A to Z Commerce Classes

Mobile No. 9826535703

Chapter - 1

Some Basic concepts of Macro Economics or Circular flow income

Dr. Ajay Vishwakarma

 Meaning of Economy
A system provides people, the means to work and earn a living. All organisations like factories, shops,
offices, business enterprises, transporters etc., who are involved undertaking three economic
activities, Production, Consumption and Capital formation(Investment) are collectively called an
economy.
• Definition of Micro-Economics:- It studies the behavior of individual economic, agents, units
like- wages of labour in a mill.

• Definition of Macro-economics:- It studies the whole economic condition of a country and

Macroeconomics is that part of economic theory which studies the behavior of aggregates of
the
economy as a whole. Difference between Macro and Micro Economics
Basis Micro-economics Macro-economics
Meaning Micro-economics is that part of economic Macro-economics is that part of
theory which studies the behaviour of economic theory which studies the
individual units of an economy. behaviour of aggregates of the
economy as a whole.
Tools The tools of micro-economics are demand The tools of macro-economics are
and supply. aggregate demand and aggregate
supply.
Basic-objects It aims to determine price of a commodity or It aims to determine income and
factor of production. employment level of the economy.
Example Individual income, individual output etc. National income, National output etc.
 Some Basic concepts of Macro Economics or Circular flow income
Meaning of circular flow:- Circular flow of goods means the flow of goods and services or
the flow of money across different sectors of an economy.

Types of Circular Flow:

1. Product Flow/ Real Flow:- It is the flow of product & service across different sectors.
2. Income/Money Flow:- It is the flow of money across different sectors.

Closed Economy

• Circular flow of Income in a One Sector Economy:

• Real Flow

Land, Labour, Capital, and Entrepreneur

Household Business

Services and Commodities

• Money Flow

Rent, Wages, Interest, and Profit

Household Business

Monetary Payment for Goods and Services

• Circular flow of Income in a Two Sector Economy:

Factor Services (Land, Labour, Capital, Entrepreneur)

Factor Income (Rent, Wages, Interest, and Profit)

Household Business

Monetary Payment for Goods and Services

Services and Commodities

(I) Features of House Hold:-
• They owner of all production factors
• Their total income includes wages, rent Interest & profit.
• They household sector provides factors services.

(II) Features of Business Sector:-

• Firm sector utilizes those services
• They payment for factor services.

• Circular flow of Income in a two sector Economy with Financial Services

Factor Services (Land, Labour, Capital, Entrepreneur)

Factor Income (Rent, Wages, Interest, and Profit)

Saving Saving
Household Loan Receive Financial Market Loan Receive
Business

Monetary Payment for Goods and Services

Services and Commodities

• Circular flow of Income in a Three-sector Economy

Wages, Salary, Transfer Payments Govt. Purchase + Subsidies

Government Sector
Saving
Direct Tax Loan Receive
Direct Tax and Indirect Tax

Factor Services (Land, Labour, Capital, Entrepreneur)

Factor Income (Rent, Wages, Interest, and Profit)

Household Saving Financial Market Saving Business

Loan Receive Loan Receive

Monetary Payment for Goods and

Services Services and

Commodities
• Circular flow of Income in a Four -sector Economy

Wages, Salary, Transfer Payments Govt. Purchase + Subsidies

Government Sector
Direct Tax Saving
Loan Receive
Direct Tax and Indirect Tax

Factor Services (Land, Labour, Capital, Entrepreneur)

Factor Income (Rent, Wages, Interest, and Profit)

Household Saving Financial Market Saving Business

Loan Receive Loan Receive

Monetary Payment for Goods and

Services Services and

Commodities

Net transfer payments External Sector Export and Import

 The Concept of Injections and leakages
A. Injections:- Governments spending investment export are important injections into the circular
flow. Increase in these variables raise the level economic activity in the economy of circular flow.

B. Leakage:- Savings, taxes, and imports are the important withdrawals from the circular flow.
Increase in these variables reduces the level of economic activity in the economy of circular flow.
Basic concept of National Income

1. A closed economy:- A country which has no economic relations with other countries is termed as
a closed economy in economics.
2. An open economy: An economy which has economic relations with other countries of the world
is termed as an open economy.
Gross National Product (GNP) = Gross Domestic Product (GDP) + Net factor income from abroad (NFIA)

Features of Closed Economy

• A closed economy has no import or export.
• In closed economy, we can understand the inter relationship between production,
consumption and capital formation in a better way.
• In the world of closed economy there is no place of international specialization and
international trade.
Features of Open economy
• Selling and purchasing of Goods and services in the world market.
• Selling and purchasing of shares in the foreign marked
• People coming and going for work in other countries.
 Difference between Open Economy and Closed Economy
Difference Open Economy Closed Economy
Meaning An economy having economic This economy has no economic
relation with other countries is called relation with other economics
open economy
GDP and GNP Gross Domestic Product and Gross Gross Domestic Product and Gross
National Product may be different. National Product are same.
Realistic concept The concept of open economy is a It is not a realistic concept. It is
realistic concept imaginary these days.

Domestic Territory:- In Gross Domestic product we include only the goods and
services produced in a domestic territory of a country.
• Political frontiers of a country including its territorial waters.
• Ships and aircraft operated by the residents of the country between two or
more countries.
For Example - Air India services.
• Finishing vessels, oil and Natural gas, rigs(Commodities), operated by the
residents of the country in the international water.
 Normal Resident of a Country
National Income is said to be the total of all the incomes of the normal residents of a country.
A normal resident of a country can be defined as a person who ordinarily resides in a country and
whose Centre of interest also lies in that country.

Summarized presentation of Normal Residents and Non-residents of India

S.No. Normal Resident of India Non-Resident of India
1 Indian working in foreign embassies and High Foreigners working in India embassies in
commission. foreign countries.
2 Indian ambassador working in foreign Ambassadors of foreign countries
countries. working in India.
3 Indian working in the institutions of United Foreigners working in the institutions of
Nations Organization (UNO), such as UNO, ILO,IMF in India.
International Labour Organization(ILO) and
international Monetary fund(IMF) In India

Stock
Stock means that quantity of an economic variable which is measured at a particular point of time.

Flow
Flow is that quantity of an economic variable which is measured during the period of time.
 Distinguish between stock and flow
Basis Stock Flow
Meaning Stock means that quantity of an Flow is that quantity of an economic
economic variable which is measured variable which is measured during the
at a particular point of time. period of time.
Time dimension Stock has no time dimension Flow has time dimension like per
hour, per day, per month.
Concept Stock is a static concept Flow is a dynamic concept
Example Wealth Investment.
National Income
The sum of income of Normal residents of a country during the year is termed as national
income.
In other word- National income is defined as the money value of all final goods and services
produced within the domestic territory of a country in an accounting year plus net factor income
from abroad.

Monetary National Income and Real National Income:- National Income at current prices is
termed as monetary national income. In this case goods and services produced during the year in
the country are valued at the prevailing price of the year. Monetary National Income is generally
more than the real National Income because constant increase in prices is the common feature of
the modern economy.
1. Real National Income or National Income at Constant Price

National Income at current price

× 100
Index Number of the current year

2. Per capital Income:- Per Capital means average per person so per capital
income is the average income of the people of the country during the year.

Per Capital Income = National Income

Population

3. Real per Capital Income:- Per Capital Income in terms of Real product
and services is known as real per capita income.

Real Per Capital Income = National Incomeof constant price

Population
 Difference between National Income and National Income Accounting
Basis National Income National Income Accounting
Meaning National Income is the sum total of the National income accounting is the method of
income of all the individuals of the country measuring National income

Measure It is the measurement of the total National income accounting measures the
factor income changes taking place among various
economic activities.

Tools National income is measured through national National income accounting is the tool
income accounting to measure national income.
 Important/uses of National Income and Accounting
1. Indicator of the Economic performance:- National Income is the simplest and
most suitable means to know and measure the economic performance of a country.

2. Measurement of economic development:- National income statistic also help

us in measuring the level and direction of economic development and economic
welfare of a country.

3. Distribution of Income:- National Income Calculation provides us information

regarding the distribution of factor income among different factors of
production.

4. Helpful in policy formulations:- the information provided by the National

Income Statistics are very helpful for the formulation of various economic policies
by the government.

5. Useful for labour organization:- Govt. also uses these statistics for formulating
its wage policies.
 Distinguish between money flow and circular /Real flow
Basis Real flow Money Flow
Meaning It is the flow of goods and services It is the flow of money between firms
between firms and households and households

Kind of exchange It involves exchanges of goods and It involves exchange of money

services
Difficulty in There may be difficulties of barter There is no such difficulty in case of
exchange system in exchange of goods and money flow.
services

Types of Goods Product in the Economy

1. Final Goods:- Final goods refer to those goods which are used either for consumption or
for investment. In other word final goods are those goods which are ready for sale or cannot
be
manufactured further. It is major part of producers’ income which includes cost of intermediate
goods and cost of Capital consumption.

2. Intermediate Goods:- Intermediate goods are those goods and services which are used in
the production process. It is major part of cost of production, therefore deducted from value of
output to calculated value added. Such goods are not ready for consumption, therefore, can be
manufactured further.
 Difference between Intermediate Goods and Final Goods
Basis Intermediate goods Final goods
Use Intermediate goods are used for Final goods are used for final
producing other goods. So value is added consumption and final investment.
to these goods So,
no value is added to these goods.
Demand These goods have derived demand These goods have direct demand.
Value The value of these goods is not included The value of these goods is include in
while calculating national income national income
Production These goods remain within the These goods cross the production
production boundary boundary.

Consumer Goods or Consumption goods

1. Durable goods:- Goods which are of relatively high value and have an expected life time
of several years are durable goods for Example - Car, T.V.

2. Semi Durable:- These goods have an expected life time of about one year or
slightly more. For Example - clothing, shoes, crockery.

3. Non-durable goods:- It includes wheat, Milk, fruit, vegetables, oils, soap, cigarettes.
4. Services:- It includes services of a Teacher, Doctor, Advocates, Barber.
 Capital Goods
Goods which are used in the process of production for many years and which are high value.
Example - Plant & Machine.
Investment
Investment refers to addition stock of capital a period.

There are two types of stock

1. Fixed investment:- Stock of Assets in end of year – Stock of Assets in beginning of year.

2. Inventory Investment:- Stock of goods in end of year – stock of goods in beginning of year.

Net Investment = Gross Investment – Depreciation

• Phases/Stages of circular flow of income

Production or Output of goods and services

Expenditure Income
(Consumption and Investment) (Rent, wages, Profit)
1. Production Phase:- Production unit assemble human factor of production and
produce goods and services and payment to factors of production is made for their
contribution in the production Example - Rent, wages.

2. Income Phase:- They get rewarded in the form of Rent, Wages, Interest

3. Expenditure phase:- We have got unlimited wants. In order to satisfy these wants we
spend our factor income and purchase goods and services.
Domestic Product

The money value of all goods and services produced in a year within the domestic territory
of a country.
National Product
The value of goods and services produced within the country or outside a country is called a
National Product.

Net Product = Domestic Product + Net Factor Income from abroad (NFIA)

Net Factor Income from abroad (NFIA):- NFIA is the difference between factor income
(Rent, Interest, Profit and wages) earned by our resident from the rest of the world and
factor income earned by non-resident within a country.
NFIA = Factor Income earned by our Resident – Facto income earned by non-residents
 A to Z Commerce Classes
Mobile No. 9826535703

Chapter - 2

National Income Accounting- Concepts and Measurement

Dr. Ajay Vishwakarma

 Methods of Measuring National Income
1. Value added / product/output Method:- Product Method is an attempt to measure
National Income on the basis of contribution made by all the producing enterprises in the
domestic territory of the country within the accounting year. The money value of these
goods and services product in the economy during the year is termed as GDP (Gross
Domestic Product).

• Gross National Product at Market price (GNP at MP) :- Value of goods and
services produced cost of material and intermediate cost.

Gross GNP at Factor Cost:- GNP at Market Price – Indirect Tax + subsidies.

Value of Output
Industry Commodity Output Price Value of Output(`)
A Wheat 1000 quintal 200 2,00,000
B Cloth 20000 metres 7 1,40,000
C Transistors 1000 120 120000
Total 460000
Value Added: - Sale proceeds of Goods & Services = …….
(+) Value of export = ……..
(-) Cost of goods = ………
(-) Value of imports = ………
Or
Value added:- Sale proceeds of goods and services (Including export) – Price of
intermediate goods (including import)
Or
Value added = Net Sale + change in stock – Intermediate goods (Raw materials, Net
purchase, power and other inputs)

Note: Change in stock = Closing stock – opening stock

Example:

Firm (Sale Price) Value of Output Intermediate goods Or Purchase Value added
X 1,000 - 1,000
Y 1,500 1,000 500
Z 3,000 1,500 1,500
 Distinction between value of output, value added and value of income generated
Basis Value of Output Value added Value of income
(Sale) (Profit) generated
(Profit – tax = NP)
Meaning It is the monetary value of all It is addition to the total It is the value of income
the goods and services value of goods at earned the factors of
produced during the different stages product in the form of
accounting year in the wages, rent, interest
economy and profit during the
accounting year.
Calculation It is calculated by multiplying It is excess of sale price of It is calculated by totaling
the units of goods produced goods over the cost of the factor income earned
with their respective price. the goods by wages, interest, rent
&
profit.
Concept It is broader concepts which It is a narrow concept as It is also narrower concept.
include both the value of compared to value of In other words it is value
intermediate as well as final output. In other words it is added less(net) indirect tax
goods. value of output less in
intermediate goods
 Important Formula

1. Value of output = Sale + Change in stock

OR
Intermediate Cost + wages & salary + Rent +interest + Profit +Net indirect tax + DEP

2. Net Indirect Tax = Total Indirect Tax – Subsidies

3. GDPMP or GVAMP = Value of output – Intermediate cost

4. Intermediate cost = (Raw material or Purchase of goods and services)

4. NDPMP or NVAMP = GDPMP or GVAMP – Depreciation

5. NDPFC or NVAFC (Domestic income)= NDPMP or NVAMP – Net Indirect tax

6. NNPFC or NI (National income) = NDPFC or NVAFC + Net factor Income from abroad

7. Net factor Income from abroad (NFIA) = Income from Abroad – Payment to abroad
1. Calculation of National Income by value Added Method

Value of Output
(-) Intermediate Consumption (Purchase of goods and services)
Gross Domestic Product at Market Price
(GDPMP) Or
Gross Value Added at Market Price (GVAMP)
(-) Depreciation (Consumption of fixed capital)
Net Domestic Product at Market Price
(NDPMP) Or
Net Value Added at Market Price (NVAMP)
(-) Net Indirect Tax (Total Indirect Tax -Subsidies)

Net Domestic Product at Factor Price

(NDPFC) Or
Net Value Added at Factor Price (NVAFC) = Domestic Income

(+) Net Factor Income from Abroad

Net National Product at Factor Cost Or National

(NFIA) Income
 2. Income Method or Distributed Share Method or factor Income Method

National income according to this method is the sum total of income

earned by all the factors of production.

Factor Income:- As we know that National Income is the sum of all factor
income .Factor income is the reward of services rendered in different
forms either forms either under domestic territory or beyond domestic
territory.

Domestic factor income:- Income generated by all the production units

within the Domestic territory of the country is termed as Domestic factor
income.
 Classification of factor income
A. Compensation of employees
S.No Compensation in cash Compensation in kind Employer’s contribution towards
Social Security.
1 Basic pay Rent free accommodation Contributory provident fund
2 Dearness allowance/ Interim Medical facilities Family allowance
relief
3 House rent allowance Educational facilities Private pension
4 City compensatory allowance Free fooding & lodging Contribution towards life insurance
5 Bonus /commission Free supply of water & electricity Contribution towards other social
security schemes.
6 Leave travel commission Conveyance facilities ------
7 Sick leave allowance ------- ------

Note:- Item to be excluded from the compensation of employees.

• Travelling, stay in hotel and other business exp. incurred by employees
and reimbursable by employer
• Pay and allowance of a armed forces and police personnel.
• Loans advanced to employees
• Compensation received by injured employee from insurance.
 B. Operating Surplus
Operating Surplus
Income from Property Income from Entrepreneur
 Rent  Dividend
 Interest  Corporation Tax
 Royalty  Undistributed Profit
 Patent, Copyright and Trademark

C. Mixed income of self-employed

Income of self-employed is known as mixed income. In other words, mixed income is the
total of wage and non-wage income. Non-wage income means income from property. In
certain case it is very difficult to distinguish between income from work and income from
property. For example: a sole trader is both an employee of this firm and also the owner of
the firm. As an employee he should get wages and as an owner he will receive profit. It is
quite difficult to separate his wage income from the non-wage income. This is why it is
mixed income.

Net Factor income from Abroad (NFIA)

• Wage income of Indian workers working abroad
• Rent earned by Indian national for the property owned by them abroad
• Profit earned by Indian from there, ventures established
• Dividend earned.
 2. Calculation of National Income by Income Method

Compensation of Employee
(+)

Rent
(+)

Interest
(+)

Royalty/ Copyright
(+)

Profit
(+)

Mixed Income = NDPFC (GDPMP –Depreciation - NIT)

National Income at Factor Cost = Domestic income (NDPFC) + Net factor income from
abroad at factor cost (NFIA)
Note:- Precautions involved in estimating National income by Income Method:
• Transfer payment
• Illegal income
• Income from the sale of second hand goods or capital gains
• Corporation Tax and Income Tax.
• Indirect Taxes
• Free services provided by the owners of the production units.
• Wind fall gain.
• Wages and salaries in cash and in kind
• Production for self-consumption
• Imputed rent of owner occupied house
• Death duties, gift tax, wealth tax etc.

Example:- Rs
Compensation of employee : 2000/-
Rent : 20/-
Interest : 30/-
Royalty : 40/-
Profit : 50/-
Mixed income : 1000/-
NFIA : -3
Indirect tax : 500/-
Subsidies : 400/-
Depreciation : 260/-
 Non-Factor Income- Transfer payment
Transfer Payment:- Payments received by households, production units and non-profit
making institute from government and other sources without rendering any services are
known as transfer payment. Transfer incomes are received by households and production
units from the government. Example: Donation, Pension, Tax, Scholarship.
In other word – Payment made by Government to household and non-profit Organisation
without any promises to supply goods and services are called Transfer Payments.

Classification of Transfer Payment

1. Current Transfer:- Transfer made from current income of the payer and added to
current income of recipient for consumption expenditure is called current transfer .
For example: Scholarship, Gifts, prizes, unemployment, allowance, direct tax,
subsidies, donation, int. or public debt etc.

2. Capital Transfer:- Capital transfer are transfers in cash and in kind for the purpose of
gross capital formation or other forms of accumulation or long term expenditure made
out of wealth or saving of the donor. Capital transfers within the country involve
transfers from government households to enterprises and households and enterprises to
Government. For example: development grant, subsidies, death duties, capital transfer
between two countries, war damages.
 3. Expenditure / Income disposal/consumption & investment method
Final expenditure method is an attempt to measure national income on the basis of final
expenditure on gross domestic product at market price during the accounting year.
Y = C +I + G + E

 Y = National Income
 C = Private consumption expenditure
 I = Private investment expenditure
 G = Govt. expenditure on consumption and investment
 E = Net income earned from abroad

Classification of final expenditure

1. Final consumption expenditure of general government

……
Current expenditure on good and services incurred in providing Services of
government administrative department ……
……
(-) Sale of goods and services
(+) Direct purchase of goods and services made abroad by the government, on current
account
……..
Final consumption expenditure of the Govt.
2. Private Final expenditure
Value of final expenditure of household and private, non- profit institutions on ……
current goods and services
(-) Net sales of second hand goods and scrap ……
(+) Value of gifts in kind (Net) received from the rest of world ……

Private Final expenditure ……..

3. Gross domestic capital formation :- Means gross capital formation in a domestic territory of
a country. It has two constituents’ Gross domestic fixed capital formation and change in stocks.

A. Classification of Gross domestic fixed capital formation:-

Purchase of New Assets in the domestic ……

market (+) Own account production of new ……
assets ……
(+) Import of new assets ……
(+) Net Purchase of Second hand physical Assets from Aboard
Gross domestic fixed capital formation ……..

Note:- Net domestic fixed capital formation = Gross domestic fixed capital formation – Consumption
of fixed capital (DEP).
 B. Change in stock:- Change in the stocks includes of following.
• Change in the stocks of raw materials and inventories (Semi-finished and finished goods)
with producer enterprises
• Change in stocks of strategic materials, such as food grains, sugar, edible oils etc. with the govt.
• Livestock raised for slaughter by the enterprises.
Change in stock is obtained by deducting the opening of the stock from the closing stock of
goods and services of the year.

Net Exports of goods and services:- Net exports = Export – Import

Precautions in ascertaining final expenditure:-

• Expenditure on the second hand goods should not be included
• Expenditure on shares, debenture bonds, and securities
• Transfer payment (Expenses) by the govt. should not be including. These payments
include government expenditure on pension, scholarship, unemployment allowances.
• Expenditure on final goods and services only should be including. In other work expenditure
on raw materials and intermediate goods should not be include
• Expenditure on intermediate goods
• Domestic income according to this method is called Expenditure on domestic product.
• It should be noted that according to this method national incomes is obtained at
market price. In order to calculate national income at factor cost net indirect taxes
should be subtracted.
• In order to calculate national product depreciation should be deducted.
3. Calculation of National income by Expenditure Method

Private final Consumption

(+)

Government final Consumption Expenses

(+)

Gross* fixed Capital Formation

(+)

Change in Stock
(+)
= GDPMP
Net Export = Export - Import
(-)

Net Indirect Tax

(-)

Depreciation
(+)

Net factor income from abroad (NFIA)

(=)

National Income
1. For example:-

Calculate National income

Private consumption expenditure = 1,50,000
Govt. consumption expenditure = 1,15,000
Gross fixed capital formation = 1,10,000
Increase in stocks = 12,000
Exports of goods and services = 15,000
Import goods and services = 17,000
Net indirect taxes = 16,500
A to Z Commerce Classes
Mobile No. 9826535703

Chapter - 3

National Income and Related Aggregates

Dr. Ajay Vishwakarma

We shall discuss the following concepts of National Income in this unit

1. Gross Domestic product at market price (GDPMP)

2. Net Domestic product at Market price (NDPMP)
3. Gross National Product at market price (GNPMP)
4. Net National product at Market price (NNPMP)
5. Gross Domestic product at factor cost GDPFC)
6. Net Domestic product at factor cost (NDPFC)
7. Gross National product at factor cost (GNPFC)
8. Net National Product at factor cost (NNPFC)

1. Gross Domestic product at market price (GDPMP):- Gross domestic product is the market value
of the final goods and services produced during a year within the domestic territory of a country. It
includes the value of Depreciation or consumption of fixed capital.

2. Net Domestic product at Market price (NDPMP):-

NDPMP is the market value of the final goods and services produced within the domestic territory of a
country. Exclusive of depreciation.
NDPMP = GDPMP – Depreciation

3. Gross National Product at market price (GNPMP):- Gross National Product at market price is the
market value of the final goods and serivces produced in the economy adjusted for net factor
income from abroad.
GNPMP = GDPMP + Net factor income from abroad
4. Net National product at Market price (NNPMP):- Net National product at
Market price is the market value of the final goods and services produced in the
economy during an accounting year. Exclusive of depreciation and adjusted for
net factor income from abroad.
NNPMP = GDPMP – Depreciation + Net factor income from abroad
Or
NNPMP = GNPMP – Depreciation

5. Gross Domestic product at factor cost (GDPFC):- Gross domestic product at

factor cost is the sum total of factor incomes (Rent + Profit + Wages + Interest)
generated within the domestic territory of a country, along with consumption of
fixed Capital (DEP) during a year.

GDPFC = NDPFC + Depreciation

6. Net Domestic product at factor cost (NDP FC):- Net Domestic product /Income is
the sum total of factor incomes (Rent + Profit + Wages + Interest) generated
within the domestic territory of a country during a year

NDPFC = GDPFC – Depreciation

7. Gross National product at factor cost (GNPFC):- Gross National product at
factor cost is the sum total of factor incomes earned by normal residents of a
country inclusive of depreciation during a accounting year.

GDPFC = NNPFC – Depreciation

8. Net National Product at factor cost (NNPFC):- Net National Product at factor cost
is the sum total of factor incomes (rent + interest + profit + wages) earned by
normal residents of a country during the period of an accounting year.

NNPFC = NDPFC + Net Factor income from

abroad Or
NNPFC = GNPFC – Depreciation
Or
NNPFC = NNPMP – Net indirect tax
 Nominal (Monetary) and Real GDP)
There are two well-known aspects of national income / domestic income.
1. Nominal (Monetary) national income (National income) at current prices
2. Real national income (National income at constant prices)

1. Monetary national income ( National income/domestic income) at current prices:- National

income at current price (also called monetary income or nominal income) refers to market value of
the final goods and services produced in the economy during an accounting year, as estimated using
the current year prices. It may increase without any increase in the quantum of output in the
economy.

Y=QXP
Y = Current price of national income
Year Commodity Quantity Price Production or income at
maintenance
2000-01 Wheat 20 ton 100/- 2000/-
Cloth 100 mtr 5/- 500/-
Sugar 5 ton 500/- 2500/-
Total Market price 5000/-
2010-11 Wheat 20 ton 1000/- 2000/-
Cloth 100 mtr 20/- 2000/-
Sugar 5 ton 1600/- 8000/-
Total Market price 30000/-
2. Real National Income (National Income/domestic income) at Constant price:- National
income at constant prices (also called Real National Income) refers to market value of the final
goods and services produced in the economy during an accounting year as estimated using
the base year prices. It increases only when there is increase in the quantum of output in the
economy.
Y= Q x P
Y = constant price on national income
Year Commodity Quantity Price Production or income at
market price
2000-01 Wheat 20 ton 100/- 2000/-
Cloth 100 mtr 5/- 500/-
Sugar 5 ton 500/- 2500/-
Total Market price 5000/-
2010-11 Wheat 30 ton 100/- 3000/-
Cloth 200 mtr 5/- 1000/-
Sugar 10 ton 500/- 5000/-
Total Market price 9000/-
Note: Real National Income or National Income at constant prices =

National Income at current prices x 100

Current price Index
A to Z Commerce Classes
Mobile No. 9826535703

Chapter - 4

Money and Supply of money

Dr. Ajay Vishwakarma

 Meaning of Money
Money is something which is generally accepted as a medium of exchange, a measure of value, a store
of value and a standard of deferred payments.
In the words of Walker:- “Money is what money does”

Barter System
In the primitive stages of economic development, human needs were very limited. The market
transactions were limited to the extent of mutual exchange of goods between two or more individuals.
This is barter. Barter means exchange of goods for goods. An economy where there is barter of goods
and services is called as C-C Economy. *“C-C means “Commodity to Commodity”]

Limitations/Problems of Barter system

1. Difficulty of Double coincidence of wants:- Double coincidence of wants implies that goods
in possession of two different individuals are needed by each other.

2. Lack of a common unit of value:- Evaluation of money offered by a system of accounting.

3. Lack of a system for future payments or contractual:- Contractual payments or future payments
would certainly be very difficult under baster system of exchange. Evolution of money was to
facilitate contractual payments.

4. Lack of system for storage and transfer of value:- You tend to save a part of your present
earnings. You save for investment as well as your future security. Because of lack of money in the C-C
economy.
 Forms of money

1. Fiat Money and Fiduciary Money:-

A. Fiat Money:- Fiat money refers to money by order/authority of

the government. It includes notes and coins.

B. Fiduciary Money:- fiduciary money refers to money booked up by

trust between the payer and the payee. Eg. Cheques.

2. Full bodied Money and Credit Money:

A. Full bodied Money:- refers to money in terms of coins whose

commodity value is equal to the money value as and when these are
issued.

B. Credit Money: refers to that money of which money value is more

than commodity value.
 Functions of Money

1. Primary or Main functions:-

A. Medium of Exchange:- It means that money acts as a medium for the sale
and purchase of goods and services.

B. Measure of value:- Money serves as a measure of value in terms of unit of

account. Unit of account means that the value of each goods or services is measured
in the monetary unit.

2. Secondary or subsidiary functions:-

A. Standard of differed payments:- Differed payments refers to those payments

which are made sometimes in the future.

B. Store of value:- Store of value implies stores of wealth. Storing wealth has
become considerably easy with the introduction of money.

C. Transfer of value:- Money also serves as a convenient mode of transfer of value.

 Supply of Money
Supply of money is a stock concept. It refers to total stock of money held by the people of a country at
point of time. Supply of money includes only that stock of money which held by people, other than the
suppliers of money themselves.

Measurement of Money supply:- In India there are four alternative measures of money supply
popularly known as M1, M2, M3 and M4

1. M1 (Measurement)
M1 = C + DD + OD
Here
• C = It refers to currency and includes coins and paper notes held by the public.
• DD = It refers to demand deposits of the people with the commercial bank.
• OD =
• Demand deposits with RBI of public financial institutions like IDBI (Industrial Development
Bank of India)
• Demand deposits with RBI of foreign central banks and of the foreign government.
• Demand deposits of international financial institutions like IMF and World Bank,
International Bank for Reconstruction and Development (IBRD).

2. M2 (Measurements):- It is a broader concept at the supply of money compared to M1. Besides

all the components M1. It also includes savings of the people with the post offices.

M2 = M1 + deposits with post office saving Bank A/c

3. M3 (Measurement):- M3 is also a broader concept of money supply M1. It
includes net limited deposit or fixed deposits of the people with the commercial
banks.

M3 = M1 + Net time/fixed deposit with commercial bank

4. M4 (measurement):- M4 concept of money supply is still broader. It is

broader than even M3. Besides the components of M3. It also includes
total deposits with the post offices (other than in the form of national
saving certificate)

M4 = M3 + total deposits with post offices (Other than in the form of national
saving certificate NSC)

OD does not include:-

• Deposited of the government of the country with RBI.
• Deposited of the country’s banking system with RBI.
 Who supplies Money?
In the modern times, the sources of supply of money are Government, central bank of the country and
commercial banks. In India, it is ministry of finance that issues one rupee note and all the coins, money
is mainly supplied by Reserve Bank of India, which is the Central Bank of the country. RBI issues
currency on the basis of minimum reserve system. Under this system Reserve Banks has to maintain
a minimum reserve of 200 crore in the form of gold and foreign securities of this reserve value of the
god must be 115 crore.
Factors affecting money supply
1. Central Bank:- Central Bank is responsible to issue currency notes in the country so it may
increase or decrease supply of money.

2. Commercial bank:- If commercial bank keep more amount within the bank the supply money will be
less and vice-versa.

3. Government: - Government decrease money supply with the increase in public revenue changed
in the form of taxes under its fiscal policy on the other hand if govt. increases its expenditure by
providing more salary to its employees the money supply will increase.

4. Volume of trade:- An increase in the volume of trade necessitates a large supply of money and
vice- versa.

5. Balance of Payment:- the changes in the foreign assets also changes the money supply. The
foreign exchanges are available in the country to pay for imports. This will increase the money supply
in the country.
 A to Z Commerce Classes
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Chapter - 5

Banking Commercial banks and the central Bank

Dr. Ajay Vishwakarma

 Commercial Bank
According to India Banking companies Act. 1949, “Banking company is one which
transacts the business of banking which means the accepting (for the purpose of
lending or investment) of deposits of money from the public repayable on demand
or otherwise and withdrawal by cheque, draft, order or otherwise”.

Primary functions of commercial banks

1. Accepting deposits:- A bank accepts deposits from the public. People can
deposit their cash balance as chequeable deposits or non chequable deposits.
Chequable deposits are those against which cheques can be issued (and
therefore money can be withdrawn) any time. Non chequeable deposits are
those against which cheques cannot be issued (and therefore money cannot be
withdrawn) anytime.
 Current deposit
 Fixed deposit
 Saving a/c deposit
 Recurring Account.
2. Advancing loan:- Another primary function of the commercial Banks is to
advance loans. Bank advances loan mostly for productive purposes, against some
approved security. The amount of loan is generally less than the value of the
security.

Note:- A financial institution is not a banking institution if it does not perform the
two primary functions.

1. Accepting Chequeable deposits

2. Making advance

• LIC is a financial institution but not a bank as it offers loans but does not accept
chequeable deposits from the people.
• Post offices are not banks, even though they accept deposits from the
people. Because they do not offer loans.
 Credit creation by the commercial Banking system [CRR + SLR + Loan]
Cash Reserve Ratio (CRR):-Every commercial bank under law has to deposit with central bank a
minimum percentage of its demand and its deposits. This percentage is called as CRR.A high CRR
means more reserves and less loans. By changing CRR, central Bank controls the lending capacity
and
credit availability of banks.
Deposit Creation by Commercial Bank
Process Deposit (Rs.) Loan Cash reserve CRR= 0.2 or 20%
Initial 100 80 20
Round-I 80 64 16
Round-II 64 51.20 12.80
- - - -
- - - -
Total 500* 400 100

Note:- 𝐈𝐧𝐭𝐢𝐚𝐥 𝐃𝐞𝐩𝐨𝐬𝐢𝐭 = 𝟏

𝑪𝑹𝑹
𝟏
𝐈𝐧𝐭𝐢𝐚𝐥 𝐃𝐞𝐩𝐨𝐬𝐢𝐭 = = 500*
𝟎.𝟐

3. Transfer of funds:- commercial banks are also able to transfer funds of a customer to
other customer account through the cheques, draft, credit, cash, cash order etc.

4. Agency functions:- In modern time, commercial bank also act as an agent of the customer. They
accept subscription for shares from various shareholders and on behalf of their respective company.
 Central Bank
Central Bank is the apex bank that controls the entire the entire banking system of
a country. It is the sole agency of note issuing in a country. It serves as a banker to
the government and control the supply of money in the country. In India Reserve
Bank, in England Bank of England and in America Federal Reserve System operate
as central banks. Although the first central bank in the world was set up in 1668 in
Sweden. Samuelson:- every central bank has one function. It operates to control
economy supply of money and credit.
Functions of the Central Bank

1. Issuing of notes:- Central bank of a country has the exclusive right

(monopoly right) of issuing notes.

2. Banker to the government:- Central bank is a banker, agent and financial

advisor to the government. As a banker to the government it manages accounts of
the government banks across all in the country. As an agent to the government it
buys and sells securities.
3. Banker’s Bank:- It is an apex bank of all the banks in the country.

4. Supervision of the banks:- As a banker’s Bank, the Central Bank also

supervises the commercial Banks like Licensing, expansion of Branches
of commercial banks.

5. Control of credit:- The most important function of the Central Bank is to

control the supply of credit in the economy. It implies increase or decrease
in the supply of money by regulating the creation of credit by the
commercial Banks.

6. Collection of statistics:- Central Bank collects statistics information

relating to banking, currency and foreign exchange.
How does the Central Bank control flow of credit (Money Supply) in the
economy?
Or
What are the principal instruments of monetary policy of the Central Bank?

Principal instruments of monetary policy or credit control of the Central Bank of

a country are broadly classified as.
A. Quantitative instrument
B. Qualitative instrument

A. Quantitative Instruments

1. Bank rate:- The Bank rate is the rate at which the central bank gives credit
to the commercial Banks. The increase or decrease in bank rate is often
followed by increase or decrease in market rate of interest. Accordingly the
cost of credit (Cost of Capital) changes in the market. During inflation the cost
of capital is increased by increasing the bank rate. Thus reduces the flow of
credit on the other hand during deflation the cost of capital is reduced by
reducing the bank rate. This increase the flow of credit.
2. Open market operations:- open market operations refers to the sale and
purchase of securities in the open market by the central Bank. By selling the
securities like National saving certificates (NSC), the Central bank withdraws
cash balances from the economy. And by buying the security the central
Bank adds to cash balance in the economy.
Cash balances are high powered money on the basis of which
commercial banks create credit. Thus
• if cash balances are increased, flow of cost of credit will be increased by
a multiplier effect.
• Likewise-if cash balances are reduced the flow of credit will decrease by
a multiplier effect.

3. Cash Reserve Ratio (CRR):- It refers to the minimum percentage of a

bank’s total deposits required to be kept with central bank.

4. Statutory liquidity ratio (SLR):- Every bank is required to maintain a

fixed percentage of its assets in the form of cash or other liquid assets
called SLR.
B. Qualitative Instrument

1. Margin requirement:- The margin requirement of loan refers to the difference between the
current value of the security offered for loans and the value of loans granted. Suppose a person
mortgage an article worth Rs 1000 with the bank and the bank gives him loan of Rs.800. the margin
requirement in this case would be 200 percent.

2. Rationing of credit:- Rationing of credit refers to fixation of credit quota for different business
activities. The Central Bank fixes credit quota for different business activities. The commercial
banks cannot exceed the quota limits while granting loans.

3. Direct action:- The Central bank may initiate direct action against the member banks in case
these do not comply with its directives. Direct action includes de-recognition of a commercial bank
as a member of the country banking system Central bank.

4. Moral suasion:- The Central Bank makes the member banks agree thought persuasion or pressure
to follow its directives on the flow of credit. The member banks generally do not ignore the advice of
the Central bank. The banks are advised to restrict the flow of credit during inflation and be liberal in
lending during deflation.
 Repo rate:- Refers o the bank rate at which central bank of the country (RBI in India) offers loans
to the commercial banks.
 Reserve Repo rate:- Refers to the rate of interest at which commercial banks can push their surplus
funds with the central bank of the country.
A to Z Commerce Classes
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Chapter - 6
Aggregate demand and its Components

Dr. Ajay Vishwakarma

 Aggregate demand and its Components
AD refers to the sum total of expenditure on the domestically produced goods and services during the
period of an accounting year.
Component of Aggregate demand (4 Sector Economy)
1. Private consumption Expenditure (C) [House hold sector]: It refers to the total expenditure
incurred by the household on the purchase of goods and services during a given period of time. There
is positive relationship between income and consumption. As income rises, consumption also rises
and vice-a-versa.

2. Investment Expenditure (I) Producers sectors:- It is total expenditure by the producing sector for
the investment such as purchase of capital goods, plant, machine etc. it is affected by rate of
interest and Marginal efficiency of capital/ Investment (MEI). There is negative relationship
between rate of interest and investment demand.

3. Government expenditure (G) It is the total expenditure incurred by government on :

• Intermediate consumption of Government Sector.
• Compensation of employees (COE) of Government Sector.
• Imports by Government Sector. Government Expenses is affected by the Government Policy.

4. Net Export (X-M):- It is the difference between exports and imports of goods and services. It
shows the effect of domestic spending on foreign goods and services (M ) and foreign spending on
domestic goods and services (X) on the level of aggregate demand.
AC= C + I + F + (X-M)
A. Relationship of Aggregate demand with price level: There is a negative
relation between them; aggregate demand falls with increase in the
general price level and vice-a-versa.
• The Curves shows negative relation between price and AD.
• A price rises from OP to OP1, AD falls from OQ to OQ1 and vice –versa.
Diagram:-

B. Relationship of Aggregate demand with income level:- There is a positive

relation between them. Aggregate demand increase with rise in Income
level. The curve has positive slope.
• The curve shows positive relation between increase and AD.
• AS income rises from OY to OY1, AD rises from OQ to OQ1 and vice-
versa. Diagram:-
 Components of aggregate demand in a two sector economy (Closed Economy)
In a two sector economy AD has two components.
1. Private Consumption (Household sector)
2. Investment (Producer’s sector)

As two sectors economy comprises (i) house hold sector and (ii) Producers sector, thus
aggregate demand / aggregate exp. in a two sector economy is sum total of consumption
and investment.
Level of Income Consumption(C) Rs Investment (I) Rs. Aggregate Demand (AD)
(Autonomous)
0 50 (Autonomous) 100 150
100 100 100 200
200 150 100 250
300 200 100 300
400 250 100 350
500 300 100 400
Diagram:-
 Consumption function
The amount of money spent by the people on the purchase of goods and services in order to satisfy
their works directly called consumption expenditure. Consumption expenditure mainly depends on
income. It is directly related to the level of income. It increases as income increases.

Consumption function:-Behaviour of C with respect of Y

Y (Income) C (Consumption)
0 30
20 35
40 40
60 45
80 50
100 55
120 60
Diagram:-

Question:-Find consumption ( C) If b = 0.8 and income (Y) is 200 and 𝐂‾ =100

𝐶 = C‾ + bY
C = 100 + 0.8 × 200
= 100 + 160 = 260
Question:- Find C, at given levels of Income given that C‾ = 50 and b = 0.5, Income level in Rs0, 100,
200, 300, 400, 500
 Propensity to consume
1. Average propensity to consume (APC) : The average propensity to consume is the ratio of
consumption expenditure to any particular level of income
C
APC =
Average PropensityYto consume
Income Consumption APC= C/Y
100 80 80/100 = 0.8
200 120 120/200= 0.6

Diagram:-

2. Marginal propensity to consume (MPC):-The marginal propensity to consume is the ratio of change
consume in consumption to a change in income.
MPC = ∆C
∆Y
Marginal Propensity to consume
Income Change Income Consumption Change MPC = ΔC/ ΔY
ΔY consumption ΔC
100 - 80 - -
200 100 120 40 40/100 = 0.4
300 100 150 30 30/100= 0.3

Diagram:-
 Saving Function
Saving is the excess of income over expenditure (consumption) during an accounting year.
S=Y-C
Or
S = - 𝐂‾+ ( 1 - MPC) Y
Or
S = - 𝐂‾ + MPS (Y)

Saving function: Behaviour of S with respect of Y

Income Consumption Saving
0 30 -30
20 35 -15
40 40 0
60 45 15
80 50 30
100 55 45
120 60 60
Diagram:-
 Propensity to Save
1. Average Propensity to Save (APS ):Average propensity to save is the ratio of saving to income.
S
APS =
Y to Save
Average Propensity
Income (Y) Saving (S) APS = S/Y
100 20 20/100 = 0.2
200 80 80/200 = 0.4

Diagram:-

2. Marginal Propensity to Save (MPS):Marginal propensity to save is the ratio of change in saving to
change in income.
MPS = ∆S
∆Y
Marginal Propensity to Save
Income Y Change Income ΔY Saving Change saving ΔS MPS = ΔS/ΔY
100 - 20 - -
200 100 80 60 60/100= 0.6
300 100 150 70 70/100 = 0.7

Diagram:-
 Investment function
Types of Investment
1. Autonomous investment
2. Induced Investment

1. Autonomous Investment:- It is an investment expenditure incurred by the govt.

with a view of promoting the level of aggregate demand in the economy when
aggregate demand (AD) falls short of aggregate supply(AS) (resulting in fall in
prices and consequently a rise in unemployment ) the govt. intends for push up
the level of aggregate demand by way of its autonomous investment.
Diagram:-

2. Induced Investment: All higher levels of income, consumption expenditure

tends to increase. Increased consumption expenditure or the increased level of
demand raises expected profitability of the producers who accordingly are induced
to make greater investment. Thus induced investment is positively related to the
level of income.
Diagram:-
 Marginal efficiency of investment (MEI)

MEI is defined as expected rates of interest of an additional unit of capital goods. In

general the rate on investment and the demand for investment are inversely related
higher rates of interest on investment for investment will be lesser and vice-a-versa.

Investment rate (%) Demand for investment

5 6
10 5
15 4
20 3
25 2
30 1

Diagram:-
A to Z Commerce Classes
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Chapter - 7

Short Run Equilibrium Output

Dr. Ajay Vishwakarma

 Keynes Concept of Income and Employment :

Keynes Concept of Income and Employment : Income and

employment are generally used interchangeably together in
macroeconomics. Income here means national income and
employment means the total employment in the economy as a
whole. According to Kenes concept; if other things remain
constant, higher level of employment should mean higher level of
output and consequently there will be higher level of income. It
indicates that the employment and income have direct positive
relational ship higher employment leads to higher income and
vice- versa
 Concept of Equilibrium output
Equilibrium level of output or Income refers to that level of output /income, where
AD = AS
Where,
AD = C+I AD =AS
AS= C+S C +I = C+S
Or I =S
AS = Y
I =S

(C = Consumption, I = Investment, S = Saving)

Equilibrium level of income/output /employment implies that there is no deficiency in the

economy. What is produced (AS) is demanded (AD) by the economy. Under AD and AS
approach it is assumed that.
1. AD is planned level of various sectors of the economy.
2. As is planned level of aggregate supply. AS is amount of goods and services
which, producers are planning to sell.
3. Equilibrium is achieved when planned expenditure (AD) is equal to planned level
of supply of goods and services(AS or AD).
 Determination of equilibrium by AD and AS approach
Y C S I (Autonomous) AD= C+I AS= C+S
0 50 -50 100 150 0
100 100 0 100 200 100
200 150 50 100 250 200
300 200 100 100 300 300
400 250 150 100 350 400
500 300 200 100 400 500
Before this income level (300) = AD >
AS After this income (300) = AD < AS
Diagram:-

Observations:-
1. AD is (C+I) curve as demand is for consumption and investment in a two sector
or economy.
2. As is total amount of goods and services or national income since income is
consumed and saved that is why it is shown by us.
 Meaning of Ex-Ante Saving and Ex-Ante Investment
1. Ex-Ante saving:- It refers to desired saving or planned saving during the period
on one year. These are the saving which people intend to make in the economy
during the period of one year.

2. Ex-Ante Investment:- It refers to desired investment or planned investment

during the period of one year. This is the investment expenditure which is
intended to be made in the economy during the period of one year.
Meaning of Ex Post saving & Ex Post Investment

1. Ex-Post saving:- It refers to ‘actual saving’ in the economy during the period
of one year. This aspect of saving is considered in the context of national income
accounting.

2. Ex-Post Investment:- It refers to ‘actual investment’ in the economy during the

period of one year. Like actual saving, this aspect of investment is considered in
the context of National Income accounting.
 Adjustment Mechanism
1. What happens if AS > AD:- When AS is more than AD, flow of goods and services in the
economy tends to exceed their demand. As a result some of the goods would remain
unsold. To clear unwanted stocks, the producers would plan a cut in production
consequently. As would reduce, to become equal to AD.

2. What happens if AS < AD:- When AS is less than AD, flow of goods and service in the
economy tends to be less than their demand. The existing stocks of the producers would
be sold out. To rebuild the desired stocks the producers would plan greater production. As
would increase to become equal to AD.

Adjustment Mechanism
1. What happens if (S > I):- According, overall expenditure in the economy would remain
lower than what is required to buy the planned out put some output would remain unsold,
and producers will have undesired stocks. To clear their stocks, the producers would now
plan lesser output. This would mean lesser income in the economy. And less income
implies lesser saving. The process will continue till (S = I)

2. What happens if (S < I):- According, overall expenditure in the economy would exceed
that what is required to buy the planned output. It is a situation of higher AD than AS. To
cope with the situation the producers would now plan higher capital. Higher output
would mean higher income and higher saving. The process would continue till (S = I).
 Meaning and components of Aggregate supply (AS)
It is the local flow of goods and services in an economy during a period of one year. Component
of aggregate supply are C +S.
Y=C+S
Or
AS = C + S
Components:-
1. Consumption (C): It is always positive even when income is zero. When income
increased, consumption increases and vice-versa
C = f (y)

2. Saving (S):- Saving increase with increase in income (S = Y- C) and vice-versa

S = f (C)
Y C S= Y - C AS = C+S
0 50 -50 0
100 100 0 100
200 150 50 200
300 200 100 300
400 250 150 400
500 300 200 500
Diagram:-
 Questions
1. Y = 2,000 1. C =100 + 0.4Y 1. S =0.25 + 0.5Y
C‾ = 200 I =1,100 I = 5,000
I = 100 Y=? Y=?
MPC = ? C=? C=?
Solution : Solution : Solution :
 Meaning of Investment Multiplier
Investment multiplier is the ratio of change in income to the initial change in investment
expenditure.Multipliergives relation between an initial increase in investment and the
corresponding increases in income.
In other words,change in income is a multiplier of change in investment. It explains the number
of times income increases due to an increase in investment.
For example:Investment increase by 4 crore and due to which income increases by 20 crore,
∆𝒀
multiplier would be. 𝐊= ∆𝑰

𝟐𝟎
𝐊 =𝟒 =𝟓
1. Relation between Multiplier and Marginal Propensity to Consume (K and MPC)
𝟏 𝟏
∆𝒀 ∆𝒀 𝐎𝐫 𝑶𝒓
𝐊 = ∆𝑰 𝑶𝒓 ∆𝒀−∆𝐂 𝟏−𝑴𝑷𝑪 𝑴𝑷𝑺

𝐌𝐏𝐂 = ∆𝑪
∆𝒀

2. Relation between Multiplier and Marginal Propensity to Save (K and MPS)

𝟏
MP MPC
Hence: S=
MPC + MPS = 1 1–
𝐊=
𝑴𝑷
𝑺
 Explanation of Multiplier by assuming data
Process ∆I ∆Y ∆C ∆S
Given: MPC = 0.5
1 100 (Assume) 100 (Assume) 50 50
2 50 25 25
3 25 12.5 12.5
4 12.5 6.25 6.25
5 6.25 3.125 3.125
6 3.125 1.5625 1.5625
7 1.5625 0.78125 0.78125
Total 100* 200* 100 100
𝐌𝐏𝐂 = ∆𝑪
∆𝒀

∆𝑪
𝟎. 𝟓 =
𝟏𝟎𝟎

∆C = 50

𝟏
𝐊=
𝟏 − 𝑴𝑷𝑪

𝟏
𝐊=
𝟏 − 𝟎. 𝟓
K = 2 times(Means If ∆I = 100* so, ∆Y will be = 200*)
 Questions

𝐌𝐏𝐂 𝟎.𝟓 1. ∆Y = 10,000 1. S = -50 + 0.5Y

1. ∆𝐘 = 𝟏𝟎𝟎𝟎
∆I = 1,000 I = 7,000
∆I = ? MPC = ? Y=?
Solution : K=? C=?
Solution : Solution :
 Forward action and backward action of multiplier
1. Forward Action:Multiplier action is forward when there is a multiple increase in income
caused by an increase in investment.
Example:-If investment increases by 100 crore and MPC = 0.5 then there will be increase in
income 2 times the increase in investment is forward action multiplier.
𝟏
𝐊=
𝟏 − 𝑴𝑷𝑪

𝐊= 𝟏
=𝟐
𝟏 − 𝟎.
𝟓

ΔY = KΔI
2 (100) = 200

1. In the event of forward action multiplier, the AD function shifts upwards and
the equilibrium level of income increase.
Diagram:-
2. Backward action:-On the other hand multiplier action is backward if there is a
multiple decrease in income caused by decrease in investment.
Example:-On the other hand, if investment decreases by Rs. 100 crore and MPC = 0.5 there
will be decrease in income 2 times the decrease in income. This is backward action
multiplier.
𝐊= 𝟏
𝟏 − 𝑴𝑷𝑪

𝐊= 𝟏
=𝟐
𝟏 − 𝟎.
𝟓

ΔY = KΔI
2 (-100) = -200

2. In the event of backward action multiplier, the AD function shifts downward and the
equilibrium level of income decreases.
Diagram:-
 Concepts of full employment, voluntary and involuntary unemployment
1. Full Employment:- It refers to a situation in which all those, who are able and
willing to work at the exiting wage rate are working.
• Full employment is measured in the context of working population only.
• Full employment implies there is equilibrium in the labour market.

Demand of labour = Supply of labour

Full employment does not imply 100% employment, as even under full employment
there can be two type of unemployment.

A. Frictional unemployment:- It occurs during the time period when workers

leave one job and join in some other job.

B. Structural unemployment:- This is associated with the structural changes in the

economy. Human resources need some training and skill in order to work with
new technologies. It occurs in the time period when they are not working due to
lack of knowledge required to work. There is no shortage of work, but there is
mismatch between the supply and demand of the human resources (labour).
2. Voluntary unemployment:-
• It refers to a situation when a person is not willing to work at the
time existing wage rate.
• When workers are unwilling to accept any work though they are physically
and mentally capable.
• Voluntary unemployment is not counted while measuring the size
of unemployment.

3. Involuntary unemployment:-
• It refers to a situation in which all those, who are willing and able to
work at the existing wage rate, do not get work.
• Though physically and mentally fit, they are rendered unemployed
against their willingness to work.
• Involuntary unemployment is taken into account while estimating the
total unemployment in an economy.
 A to Z Commerce Classes
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Chapter - 8

Problem of deficient demand and Excess Demand

Dr. Ajay Vishwakarma

 Full employment equilibrium and under employment equilibrium
1. Full employment:- Full employment equilibrium refers to a situation which the
aggregate demand is equal to the aggregate supply at employment level all those
who are willing to work at the prevailing wage rate are able to find employment.
So full employment means there is no involuntary unemployment.
Diagram:-

2. Over full Employment Equilibrium:- Over full Employment Equilibrium refers to

a situation when the aggregate demand is equal to the aggregate supply beyond
the full employment level.
Diagram:-

3. Under Employment Equilibrium:- Under employment equilibrium refers to

a situation when the aggregate demand is equal to the aggregate supply
corresponding to under employment resources. It occurs prior to the full
employment level.
Diagram:-
 Classical theory
The classical economists believed that full employment is a normal feature of a capitalist
economy.
The economy is always at full employment equilibrium because of two assumptions
• Supply creates its own demand.
• Wage rate and price of the commodity are flexible.
Keynesian theory
Keynesian theory believes that full employment is an ideal situation, but economy can be in
equilibrium even at less than full Employment level.
The economy may not always be at full employment equilibrium because of two assumptions.
• Demand creates its own supply.
• Wage rate and price of the commodity are fixed
Meaning of Excess Demand/ Inflationary Gap
Excess demand refers to the situation when aggregate demand is in excess of aggregate supply
corresponding to full employment in the economy. AD > AS
Or
When actual level of aggregate demand is more than required/ planned level of aggregate
demand to maintain full employment.
Inflationary gap refers to the situation of excess demand. It is equal to the difference
between AD beyond full employment and AD at full employment equilibrium.
Diagram:-
 Causes of Excess Demand
1. Increase in consumption expenditure
2. Increase in investment expenditure
3. Increase in exports

Impact of excess demand

1. Impact on employment:- As there is full utilization of the resources

available in the economy thus there is full employment. Hence, excess
demand does not lead to any increase in the level of employment.

2. Impact on output:- Since the resources have already been utilized to the
full, thus excess demand does not lead to any increase in the output.

3. Impact on prices:- As output and employment cannot change, so ultimate

pressure is on price. Prices tend to rise as competition among buyers will
push the price up.
 Meaning of Deficient Demand / Deflationary Gap
Deficient demand refers to the situation when aggregate demand is short of aggregate
supply corresponding to full employment in the economy. AD < AS
Or
When actual AD is less than required / planned AD to maintain full employment.
Deflationary Gap refers to the situation of deficient demand. It is the short fall
in aggregate demand from the level required to maintain full employment equilibrium in
the economy.
Diagram:-
Causes of deficient demand
1. Decrease in consumption expenditure
2. Decrease in exports
3. Decrease in investment expenditure.
Impact of deficient demand
1. Impact on employment:- As the level of investment falls in an economy, the level
of employment also decreases thereby causing unemployment in the economy.

2. Impact on output:- Due to fall in investment and employment in the economy the output
also tends to fall.

3. Impact on prices:- As there is excess supply in the economy thus the prices tend to
decrease leading to deflation which causes deflationary gap.
 Meaning and phases of Trade cycles
Aggregate demand should be equal to aggregate supply. However in reality aggregate
demand keeps changing, causing trade cycles. Trade cycles or business refer to the
fluctuations in business activity. Thus trade cycles refer to the ups and downs of business
activities.
The curves moves in a cyclical manner showing the trade cycle which has four phases.

1. Boom:- It is situational aggregate demand is maximum because of increasing

economic activity, investment, employment, income and output. It causes inflation.

2. Recession:- Because of inflation aggregate demand starts falling which reduces

investment, employment, income and output.

3. Depression:- it is a stage where economic activities like income, production,

employment, output and prices fall. Profitability is low and aggregate demand is as
its lowest.

4. Recovery:- In depression the government and monetary authorities start investing

more and help economy recover from depression by raising income, employment and
thus aggregate demand.
Diagram:-
. Policy Measures to control excess demand and deficient demand
1. Fiscal policy measures
2. Monetary policy measures
1. Fiscal Policy Measures
Meaning: Fiscal policy refer to the budgetary policy of the government or the policy related
to revenue and expenditure of the government with a view to correct the situation of
excess demand or deficient demand in the economy.

Instruments of Fiscal Policy

Instruments of Fiscal Policy

Government Revenue Government Expenditure

Taxes Public Debt Deficit Financing

 Fiscal instrument related to Government Revenue
1. Taxes:- Tax is a compulsory payment to the Government according to prescribed
laws. Taxes are two types.
a) Direct Tax
b) Indirect Tax

2. Public debt or Borrowing:- It refers to the borrowings by the Government

from the public through issuing securities.

3. Deficit Financing:- It refers to the issuing of more currency to meet the

budgetary deficit. It increases the money supply in the economy.
Fiscal instrument related to Government Expenditure

Government spends on –
• Public works programmes like construction of Roads, Dams, Bridges. Flyovers.
Building etc.
• Education and public welfare programmes.
• Defence of the country and maintenance of law and order.
• Provision of subsidies to producers to encourage production.
 Fiscal Measures to correct excess demand or inflationary gap
A. Fiscal Measures related to Government Revenue.

1. Taxes:- A compulsory payment to be made to the Government by whom on it is imposed to

control excess demand.
• The government should impose new taxes and raise the rate of existing taxes.
• It will reduce the disposable income.
• Consumption and investment will full.
• AD is reduced and excess demand is corrected.

2. Public debt or borrowing:- It refers to borrowing by government by issuing certain securities

to control excess demand.
• The government should increase public debt or borrowing.
• It will reduce the disposal income.
• Consumption and investment will fall.
• AD is reduced and excess demand is corrected.

3. Deficit financing:- It refers to issue of New currency by the government to control excess
demand. Govt. should reduce deficit financing.
• It will reduce the supply of money.
• It will reduce the disposable income.
• Consumption and investment will fall.
• AD is reduced and excess demand is corrected.
 Fiscal Measures to correct Deficient Demand or deflationary gap
A. Fiscal measures related to Government revenue:-

1. Taxes:- A compulsory payment to be made to government by who on it is imposed to control

deficient demand.
• The government should not impose new taxes and reduce the rate of existing taxes.
• It will increase the disposable income.
• Consumption and investment will rise.
• AD is increased and deficient demand is correct.

2. Public debt or borrowing:- It refers to borrowing by government by issuing certain securities.

To control deficient demand.
• The govt. should decrease public debt or borrowing.
• It will increase the disposable income.
• Consumption and investment will rise.
• AD is increase and deficit demand is corrected.

3. Deficit financing:- It refers to issue of new currency by the government. To control

deficient demand.
• The govt. should resort to deficit financing.
• It will increase the supply of money.
• It will increase the disposable income.
• Consumption and investment will rise.
• AD is increased and deficient demand is corrected
B. Fiscal measures related to Govt. Expenditures:

It refers to government expenditures on education, health, administration, defence, etc. to control

deficient demand.
• Government should increase its expenditure and development and productive work.
• It will increase the supply of money.
• It will increase the level of AD in the economy.
• It will help to correct deficient demand or deflationary pressure in the economy.
2. Monetary Policy Measures
Monetary policy refers to the policy of the central bank of a country to control money supply and
credit in the economy.

Instrument of monetary policy

Quantitative Measures Qualitative Measures

Bank Rate
Open Market
Varying
Operation
Legal Reserve
Imposing
Requirement
Margin Requiremen
Moral tSelective Credit Control
(CRR + SLR + Loan) Suasion
 Monetary measures to correct Excess Demand or Inflationary Gap

A. Quantitative Measure are:

1. Bank Rate:- it is the minimum rate at which the central bank of a country gives
credit to the commercial banks against approved securities. To control excess
demand.
• Bank rate is increased the lending rates of commercial banks.
• It makes the credit costlier.
• Less money the credit costlier.
• Demand for credit reduces.
• AD falls.

2. Open market operations:- It refers to purchase and sale of government securities

in the open market. (Public and commercial Bank) by the central bank. To control
excess demand.
• Govt. securities are sold by the central bank in the open market.
• The central bank withdrawn additional purchasing power from the system.
• There will be contraction.
• Less money will flow in the system.
• AD falls.
3. Varying legal reserve requirement:- There are two types of Reserve ratio.

a. CRR (Cash reserve ratio or minimum Reserve ratio):- It is the minimum percentage of
deposit of commercial banks which is kept with RBI. To control excess demand.
• CRR is increased to control excess demand.
• There will be contraction of credit.
• Less money will flow in the system.

b. SLR (Statutory Liquidity Ration):- It is the percentage of deposit of commercial banks

which every bank is required to maintain in the form of designated liquid assets. To control
excess demand.

B. Qualitative Measures are:-

1. Imposing margin requirement:- Margin is the difference the amount of the security
offered by the borrower against the loan.

2. Moral suasion:- It is a combination of persuasion and pressure that the central bank applies
to other banks in order to get them fall in line with its policy. It is other banks in order to
speeches and hints to the banks.

3. Selective credit control/ Rationing:- Here, areas are selected as priority sectors for
either credit extension or contraction.
A to Z Commerce Classes
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Chapter - 9

Government Budget and the Economy

Dr. Ajay Vishwakarma

 Government budget
budget is a statement of the estimate of the government receipts and government
expenditure during the period of the financial(fiscal) year which run from Aril 1st
to 31st March.
Objectives of Government budget

1. Redistribution of Income and wealth:- The government uses fiscal instruments

of taxation and subsidies to improve the distribution of income and wealth in the
economy.

2. Reallocation of resources:- The government seeks to re-allocate resources with a

view to balance the goals of profit maximisation and social welfare.

3. Economic stability:- using its revenue and expenditure policy, the

government ensures economy stability in the economy. Free interaction of
market force s the forces of supply and demand are bound to generate trade
cycles, also called business cycles.

4. Managing Public enterprises:- Growth through, public enterprises to uses on

social welfare rather than profit maximation.
 Component of Budget

1. Budget receipts:- budget receipts refers to estimated money

receipts of the government from all sources during the fiscal year. It
consists of

A. Revenue Receipts:- Revenue receipts are those estimated receipts of

the government during the fiscal year which do not affect asset or
liability status of the government.
• These receipts do not create corresponding liabilities for
the government Example: tax receipt.
• These receipts do not lead to reduction in assets of the government
Example: Fees, fines, grants etc.
 There are two type of Revenue Receipt
a. Tax Receipts:- A tax is a compulsory payment made by an individual household or a firm to
the govt.

There are six types of tax receipts:

i. Progressive Tax:- Progressive tax implies that the rate of tax increases with an increase
in income e.g. income tax.

ii. Regressive Tax:- Regressive tax implies that rate of tax decreases with the increase in income.

iii. Ad-valorem tax:- It is an indirect tax which is imposed on “value added” at the various
stages of production.

iv. Specific tax:- When a tax is levied on a commodity on the basis of its units, size or weight.
It is Called the specific tax.

v. Direct tax:- Direct tax are those taxes whose final burden falls on that person who makes the
payment to the government e.g. income tax, wealth tax.

vi. Indirect tax:- Indirect taxes are those taxes which are paid to the government by one
person but their burden is borne by another person.
b. Non-tax Receipts: - Non tax receipts are those receipts which are received from
sources other than taxes like fees, fine etc.

Some of the non-tax receipts are as follows

i. Fees, licence and permit:- A fee is a payment to the govt. for the services that it renders
to the people e.g. land, registration fee, birth and death registration, passport, court fee.

ii. Fines: fines are those payments which are made by the law breakers to the
government by way of economic punishments.

iii. Escheat:- Escheat refers to the income of the state which arises out of the property left
by the people without a legal heir. There is no claimant of such property.

iv. Income from public enterprises:- Several enterprises are owned by the government
e.g. Indian railways, Indian Oil, Bhilai Steel Plant.

v. Grant/Donations:- In the event of some natural calamities like earthquake,

floods, famines, citizens of the country often make some donations and grants to
the government.
B. Capital Receipts:- Capital receipts are those estimated receipt of the government
during the fiscal year which affect assets or liability status of the government.
• These receipts create a corresponding Liability for the government. Eg. Borrowings
• These receipts create lead to reduction in assets of government. Eg. dis
Investment, recovery of loans.

There are three types of capital Receipts

1. Borrowings and other Liabilities- Borrowing create Liability for the government
borrowings are to be treated as capital receipt. The government borrows money
from
• The general public.
• RBI
• The rest of the world.

2. Recovery of loans- The debtors are assets of the government. Recovery of loans causes a
reduction in assets (Debtors) of the government. Hence recovery of loans is a capital
receipt.

3. Other receipts- It includes ‘Disinvestment’ it is the opposite of investment.

Disinvestment occurs when the government sells off its share of public sector enterprises
to private sector. It is called privatization. It is treated as capital receipts because it causes
reduction in assets of the government
2. Budgetary Expenditure:- It refers to the estimated expenditure of the government on
its development and non-development programmes or on its plan and non-planned
programmes during the fiscal year. It may be classified in three ways.
1. Revenue expenditure and capital expenditure
2. Development Expenditure and Non-Development Expenditure
3. Plan Expenditure and Non-Plan Expenditure

1. Revenue expenditure and capital expenditure

A. Revenue expenditure- It refers to the estimated expenditure of the government in
a fiscal year which does not affect assets and liabilities status of the government. This
expenditure-
• Does not create assets of the government.
• Does not cause a reduction in liabilities of the government.
• Example: Old age pension, Salaries and Scholarships

B. Capital expenditure- It refers to the estimated expenditure of the government in a

fiscal year which affect assets and liabilities status of the government. This expenditure-
• Creates assets of the government.
• Cause a reduction in liabilities of the government.
• Example: Purchase of shares of MNCs, construction of dams and steel
plants, repayment of loans etc.
 2. Development expenditure and Non Development expenditure
A. Development Expenditure- It is incurred on economic and social development
of country. It relates to growth and development projects of the country. For
Example: Expenditure on development of agriculture, industries, transports,
education etc.

B. Non Development expenditure- It is the expenditure on general services of the

government which do not usually promote economic development. It relates to
Non development activities of the governments. Example: Expenditure on
Administration, Defence , Justice, Grants to state government .
3. Plan Expenditure and Non-Plan Expenditure

A. Plan Expenditure- It is the expenditure to be incurred during the year in

accordance with the central plan of the country. It is incurred on financing the
objective of central plan of different sectors of the economy. Example:
Planned expenditure on Health, Education, Law and Order etc.

B. Non plan Expenditure- It refers to all such government expenditures which are
not planned. It is incurred on financing those projects which are not planned in
the central plan. Example: Expenditure as a relief to the earthquake, Expenditure
on Construction..
 Budget Deficit and its types
Budgetary deficit is defined as the excess of total estimated expenditure over total estimated
revenue. When the government expenditure exceeds its revenue it incurs a budgetary
deficit.

Budgetary deficit can be of three types:

1. Revenue Deficit = Total revenue expenditure – Total revenue receipt
2. Fiscal deficit = Total expenditure – Total receipts (Excluding borrowing)
3. Primary Deficit= Fiscal deficit – interest payment.

1. Revenue Deficit:- It refers to excess of revenue expenditure over revenue receipts during the
given fiscal year.
Implication of revenue deficit
• It means that revenue deficit either leads to an increase in liability in the form of
borrowing or reduces the assets through sale of its assets (disinvestment).
• Higher borrowing would increase the future burden to repay the loan amount and interest
payment. Measures to reduce revenue deficit

• Reduction in government expenditure:- Govt. should resort to reduction in

unproductive expenditure.
• Increase in government revenue:- Govt. should increase its receipt by imposing new
taxes and increasing the rate of existing taxes. It should also increase non tax revenue
receipts.
 Fiscal Deficit
It refers to the excess of total expenditure over total receipts. (Excluding borrowings) during the
given fiscal year.
Implementation of Fiscal Deficit
1. Causes inflation:- the govt. resort to borrowing from the RBI to meet its fiscal deficit.
This increases the circulation of money in the economy and creates inflationary of
money.

2. Increase foreign dependence:- Government also borrows from the rest of world because
of its fiscal deficit will rise.

3. Financial burden for future generation:- Borrowing lead to burden for future generations as
payment of loans and interest on loans get accumulated whose burden is to be borne by the
future generation.
Measure to reduce fiscal deficit

1. Measure to reduce public expenditure

• A drastic reduction in wasteful expenses. Example: Subsidies.
• By curtailing non plan expenditure.

2. Measures to increase revenue are

• Increase in existing tax rates.
• Impose new taxes.
• Tax evasion should be control.
 Primary deficit
It is the difference between fiscal deficit and interest payment.
Primary deficit = fiscal deficit – interest payable

Implication of primary deficit

• Primary deficit is defined as fiscal deficit minus interest payment on
previous borrowings. Therefore it indicates the amount of borrowings
require to meet expenditure other than interest payment.

• It implies that if primary deficit is zero than fiscal deficit is equal to interest
payments which indicate that interest payments on previous loans have led
to borrowing.
Measures to reduce primary deficit

• Primary deficit indicate borrowing requirement of the government to

meet deficit other than interest payment. Therefore efforts should be
made to reduce fiscal deficit.

• To reduce fiscal deficit, interest payments should be reduce through repayment

of loans as early as possible.
 Types of Budget
1. Balance Budget:- A balance budget is that budget in which govt. receipts are
equal to government expenditure.

Merits of balanced budget

 The govt. does not include in wasteful expenditure.
 A balance budget implies financial stability of the economy.

Demerits of balanced budget

 It is not useful to solve the problem of unemployment during dispersion.
 Process of economic growth is very slow.

2. Unbalanced budget:- An unbalance budget is that budget in which receipts

and expenditure of the govt. are not equal. It may be.
a. Surplus Budget
b. Deficit Budget
a. Surplus Budget: It is that budget government receipts are greater than the
government. expenditure.

Merits of surplus budget

 Revenue collection of government which reduces purchasing power of the people.
 Reduced government expenditure which reduces supply of money to correct inflation.

Demerits of Surplus budget

 During depression a surplus budget may lower the level of AD to such an extent that
comes low level of output, low level of employment and low level of income in the
economy as government spends less and generates more revenue.

b. Deficit Budget:- it is that budget in which government receipts are less than
government expenditures

Merits of Deficit Budget

 It solves the problem of deflation or deficient demand during depression.
 Deficit budget raises the level of AD.

Demerits of Deficit budget

 During excess demand a deficit budget would further increase the difference between AD
and AS which would lead to inflationary gap as above govt. spends more and generates
less revenue.
A to Z Commerce Classes
Mobile No. 9826535703

Chapter - 10

Foreign Exchange Rate

Dr. Ajay Vishwakarma

 Meaning of foreign Exchange
It is defined as the market in which foreign currencies are bought and sold. It is a system
where buyers and sellers of foreign currency provide facilities in trading of foreign currencies.
Foreign exchange market constitutes brokers, banks, central bank etc.

Functions of foreign exchange market

1. Transfer function:- It implies function of purchasing power in terms of foreign exchange

across different countries of the world

2. Credit Function:- Like domestic trade foreign trade also depends on credit. Foreign
Exchange market provides for credit in foreign trade transaction.

3. Hedging functions:- It implies protection against the risk concerning variations in

foreign exchange rate.

Operation of foreign exchange market

1. Spot (Current) Market:- Spot market for foreign exchange is than market which handles only
spot transaction or current transactions.in other words only present transactions are
recorded.

2. Forward Market:- Forward market for foreign exchange is that market which handles
such transaction of foreign exchange are as meant like speculation.
 Foreign Exchange Rate
The rate of exchange measures number of units of one currency which is exchanged
in the foreign market for one unit of another. [Crowther]
Eg. 1$ = 50 Rs.

Types of exchange rate

1. Fixed exchange rate system
2. Flexible exchange rate system
3. Managed Floating Rate System

1. Fixed Exchange Rate System

Fixed rate of exchange refers to rate of exchange as fixed by the Government. There
are two system of fixed exchange rate.

A. Gold standard system of exchange rate:- According to this system gold was
taken as the common unit of parity between currencies of different countries..
Example: 1£ (U.K Pound) = 2 gm. Gold
1$ (U.S Dollar) = 1 gm. Gold
B. The Bretton Woods system:- The Bretton Woods system of monetary
management established the rules for commercial and financial relations among
the United States, Canada, Western European countries, Australia, and Japan
after the 1944 Bretton Woods Agreement. The Bretton Woods system was the first
example of a fully negotiated monetary order intended to govern monetary
relations among independent states. This system was adopted to have
transparency in the system. Under this system, all currencies were related to U.S.
dollar which ultimately was conversable into gold. IMF (International Monetary
fund) worked as central institution in controlling the system.

Merits of Fixed exchange rate

• It ensures stability in exchange rate.
• Coordination of macro policies becomes convenient.
• It prevents speculation in foreign exchange market.

Demerits of fixed exchange rate

• Huge reserves of gold.
• Huge gold reserves hinder movement of capital.
• Fixed exchange rate may not be the equilibrium rate.
2. Flexible exchange rate system

Flexible rate of exchange is that rate which is determined by the demand for and
supply of different currencies concerned in with foreign exchange market.
R = f (D, S)
R = Exchange rate, D = Demand of currencies in the world, S = Supply of currencies
in the world

Merits
• Gold Reserve not required
• International mobility of capital
• Venture capital
• Optimum resource allocation.

Demerits
• Market instability flexible exchange rate keeps fluctuating according to
demand and supply
• Policy formations become difficulty.
3. Managed Floating Rate System

Managed Floating is a System that allows adjustment in exchange rate according

to a set of rules and regulation which are officially declared in the foreign
exchange market. It is also called a hybrid system between fixed rate and flexible
exchange rate. If a country, manipulates the exchange rate by not following rules
and regulation it is called dirty floating. The Central Bank intervenes to control
fluctuation in the exchange rate. .

Determination of foreign exchange rate/ flexible exchange rate

Resources of demand for foreign exchange:

• Payment of international loan.
• Gifts and grants to rest of world.
• Investment in rest of world.
• Direct purchase for abroad.
• Speculative trading in foreign exchange rate.
• Tourism.
 Relation between price of foreign exchange demand for foreign exchange
There is an inverse relationship between the price of foreign exchange and the
demand for foreign exchange . Example: At a higher price, less of the foreign
exchange is demanded and vice-versa.
Diagram:-

Sources of supply of foreign exchange

• Exports of the country of rest of the world
• Foreign tourists in India
• Remittances by Indians working abroad
• Foreign direct investment by multinational companies
• Purchase of shares by foreign investors.

Relationship between the price of foreign exchange and supply foreign exchange
The supply of foreign exchange has a direct relationship with the price of foreign
exchange. If the price of foreign exchange goes up the quantity supplied of foreign
exchange will also rise and vice-versa.
Diagram:-
 Equilibrium Rate of foreign exchange (flexible)
Equilibrium rate of exchange is established at a point where the quantity demanded
and the quantity supplied of foreign exchange are equal.
Diagram:-

Causes of change in Rate of foreign exchange

• Currency Depreciation (when exchange rate rises)
• Currency appreciation (when exchange rate falls).
 Depreciation in Currency
Depreciation in currency refers to decrease in the value of domestic currency
in terms of foreign currency. A rise in exchange rate implies depreciation of
Indian rupee.

Example: Old exchange rate 1$ = 60 Rs

Present Exchange rate 1$ = 64
Rs

Causes of rise in exchange rate are

A. Increase in demand for foreign

exchange Diagram:-

B. Decrease in supply of foreign

exchange Diagram:-
 Appreciation of Currency
Appreciation of currency refers to increase in the value of domestic currency
in terms of foreign currency. A fall in exchange rate implies appreciation of
Indian Rupee (Currency).

Example: Old exchange rate 1$ = 64 Rs

Present Exchange rate 1$ = 60
Rs

Causes for decrease in exchange rate are

A. Fall in demand of foreign

currency Diagram:-

B. Rise in supply of foreign

currency Diagram:-
A to Z Commerce Classes
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Chapter - 11
Balance of payments

Dr. Ajay Vishwakarma

 Balance of payments
Every government maintains a record of the transaction that take place between the
residents of country and the rest of the world during a given period of time. This is
record is known as the country’s balance of payments (BOP).

Economic Transaction in BOP

1. Visible items or goods:- these include export and import of physical goods. These
are called ‘visible goods’ as they are made of some matter or material and can be seen,
touched and measured.

2. Invisible items or services:- Invisible items of trade refer to export and import of
services like shipping, banking, insurance. These are called as ‘invisible items’ as
they cannot be seen, touched or measured.

3. Unilateral transfer:- Unilateral transfer include receipts and payments of gifts,

donation, remittances and other one sided transaction.

4. Capital transfer:- Capital transfer are related to capital receipt e.g. borrowing or
sale of assets.
 Meaning of balance of payment accounting

The transactions are recorded in the balance of payment account in

double entry book keeping. Each international transaction undertaken
by the country will result in a credit entry and debit entry of equal
amount.
As international transaction are recorded in double entry accounting the
BOP accounting must be always balanced that is total amount of Dr. must
be equal to total amount of Cr.
Meaning of Balance of Trade

Balance of trade (BOT) refers to the difference between value of exports

and imports of visible items (goods) only.

BOT = Exports of Goods – Imports of Goods

 Components of Balance of payment
1. Meaning and Components of current A/c:- Current A/c is that a/c which records
imports and exports of goods and services and unilateral transfer which do not cause
a change in the assets or liabilities of the residents of the country or its govt. current
A/c contains the receipts and payments relating to all the transaction of visible,
invisible and unilateral transfer.
Components of Current A/c
• Export and import of goods (visible)
• Export and import of services (invisibles)
• Receipt and payments of unilateral transfer (Gifts and Donations)

Important observations
• In a current A/c, receipts from export of goods and services and unilateral
transfers are entered as Cr (+) items as they represent in flow of foreign exchange.
• Payments for import of gods and services and unilateral transfer are entered as Dr.
(-) items as they represent outflow of foreign exchange.
• Surplus on current account implies new inflow of foreign exchange.
• Deficit on current account implies net out flow of foreign exchange.
2. Meaning and components of Capital accounts:- Capital account of BOP records
all those transactions between the residents of a country and the rest of the world
which cause a change in the assets or liabilities of the residents of the country or
its government.
Components of Capital A/c

1. Private Transactions:- these affect assets and liabilities of non-government

entities or private sector. For Example: Private sector of the country receives
short term and long term foreign loan. Receipts of such loans are recorded as
positive (Credit) items and their repayments are recorded as negative (Dr) items
of BOP.

2. Official transactions:- these affect assets and liabilities status of government of a

country .Example: Govt. borrow loans from foreign govt. to finance the deficit in
the BOP. Receipt of such loan are recorded on the positive (Cr) and Repayment of
loan recorded on the negative (Dr) side.

3. Foreign Direct Investment:- It refers to purchase of an assets in the world

which gives full control to the buyer over the assets.
4. Portfolio investment:- It refers to purchase of an assets in the rest of the world
which does not give full control over the assets.

5. Banking Capital:- It refers to foreign exchange transactions and investment

in foreign currency and security by Indian commercial and other banks which
are authorized to deal in foreign exchange.
Important observations

 The transaction which leads to inflow of foreign exchange are recorded on

the credit side. (Positive)
 The transaction which lead to outflow of foreign exchange are recorded on the
Dr. side. (Negative)
 Surplus on Capital A/C implies net inflow of foreign exchange
 Deficit on Capital A/C implies net outflow of foreign exchange
 Meaning of autonomous and accommodating items
A. Autonomous items:-
• These refer to economic transaction which take place due to some
economic motive fir maximised profits.
• These items are also known as above the line items.
• Accommodating transaction take place on both, current and capital account.

Accommodating items:-
• These are not related to those transactions which are determined by
profit maximisation.
• These items are also known as below the line items.
• Accommodating transaction take place on capital account.

Disequilibrium in BOP:- There are two types of disequilibrium.

A. Surplus BOP:- When the payments of the country are less than its receipts
the BOP is said to be surplus BOP.

B. Deficit BOP:- When the payments of the country are more than its receipts the
BOP is said to be deficit BOP.
 Causes of equilibrium
A. Economic factors:-
• Development expenditure
• High rate of inflation
• Trade of cycles
• Development of import substitutes

B. Political factors:-

• Political instability:- political instability may lead to payments and

reduced receipts lf foreign capital thus creating BOP deficit.

• Policies of government:- If policies of the government favour imports, there

will be deficit in BOP and vice versa.

C. Social factors:-

• Change in tastes and preference.

• Demonstration effect:-when the people of a country prefer goods made in
the advanced countries they start importing more of foreign goods.
 Balance of payment in Accounting sense

Outflow Rs Inflow Rs
Import of goods 3000 Exports of goods 5000
Import of services 8000 Export of services 1000
Unilateral transfer to other 600 Unilateral transfer received e.g 1000
country donations
Capital payments 2000 Capital Receipts 6600
Total 13600 Total 13600
Balance of payment in Operational sense
It will explain how the two sides got equal to each other for this we need to calculate.

A. Current account balance:-

(Balance of visible trade) + (Balance of invisible trade) + (Balance of unilateral trade)
=(Exports - Imports of goods) + (Export - Imports of services) + (Receipts – Payments of unilateral
transfer)
=(5000 – 3000) + (1000–8000) + (1000 – 600)
=2000 – 7000 + 400 = - 4600 crore (Deficit).

B. Capital account balance:-

Capital receipts – Capital
payments 6600 – 2200 = 4600
crore (Surplus)