bring more foreign exchange into, the country (i.e. increase in supply of foreign exchange)., This situation may result into excess supply of foreign, currency in the economy at the prevailing foreign exchange, rate., As a result, a new equilibrium rate of foreign exchange will, be determined which will be lower than the prevailing, foreign exchange rate, leading to appreciation of domestic, currency., Thus, foreign exchange rate is likely to fall., HOTS — Analysing, Evaluating & Creating Type Questions
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Question 9, Suppose the present foreign exchange rate is 1 $= `70. It, rises to 1 $ = `74 leading to rise in prices of imports of, essential goods. How can Reserve Bank of India help in, bringing down the foreign exchange rate which is very, high?, (CBSE 2013) (4 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 9, Rise in exchange rate from 1 $ = `70 to 1 $ = `74 means, depreciation of Indian currency. Foreign goods become, costlier. Prices of imports of essential goods rise. So,, imports decrease. The Reserve Bank of India should sell, US Dollars from its foreign exchange reserves. As a result,, supply of foreign exchange (dollars) in the foreign, exchange market increases. It will lead to fall in the foreign, exchange rate., , HOTS — Analysing, Evaluating & Creating Type Questions
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Question 10, How can increase in foreign direct investment affect the, price of foreign exchange and exports?, (4 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 10, Foreign direct investment (FDI) is a source of supply of, foreign exchange as it brings in foreign exchange into the, country. Supply of foreign exchange will increase in the, market. This situation may result into excess supply of, foreign currency in the economy at the prevailing foreign, exchange rate. As a result, a new equilibrium rate of, foreign exchange will be determined which will be lower, than the prevailing foreign exchange rate, leading to, appreciation of domestic currency. Thus, foreign exchange, rate is likely to fall., Fall in exchange rate means that exports become costlier, HOTS — Analysing, Evaluating & Creating Type Questions
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for the foreign buyers because they will now get less, goods and services for each unit of foreign currency. This, will reduce exports from India., , HOTS — Analysing, Evaluating & Creating Type Questions
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Question 11, According to recent media reports: ‘USA has accused, China of currency devaluation to promote its exports’., In the light of the given media report comment, how, exports can be promoted through the Currency, devaluation?, (CBSE SQP 2019) (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 11, USA has a valid point of argument as devaluation of a, currency encourages exports of a country. As exported, goods become cheaper in the international market, giving a competitive edge for the goods of domestic, country (China)., Devaluation of the value of domestic currency, promotes the exports of the country and may, adversely impact the production and sale of importing, country (USA)., , HOTS — Analysing, Evaluating & Creating Type Questions
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Question 12, Indian investors lend abroad. Answer the following, questions:, (a) In which sub-account and on which side of the, Balance of Payments such lending is recorded?, Give reasons., (b) Explain the impact of this lending on foreign, exchange rate., (4 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 12, (a) Indians lending abroad is recorded in capital account, of the Balance of Payments because it is an, international transaction of assets. It is recorded on, the debit side because it leads to outflow of foreign, exchange., (b) Lending abroad increases demand for foreign exchange., Supply of foreign exchange remaining unchanged, the, exchange rate may rise., , HOTS — Analysing, Evaluating & Creating Type Questions
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Question 13, If USA has higher rate of inflation than in India, US, dollar will be depreciating. Do you agree with the given, statement? Support your answer with an example., (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 13, Yes, the given statement is true., Example: Suppose a shirt costs $10 in the US and ` 700, in India, the rupee-dollar exchange rate should be ` 70/$., Suppose prices in India rise by 20 per cent while prices in, the US rise by 50 per cent. Indian shirts would now cost, `840 per shirt while American shirts cost $15 per shirt., For these two prices to be equivalent, $15 must be, worth `840, or one dollar must be worth ` 56 (840/15)., The dollar, therefore, has depreciated since USA has, higher rate of inflation., HOTS — Analysing, Evaluating & Creating Type Questions
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Question 14, Explain the effect of rise in income at home on the, foreign exchange rate., (4 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 14, When income of people of India increases, consumer, spending increases. Spending on imported goods is also, likely to increase. When imports increase, the demand for, foreign exchange rises. This situation might lead to, excess demand of foreign currency at the prevailing, foreign exchange rate. As a result, a new equilibrium rate, of foreign exchange will be determined which will be, higher than the prevailing foreign exchange rate, leading, to depreciation of domestic currency. Thus, foreign, exchange rate likely to rise., HOTS — Analysing, Evaluating & Creating Type Questions
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Question 15, Explain the impact of rise in exchange rate on national, income., (CBSE 2018) (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 15, A rise in exchange rate, say rupee-dollar exchange rate, rises from `70/$ to `75/$, denotes depreciation of Indian, Currency (rupee). Indian goods will become cheaper to, foreigners because they can now buy more goods with, one unit of foreign currency (dollars). Exports become, cheaper. So, exports will increase., On the contrary, our imports become costlier because, importers have to pay more rupees to buy one unit of, foreign currency worth goods. So, imports will decrease., As a result, net exports (i.e., exports – imports) will, increase. Since net exports is a component of aggregate, HOTS — Analysing, Evaluating & Creating Type Questions
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demand, therefore, aggregate demand will increase [AD =, C + I + G + (X – M)]. Increase in aggregate demand will, increase the national income., , HOTS — Analysing, Evaluating & Creating Type Questions
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Question 16, How does foreign exchange speculation affect the, exchange rate? Explain with an example., (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 16, Foreign exchange rate is affected by foreign exchange, speculation where foreign exchange is demanded for the, possible gains from appreciation of foreign currency., Suppose the investors believe that the Rupee-Dollar, exchange rate is going to rise from `70/$ to `75/$ by the, end of the month. They think if they took `70000 and, bought 1000 dollars, at the end of the month they would, be able to exchange the dollars for `75000, thus making a, profit of `5000. This expectation would increase the, demand for dollars. Supply of foreign exchange remaining, unchanged, increase in demand will cause the exchange, rate to rise in the present., HOTS — Analysing, Evaluating & Creating Type Questions
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Question 17, What is the effect of rise in interest rates at home on the, foreign exchange rate? Explain., (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 17, A rise in interest rates at home will attract foreign, investors to invest in the home country. This will lead to, inflow of more foreign currency (i.e. increase in supply, of foreign exchange)., Demand of the foreign exchange remaining unchanged,, the exchange rate is likely to fall causing appreciation of, the domestic currency and depreciation of the foreign, currency., , HOTS — Analysing, Evaluating & Creating Type Questions
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Question 18, Suppose a shirt costs $10 in the US and `600 in India,, what will be the effect on exports of India if the rupeedollar exchange rate is `70/$?, (3 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 18, At the exchange rate `70/$, it costs `700 per shirt in, the US but only `600 in India. That is, international, competitiveness of shirts reduced in India gets better. In, that case, all foreign customers would buy shirts from, India.Thus, exports of shirts from India will increase., , HOTS — Analysing, Evaluating & Creating Type Questions
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Question 19, Explain the effect of rise in income on the exchange rate., (6 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 19, When income of people of India increases, consumer, spending increases. Spending on imported goods is also, likely to increase. When imports increase, the demand for, foreign exchange rises. Supply of foreign exchange, remaining unchanged, the exchange rate is likely to rise., There is a depreciation of the domestic currency., If there is an increase in income abroad as well, domestic, exports will rise, i.e. more inflow of foreign exchange., Therefore, supply of foreign exchange also increases. On, balance, the domestic currency may or may not, depreciate. What happens will depend on whether exports, HOTS — Analysing, Evaluating & Creating Type Questions
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are growing faster than imports. If exports are growing, faster than imports, domestic currency will appreciate., On the other hand, if imports are growing faster, than, domestic currency will be depreciating., , HOTS — Analysing, Evaluating & Creating Type Questions
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Question 20, Explain the effect of difference in interest rates between, countries on the exchange rate with an example., (6 marks), , HOTS — Analysing, Evaluating & Creating Type Questions
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Answer 20, In the short run, the interest rate differential i.e. the, difference between interest rates between countries is, an important factor in determining exchange rate, movements. For example, if government bonds in, country A pay 8 per cent rate of interest whereas, equally safe bonds in county B yield 10 per cent, the, interest rate differential is 2 per cent. Investors from, country A will be attracted by the higher interest rates, in country B and will buy the currency of country B, selling their own currency. At the same time investors, in country B will also find investing in their own country, HOTS — Analysing, Evaluating & Creating Type Questions
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more attractive and will therefore demand less of country, A’s currency. This means that the demand for country A’s, currency will decrease and the supply will increase causing, a depreciation of country A’s currency and an appreciation, of country B’s currency. Thus, a rise in the interest rates at, home often leads to an appreciation of the domestic, currency, other things remaining the same, e.g. no, restrictions exist in buying bonds issued by foreign, governments., , HOTS — Analysing, Evaluating & Creating Type Questions
