Introduction to Macroeconomics and its Concepts-Chapter-1

Introduction and Structure of MacroEconomics:

1. Macroeconomics is the part of economic theory that studies the economy as a whole, such as national income, aggregate employment, general price level, aggregate consumption, aggregate investment, etc. Its main instruments are aggregate demand and aggregate supply. It is also called the ‘Income Theory’ or ‘Employment Theory’.
2. Structure of macro economy: As we know, Macroeconomics is concerned with economic problems at the level of an economy as a whole. Structure of Macroeconomics implies study of different sectors of the economy.

An economy may be divided into different sectors depending on the nature of study.

(a) Producer sector engaged in the production of goods and services.

(b) Household sector engaged in the consumption of goods and services.

Note: Households are taken as the owners of factors of production.

(c) The government sector engaged in activities like taxation and subsidies

(d) Rest of the world sector engaged in exports and imports.

(e) Financial sector (or financial system) engaged in the activity of borrowing and lending.

3. Circular flow of income.

It refers to flow of money, income or the flow of goods and services across different sectors of the economy in a circular form.

There are two types of Circular flow:

(a) Real/Product/Physical Flow

(b) Money/Monetary/Nominal Flow

(a) Real flow

(i) Real flow of income implies the flow of factor services from the household sector to the producing sector and corresponding flow of goods and services from the producing sector to the household sector.

(ii) Let us consider a simple economy consisting only of 2 sectors:

• Producer Sector.
• Household Sector.

 (iii) These two sectors are dependent on each other in the following ways:

• Producers supply goods and services to the households.
• Household (as the owners of factors of production) supplies factors of production (or factor services) to the producers.

This interdependence can be explained with the help of the diagram given here.

(b) Money Flow

(i) Money flow refers to the flow of factor income, as rent, interest, profit and wages from the producing sector to the household sector as monetary rewards for their factor services as shown in the flowchart.

 (ii) The households spend their incomes on the goods and services produced by the producing sector. Accordingly, money flows back to the producing sector as household expenditure as shown in the flowchart.

Circular Flow of Income in Two Sector Model:

The following assumptions with regard to a simple economy with only two sector of economics activity are:

(i) There are only two sectors in the economy; that is, household and firms.

(ii) Household supply factor services to firms.

(iii) Firms hire factor services from Households.

 (iv) Households spend their entire income on consumption.

(v) Firms sell all that is produced to the households.

(vi) There is no government or foreign trade.

Such an economy described above has two types of markets.

(i) Market for goods and services that is product market.

(ii) Market for factors of production, factor market.

As a result we can derive the following, in the case of our simple economy:

(i) Total production of goods and services by firms = Total consumption of goods and services by Household Sector.

(ii) Factor Payments by Firms = Factor Incomes of Household Sector.

(iii) Consumption expenditure of Household sector = Income of Firm.

(iv) Hence, Real flows of production and consumption of Firms and households = Money flows of income and expenditure of Firms and Households.

Phases of Circular Flow:

There are three types of phases of Circular flow.

(i) Production Phase:

• It deals with the production of goods and services by the producer sector.
• If we study it in term of the quantity of goods and services produced, it is a Real Flow. But, it is a Money flow, if we study it in terms of the market value of the goods produced.

(ii) Distribution Phase: It means the flow of income in the form of rent, interest, profit and wages, paid by producer sector to the household sector. It is a Money Flow.

(iii) Disposition Phase:

• Disposition means expenditure made. This phase deals with expenditure on the purchase of goods and services by households and other sectors.
• This is a Money Flow from other sectors to the producer sector. These phases are illustrated in the figure given here.

Some Basic Concepts of MacroEconomics

1. Factor Income

(a) Income earned by factor of production by rendering their productive services in the production process is known as Factor Income.

(b) It is a bilateral [Two-Sided] Concept.

(c) It is included in National Income as it contribute something in the flow of goods and services.

Examples: Rent, interest, wages and profit.

2. Transfer Income

(a) Income received without rendering any productive services is known as transfer income.

(b) It is a unilateral [one-sided] concept.

(c) It is not included in National Income as it does not contribute anything in the flow of goods and services.

Examples: Old Age Pension, Scholarship, Unemployment allowance.

There are two types of transfers:

(i) Current transfers

(ii) Capital transfers

(i) Current Transfers

• Transfers made from the income of the payer and added to the income of the recipient (who receive) for consumption expenditure are called current transfers.
• It is recurring or regular in nature.

For example, scholarships, gifts, old age pension, etc.

(ii) Capital Transfers

• Capital transfers are defined as transfers in cash and in kind for the purpose of investment to recipients, made out of the wealth or saving of the donor.
• It is none recurring or irregular in nature.

For example, investment grant, capital gains tax, war damages, etc.

3. Stock

(a) Any economic variable which is calculated at a particular point of time is known as stock.

(b) It is static in nature, i.e., it do not change.

(c) There is no time dimension in stock variables.

For example, Distance, Amount of Money, Money Supply, Water in Tank, etc.

4. Flow

(a) Any economic variable which is calculated during a period of time is known as flow.

(b) It is dynamic in nature, i.e., it can be changed.

(c) There is time dimension in flow variables.

For example, Speed, Spending of Money, Water in River, Exports, Imports, etc.

5. Economic territory or Domestic Territory:

(a) According to the United Nations, economic territory is the geographical territory administered by a government within which persons, goods and capital circulate freely.

(b) The above definition is based on the criterion “freedom of circulation of persons, goods and capital”. Clearly, those parts of the political frontiers (or boundaries) of a country where the government of that country does not enjoy the above “freedom” are not to be included in economic Territory of that country

(i) One example is embassies. Government of India does not enjoy the above freedom in the foreign embassies located within India. So, these are not treated as a part of economic territory of India. They are treated as part of the economic territories of their respective countries. For example the U.S. embassy in India is a part of economic territory of the U.S.A. Similarly, the Indian embassy in Washington is a part of economic territory of India.

(ii) International organizations like UNO, WHO, etc. located within the geographical boundaries of a country.

(iii) In layman terms, the domestic territory of a nation is understood to be the territory lying within the political frontiers (or boundaries) of a country. But in national income accounting, the term domestic territory is used in a wider sense. Based on ‘freedom’ criterion, the scope of economic territory is defined to cover:

• Ships and aircrafts owned and operated by normal residents between two or more countries. For example, Indian Ships moving between china and India

I regularly are part of domestic territory of India. Similarly, planes operated by Air India between Russia and Japan are part of the domestic territory of India. Similarly, planes operated by Malaysian Airlines between India and Japan are a part of the domestic territory of Malaysia.

• Fishing vessels, oil and natural gas rigs and floating platforms operated by the residents of a country in the international waters where they have exclusive

Rights of operation. For example, fishing boats operated by Indian fishermen in international waters of Indian Ocean will be considered a part of domestic territory of India.

• Embassies, consulates and military establishments of a country located abroad. For example, Indian Embassy in Russia is a part of the domestic territory of India. ‘Consulate’ is an office or building used by consul (an officer commissioned by the government to reside in a foreign country to promote the interest of the countiy to which he belongs).

6. Citizenship/Nationalship

(a) Citizenship is basically a legal concept based on the place of birth of the person or some legal provisions allowing a person to become a citizen.

(b) It means, Indian citizenship can arise in two ways:

(i) When a person is born in India, he acquires automatic citizenship of India.

(ii) A person born outside India applies for citizenship and Indian Law allows him to become Indian Citizen.

7. Normal Resident/Resident

(a) A Normal residenf, whether a person or an institution, is one whose centre of economic interest lies in the economic territory of the country in which he lives.

(b) The centre of economic interest implies in two things:

(i) The resident lives or is located within the economic territory for more than one year and

(ii) The resident carries out the basic economic activities of earnings, spending and accumulation from that location

(c) There is a difference between the terms normal resident (resident) and citizen (or national).

(i) A person becomes a national of a countiy because he was born in the country or on the basis of some other legal criterion.

(ii) A person is treated resident of a country on the basis of economic criterion.

(iii) It is not necessary that a resident must also be the national of that country. Even foreigners can be the residents if they pass the above stated economic criterion.

For example, a large number of Indian nationals have settled in U.S.A., England,

Australia, etc. as residents (and not as nationals) of these countries. For India, they

Are Non-resident Indians (NRI) but continue to remain Indian nationals?

Following are not included under the category of Normal residents:

(i) Foreign visitors in the country for such purposes as recreation, holidays, medical treatment, study tours, conferences, sports events, business etc. (they are supposed to stay in the host country for less than one year. In case they continue to stay for one year or more in the host country, they will be treated as normal residents of the host countiy).

(ii) Crew members of foreign vessels, commercial travelers and seasonal workers in , the country (Foreign workers who work part of the year in the country in response to the varying seasonal demand for labour and return to their households and border workers who regularly cross the frontier each day or somewhat less regularly, (i.e. each week) to work in the neighbouring country are the normal residents of their own countries. Example: Nepal.

(iii) Officials, diplomats and members of the armed forces of a foreign country.

(iv) International bodies like World Bank, World Health Organisation or International Monetary Fund are not considered residents of the country in which these organisations operate but are treated as residents of international territory. However, the staffs of these bodies are treated as normal residents of the country in which the international body operates. For example, international body like World Health Organisation located in India is not normal resident of India but Americans working in its office for more than a year will be treated as normal residents of India.

(v) Foreigners who are the employees of non-resident enterprises and who have come to the country for purposes of installing machinery or equipment purchased from their employers. (They are supposed to stay for less than one year. In case they continue to stay for one year or more, they will be treated as normal residents of the host country).

8. Final Goods

(a) These are the goods that are used for:

(i) Personal Consumption (like bread purchased by consumer household), or (if) Investment Or Capital Formation (like building, machinery purchased by a firm)

(b) In other words, final goods are those, which require no further processing and are available in an economy for consumption purpose or investment. These give direct satisfaction to a consumer.

(c) According to production boundary, if a good crosses the imaginary line around the production unit and reaches to final consumer or investment made by a producer within the imaginary line of production unit is known as the final good.

9. Intermediate Goods

(a) These are the goods that are used for:

(i) Further processing (like sugar used for making sweets); or

(ii) Resale in the same year (If car purchased by car dealer for resale).

(b) In other words, intermediate goods are the ones, which require further processing and are not available in an economy for the purpose of consumption. These goods give indirect satisfaction to a consumer.

(c) According to the production boundary, if a good does not cross the imaginary line around the production unit and reaches to other firm within the production boundary, is known as intermediate good.

10. Point to Remember for Final Goods and Intermediate Goods

(a) Basis of Classification: If a good is used for:

(i) Personal consumption; or (ii) Investment

Then it is a final good, whereas, if a good is used for:

(i) Further processing; or

(ii) Resale in the same year, then it is known as intermediate good.

Thus, the basis of classification between these two goods is not the commodity itself, but the use made of it.

For example, bread used by a consumer household is a final goods, but the same used by a bakery for making a sandwich is an intermediate goods.

(b) Production Boundary

(i) Production boundary plays a vital role to differentiate between intermediate and final goods. The production boundary is the imaginary line around the production unit.

(ii) According to the production boundary, if a good crosses the imaginary line around the production unit and reaches to final consumer or investment made by a producer within the imaginary line of production unit, it is known as final good.

As against it, if a good does not cross the imaginary line around the production unit and reaches to other firm within the production boundary, it is known as intermediate good.

In the given diagram, there are 3 production units. The thick border drawn around these three units is the Production Boundary.

Within this limit, wheat and flour are intermediate goods.

Bread is final good as it lies outside the purview of production boundary.

11. Important Points about

Intermediate Goods: As far as intermediate consumption of general government is concerned, it’s purchased goods ranges from ordinary writing paper, pencils and pens to sophisticated fighter aircrafts. The goods and services purchased include both durable goods and non-durable goods and services. The intermediate consumption of the general government includes the following items:

(a) Value of all Non-durable Goods and Services such as petrol, electricity, lubricants, stationery, soaps, towels etc. including repair and maintenance of capital stock: Non-durable goods and services are those which have an expected life time of use of less than one year. Repair and maintenance of capital stock mean expenditure incurred for maintaining fixed assets and keep them in good working order. This includes the expenditure on new parts of the fixed assets. The life of the new parts may be around one year or slightly more and the value should be relatively small. For example, replacement of the tyres of a truck is an intermediate consumption, but not the replacement of its engine.

(b) Expenditure on Military Equipment missiles, rockets, bombs, warships, submarines, military aircrafts, tanks, missile carriers and rocket-launchers etc. whose function is to release weapons. Military vehicles and light weapons.

(c) Value of goods received from foreign governments in form of gifts or as transfers. Examples of these transfers in kind are food, clothing, medicines, vegetable oils, butter, toys sent by the government of one country to the other in times of natural calamities or as a token of goodwill and friendship between two countries.

However, the goods received for distribution to consumer households without renovation or alternation should not be included in intermediate consumption as these goods go into the final consumption of consumer households.

(d) As we know, intermediate goods are purchased by one production unit from another production unit within the production boundary.

However, it’s not necessary that all purchases by one production unit from other production units are intermediate purchases. For example, purchases of building, machinery, etc. are not intermediate purchases (if they are not meant for resale in the same year). Rather, these purchases are meant for investment and are termed as final product.

(e) Research and development

• Commodities consumed. In research and exploratory activities (like oil exploration in different parts of India by the Oil and Natural Gas Commission) or improving the technology of a particular production process.
• Commodities used in basic scientific research.
• Advertisements, market research and public relationship meant for improving the goodwill of the business enterprises.
• Business expenses of the employees on tours and entertainment.

12. Final goods can be classified into two groups: Consumption Goods and Capital Goods.

(a) Consumption Goods:

(i) Meaning: Consumption goods are those which satisfy the wants of the consumers directly. For

Example, cars, television sets, bread, furniture, air-conditioners, etc.

Categories of Consumption Goods:

• Durable goods: These goods have an expected life time of several years and of relatively high value. They are motor cars, refrigerators, television sets, washing machines, air-conditioners, kitchen equipments, computers, communication equipments etc.
• Semi-durable goods: These goods have an expected life time of use of one year or slightly more. They are not of relatively great value. Examples are clothing, furniture, electrical appliances like fans, electric irons, hot plates and crockery.
• Non-durable goods: Goods which can not be used again and again, i.e., they lose their identity in a single act of consumption are known as non-durable goods. These are foodgrains, milk and milk products, edible oils, beverages, vegetables, tobacco and other food articles.
• Services: Services are non-material goods which satisfy the human wants directly. They cannot be seen or touched, i.e., they are intangible in nature. These are medical care, transport and communications, education, domestic services rendered by hired servants, etc.

(b) Capital Goods:

(i) Capital goods are defined as all goods produced for use in future productive processes.

For example, all the durable goods like cars, trucks, refrigerators, buildings, aircrafts,

Air-fields and submarines used to produce goods and are ready for sale in the market

Are a part of capital goods?

(ii) Stocks of raw materials, semi-finished and finished goods lying with the producers at the end of an accounting year are also a part of capital goods

(iii) Some more examples of capital goods are machinery, equipment, roads and bridges.

(iv) These goods require repair or replacement over time as their value depreciate over a period of time.

13. Differentiate between final goods and intermediate goods on the basis of end used classification of goods and services with example.

Words that Matter

1. Circular flow of income: It refers to flow of money income or the flow of goods and services across different sectors of the economy in a circular form.
2. Money flow (nominal flow): Money flow refers to the flow of factor income, as rent, interest, profit and wages from the producing sector to the household sector as monetary rewards for their factor services.
3. Real flow or physical flow: Real flow of income implies the flow of factor services from the household sector to the producing sector and corresponding flow of goods and services from the producing sector to the household sector.
4. Factor income: Income earned by factor of production by rendering their productive services in the production process is known as Factor Income.
5. Transfer income: Income received without rendering any productive services is known as Transfer Income.
6. Current transfers: Transfers made from the current income of the payer and added to the current income of the recipient (who receive) for consumption expenditure are called current transfers.
7. Capital transfers: Capital transfers are defined as transfers in cash and in kind for the purpose of investment to recipient made out of the wealth or saving of a donor.
8. Final goods: These are those which are used for:

(a) Personal consumption (like bread purchased by consumer household), or

(b) Investment or capital formation (like building, machinery purchased by a firm)

9. Intermediate goods: These are those, which are used for:

(a) Further processing (like sugar used for making sweets), or

(b) Resale in the same year (If car purchased by a car dealer for resale).

10. Consumption goods: Consumption goods are those goods which satisfy the wants of consumers directly.
11. Capital goods: Capital goods are defined as all goods produced for use in future Productive processes.

    National Income and Related Aggregates Chapter-2

Introduction:

This is a numerical based chapter to calculate national income by different methods (Income, expenditure and value added method, their steps and precautions). Numerically to determine private income, personal income, personal disposable income, National disposable income (net and gross) and their differences.

Gross and Net:

1. Gross means the value of product including depreciation. Net means the value of product excluding depreciation.
2. The difference between these two terms is depreciation.
3. Where depreciation is the expected decrease in the value of fixed capital assets due to its general use.
4. It is the result of production process.

Gross = Net + Depreciation Net = Gross – Depreciation

Note: Other names of depreciation are:

(a) Consumption of fixed capital

(b) Capital consumption allowance

(c) Current replacement cost.

National Income and Domestic Income:

1. National Income refers to net money value of all the final goods and services produced by the normal residents of a country during an accounting year.
2. Domestic Income refers to a total factor incomes earned by the factor of production within the domestic territory of a country during an accounting year.
3. The difference between these two incomes is Net Factor Income from abroad (NFIA), which is included in National Income (NY) and excluded from Domestic Income (DY).
4. Where NFIA is the difference between income earned by normal residents from rest of the world and similar payments made to Non residents within the domestic territory. NFIA = Income earned by Residents from rest of the world (ROW) – Payments to

Non-Residents within Domestic territory.

NY = DY + NFIA DY = NY – NFIA

Note:

Case I: Income paid to abroad is given, then to make NFIA inverse the sign. For this put income from abroad 0.

Example, Income paid to abroad =100

NFIA = Income from Abroad – Income paid to abroad

= 0 – 100 = -100 and vice versa.

Case II: Income from abroad is given, then NFIA = Income from abroad. For this put income paid to abroad 0.

Example, Income from abroad =100

NFIA = Income from Abroad- Income paid to abroad = 100 – 0 = 100 and vice versa Case III: If income from abroad and income paid to abroad both are given, then NFIA is the difference between them,

Example, Income from abroad =100 Income paid to abroad =120

NFIA = Income from Abroad- Income paid to abroad = 100 – 120 = (-) 20 and vice versa Case IV: Net factor income to abroad be given, then to make NFIA inverse the sign.

Net factor income paid to abroad (NFPA) = income to abroad – income from abroad.

Example,

(i) Net Factor Income to abroad (NFPA = 100). In this NFPA is positive, which means that income to abroad is greater than income from abroad, which makes,

NFIA = (-) 100

(ii) Net Factor Income to abroad [NFPA = (-) 100]. In this NFPA is negative, which

Means that income to abroad is less than income from abroad, which makes,

NFIA = (+) 100

Factor Cost and Market Price:

1. Factor Cost (FC): It refers to amount paid to factors of production for their contribution in the production process.
2. Market Price (MP): It refers to the price at which product is actually sold in the market. The difference between these two is Net Indirect Taxes (NIT) which is included in MP and excluded from FC. Where NIT is the difference between indirect taxes and subsidies.

NIT = IT – Subsidies

Where, Indirect Taxes are the taxes which are levied by the government on production and sale of commodity. Sales tax, excise duty, custom duty, etc. are some of the indirect taxes, and subsidies are the cash grants given by the government to the enterprises to encourage production of certain commodities, to promote exports or to sell goods at prices lower than the free market Price. In India, LPG cylinder is sold at subsidized rates.

MP = FC + NIT (Indirect Taxes – Subsidies)

FC = MP – NIT (Indirect Taxes – Subsidies)

Note:

Case I: Subsidy is given, then to make NIT inverse the sign. For this put Indirect tax = 0.

Example, Subsidy = 100

NIT = Indirect Tax – subsidies = 0-100 = (-) 100 and vice versa

 Case II: IT is given, then NIT = IT (For this put subsidy 0)

Example, IT = 100

NIT = Indirect Tax – subsidies = 100-0 = 100 and vice versa

Case III: If IT and subsidy both are given, then NIT is the difference.

Example, IT = 100

Subsidy = 80

NIT = Indirect Tax – subsidies = 100-80 = 20

Case IV: If sales tax and excise duty are given, then by adding both, we get indirect taxes.

Example, Sales tax = Rs. 1000

Excise duty = Rs.1000 Subsidy = Rs.500

NIT = Indirect Tax (sales tax + excise duty)-subsidies = (1000 + 1000) – 500 = 1500

Case V: If Net subsidy is given, then to convert it into Net Indirect tax, we have to inverse the sign,

Net Subsidy = Subsidy – Indirect Tax

Example,

(a) Net Subsidy = 100. In this, Net subsidy is positive, which means that indirect tax is less than subsidy which makes,

NIT = (-) 100

(b) Net Subsidy = (-) 100. In this Net subsidy is negative which means that Indirect tax is greater than subsidy which makes,

NIT = 100

Case VI: If Net subsidy and Indirect tax both are given, then we have to ignore Indirect Tax and inverse the sign of Net subsidy.

Example, Net Subsidy = 100

Indirect Tax = 20 Net Indirect Tax = (-) 100 Numeribals Illustration on Basic Concept

Aggregate of National Income

1. Gross Domestic Product at Market Price (GDP_MP):

GDP_MP is defined as the gross market value of the final goods and services produced within the domestic territory of a country during an accounting year by all production units.

(a) ‘Gross’ in GDP_MP signifies that depreciation is included, i.e., no provision has been made for depreciation.

(b) ‘Domestic’ in GDP_MP signifies that it includes all the final goods and services produced by all the production units located within the economic territory (irrespective of the fact whether produced by residents or non-residents).

(c) ‘Market Price’ in GDP_MP signifies that indirect taxes are included and subsidies are excluded, i.e., it shows that Net Indirect Taxes (NIT) have been included.

(d) ‘Product’ in GDPMP  signifies that only final goods and services have to be included and intermediate goods should not be included to avoid the double counting.

2. Gross Domestic Product at Factor Cost (GDP_FC):

GDP_FC is defined as the gross factor value of the Final goods and services produced within the domestic territory of a country during an accounting year by all production units excluding Net Indirect Tax.

GDP_FC = GDP_MP – Net Indirect Taxes

3. Net Domestic Product at Market Price (NDP_MP).

NDP_MP is defined as the net market value of all the final goods and services produced within the domestic territory of a country by its normal residents and non-residents during an accounting year.

NDP_MP =GDP_MP – Depreciation

4. Net Domestic Product at Factor Cost (NDP_FC).

NDP_FC refers to a total factor income earned by the factor of production within the domestic territory of a country during an accounting year.

NDP_FC = GDP_MP – Depreciation – Net Indirect Taxes NDPFC is also known as Domestic Income or Domestic factor income.

5. Gross National Product at Market Price (GNP_MP).

GNP_MP refers to market value of all the final goods and services produced by the normal residents of a country during an accounting year.

GNP_MP = GDP_MP + Net factor income from abroad It must be noted that GNPMP can be less than GDPMP when NFIA is negative. However, GNPMP will be more than GDP_MP when NFIA is positive.

6. Gross National Product at Factor Cost (GDP_FC): or Gross National Income GNP_FC refers to gross factor value of all the final goods and services produced by the normal residents of a country during an accounting year.

GDP_FC = GNP_MP – Net Indirect Taxes

7. Net National Product at Market Price (NNP_MP).

NNP_MP refers to net market value of all the final goods and services produced by the normal residents of a country during an accounting year.

NNP_MP = GNP_MP – Depreciation

8. Net National Product at Factor Cost (NNP_FC).

NNP_FC refers to net money value of all the final goods and services produced by the normal residents of a country during an accounting year.

NNP_FC = GNP_MP – Depreciation – Net Indirect Taxes It must be noted that NNP_FC is also known as National Income.

Real, Nominal Aggregates, Activities Excluded From GDP and Does GDP Measures Social Welfare:

1. National Income at Constant Price:

(a) If national income is calculated on the basis of base year price index, then it is known as National income at constant price.

(b) It is also called Real National Income as it fluctuates due to the fluctuation in the flow of goods and services and price remains constant.

2. National Income at Current Price:

(a) If National Income is calculated on the basis of current year price index, then it is known as national income at current price.

(b) It is also called Monetary National Income as it fluctuates due to the fluctuation in the flow of goods and services along with the price of the commodity.

3. GNP at current MP: When final goods and services included in GNP are valued at current MP, i.e., prices prevailing in the year for which GNP is being measured, it is called GNP at current MP or Nominal GNP.
4. GNP at constant MP: When final goods and services included in GNP are valued at constant prices, i.e. prices of the base year, it is called GNP at constant MP or Real GNP.
5. GNP Deflator: GNP Deflator measures the average level of the prices of all the final goods and services that are produced within the domestic territory of an economy including NFIA. GNP deflator is measured as the ratio of nominal GNP to real GNP, multiplied by 100.
6. Green GNP: Green GNP refers to GNP adjusted for loss of value due to,

(a) Environmental degradation; and

(b) Depletion of natural resources on account of overall production activity in the Economy.

7. Activities excluded from GDPMP: The activities are as follows:

(a) Purely financial transactions: It may be of three types:

(i) Buying and selling of securities

(ii) Government Transfer payments

(Iii) Private Transfer Payments

(i) Buying and selling of securities:

• In financial markets potential savers and investors buy and sell financial assets such as shares and bonds.
• While someone buys a share, there is only a transfer of ownership right. It is a claim to ownership of assets.
• Trading in financial instruments does not imply production of final goods and services. As such these are not included in the GNP.

(ii) Government Transfer Payments:

• Transfer Payments are payments for which no goods and services are provided in exchange.
• Pension payments employees social security measures, etc. are examples for

Government Transfer Payment as there is no production of final goods and services in response to transfer Payment, transfer payments are not included in GNP.

(Iii) Private Transfer Payments:

• Items such as pocket money given by parents to their children, elders gifting money to the young ones are private transfer payments.

This is merely a transfer of money from one individual to another. Hence, this is not included in GNP.

(b) Transfer of used goods:

(i) GNP refers to the value of the final goods and services produced in a given year.

(ii) Hence, goods produced in the previous time period cannot be included in the GNP. For example, Mr A sells his old bike to Mr B for rs. 30,000 on 25th April 2011 which was purchased by Mr A on 1st March 2010 for Rs. 45,000. This transaction should not be included as it has already been included in the 2010 GNP and if we again include it, then it will create the problem of double counting.

(c) Non-market goods and services:

(i) Many final goods and services are not acquired through regular market transaction. Vegetables can be grown in the backyard instead of buying them from the super market or an electrical fault can be repaired by the house owner himself instead of hiring an electrician.

(ii) These are examples of Non-marketed goods and services that have been consumed with using organized markets as GNP includes only those transactions that occur through market activities.

(d) Illegal Activities: Activities like gambling, black-marketing etc., should be excluded because all unlawful activities are beyond the scope of NY and also because there is statistical problem of their estimation.

(e) Leisure Time Activities: Activities like painting, growing of flowers in kitchen garden, etc. is not included as their aim is not to earn money but to pass away free time in one’s hobby or entertainment, again there is statistical problem of measuring their satisfaction derived in painting or any other leisure activities.

8. Limitations of using GDP as an index of welfare of a country: There are many Reasons behind this. These are:

 (a) Many goods and services contributing economic welfare are not included in GDP or Non-Monetary exchanges:

(i) There are many goods and services which are left out of estimation of national income on account of practical estimation difficulties e.g., services of housewives and other members, own account production, etc.

(ii) These are left on account of non-availability of data and problem in valuation.

(iii) It is generally agreed that these items contribute to economic welfare.

(iv) So, if we depend only on GDP, we would be underestimating economic welfare.

(b) Externality:

(i) When the activities of somebody result in benefits or harms to others with no payment received for the benefit and na payment made for the harm done, such benefits and harms are called externalities.

(ii) Activities resulting in benefits to others are positive externalities and increase welfare; and those resulting in harm to others are called negative externalities, and thus decrease welfare.

(iii) GDP does not take into account these externalities.

For example, construction of a flyover or a highway reduces transport cost and journey time of its users who have not contributed anything towards its cost. Expenditure on construction is included in GDP but not the positive externalities flowing from it. GDP and positive externalities both increase welfare. Therefore, taking only GDP as an index of welfare understates welfare. It means that welfare is much more than it is indicated by GDP.

(iv) Similarly, GDP also does not take into account negative externalities. For examples, factories produce goods but at the same time create pollution of water and air. River Yamuna, now a drain, is a living example. The pollution harms people. The factories are not required to pay anything for harming people. Producing goods increases welfare but creating pollution reduces welfare. Therefore, taking only GDP as an index of welfare overstates welfare. In this case, welfare is much less than indicated by GDP.

(c) Change in the distribution of income (GDP) may affect welfare:

(i) All people do not earn the same amount of income. Some earn more and some earn less. In other words, there is unequal distribution of income.

(ii) At the same time, it is also true that in the event of rise in ‘per capita real income’ all are not better off equally. ‘Per capita’ is only an average. Income of some may rise by less and of some by more than the national average. In case of some it may even fall.

(iii) It means that the inequality in the distribution of income may increase or decrease.

(iv) If it increase it implies that rich become richer and the poor become poorer.

(v) Utility of a rupee of income to the poor is more than to the rich. Suppose, the income of the poor declines by one rupee and that of the rich increases by one rupee. In such a case, the decline in welfare of the poor will be more than the increase in welfare of the rich.

(vi) Therefore, if the rise in per capita real income inequality increases, it may lead to a decline in welfare (in the macro sense).

(d) All products may not contribute equally to economic welfare:

(i) GDP includes different types of products, like food articles, houses, clothes, police services, military services, etc.

(ii) Some of these products contribute more to the welfare of the people, like food, clothes, houses, etc. Other products like police services, military services etc. may comparatively contribute less and may not directly affect the standard of living of the people.

(iii) Therefore, how much is the economic welfare would depend more on the types of goods and services produced, and not simply how much is produced.

(iv) It means that if GDP rises, the increase in welfare may not be in the same proportion.

(e) Contribution of some products may be negative:

(i) GDP includes all final products whether it is milk or liquor.

(ii) Milk may provide both immediate and ultimate satisfaction to consumers. On the other hand, liquor may provide some immediate satisfaction, but because of its harmful effects on health it may lead to decline in welfare.

(iii) GDP include only the monetary values of the products and not their contribution to welfare.

(iv) Therefore, economic welfare depends not only on the volume of consumption but also on the type or goods and services consumed.

Methods of National Income and How to Determine National Income By Income Method and Its Numericals, Steps and Precaution:

There are three methods of calculating national income.

These are:

(a) Income Method

(b) Expenditure Method

(c) Value Added Method/Product Method/Output Method

National Income determination under income method:

(a) “Production creates income”. If we want to calculate National Income by Income method, then we have to add different factor incomes from the economy.

(b) The addition of all these factor incomes gives us the calculation near by the

National Income, i.e., Net Domestic Product at FC (NDPfc).

(c) Components of Income Method

1. Compensation Of Employees (COE)/Emoluments of employees: The amount Earned by employees from their employers, whether in cash or in kind or through any other social security scheme is known as compensation of employees.

This is broadly divided into the following three components:

(a) Wages and Salaries payable in Cash:

(i) Wages and salaries receivable by the employees in respect of their work.

(ii) Special allowances for working overtime.

(Iii) Cost of travel to and from work, and car parking.

(iv) Bonuses

(v) Commissions, gratuities, tips, cost of living (i.e., dearness allowance paid in our country) honorarium, vacation, sick leave allowance etc.

(vi) Pensions at the time of retirement (Deferred Wage): Pensions at the time of retirement are related to factor services rendered by recipient prior to their retirement. It is also known as deferred wage.

Any expenses incurred by the employees and thereafter reimbursed by the business enterprise should be excluded from Compensation of Employees (COE) as such expenses are part of intermediate

Consumption of business enterprise.

(b) Wages and Salaries in Kind: Remuneration in kind consists of goods and services that are not necessary for work and can be used by employees at their own discretion, for the satisfaction of their needs or wants or those of other members of their households. It includes:

(i) Meals and drinks including those consumed when travelling for business.

(ii) Accommodation.

(iii) The services of vehicles or other durables provided for the personal use of the employees.

(iv) Goods and services produced as outputs from the employer’s own process of production such as free travel for the employees of railways or airlines, or free coal for miners.

(v) Sports, recreation or holiday facilities for employees and their families.

(vi) Creches for children of employees.

(vii) Value of the interest foregone by employers when they provide loans to employees at reduced, or even zero rates of interest for the purposes of buying houses, furniture or other goods and services.

It should be kept in mind that it does not include any facilities which are necessary for work and in which employees do not have any discretion.

For example, uniforms or other forms of special clothing to be used for work only. Examples are uniforms for police, uniforms of drivers, and uniforms for nurses in the hospital. It’s so because such payments are intermediate consumption of business enterprises.

(c) Employers’ Contribution to Social Security Schemes: Employers’ make payments to social security schemes like life insurance, causality insurance, pension schemes etc. For example, there is a Contributory provident Fund Scheme for employees of educational institutions and public sector undertakings. The contribution made by the employers for such schemes is a part of compensation of employees.

The thing which has to be remembered is that, employers’ contribution towards social security scheme should be included whereas employees’ contribution towards Social Security Scheme should not be included as COE is that what the employer pays to employee and if anything borne by employee himself should not be included under COE.

2. Operating Surplus: The CSO (Central Statistical Organization) has defined operating surplus as “value of gross output less the sum of intermediate consumption, compensation of employees, mixed income, depreciation and NIT.”

Operating Surplus = GVOMP – Intermediate consumption – COE – Mixed Income – Depreciation – NIT

In other words, it is the sum of income from property and income from entrepreneurship. Operating surplus have the following two components:

(a) Income from property: It is the income which has been arisen from rent, interest and royalty.

It is divided into three components:

(i) Rent: The income arising from ownership of land and building is known as rent. It also includes imputed rent. If a person living in his own house, then it is assumed in an economy that he is paying rent to himself. This concept is known as imputed rent.

(ii) Royalty: Royalties are the payments made for the use of mineral deposits such as coal, oil, etc. or for the use of patents, copyrights, trademarks, etc.

(iii) Interest: It is the amount earned for lending funds to the production units. It also includes imputed interest of funds provided by entrepreneur. But interest income includes interest on loan taken for productive services only.

The following categories of interest should not be included:

• Interest on national debt or interest paid by government on nation debt should not be included as it is assumed that such interest is paid on loan taken for consumption purpose.
• Interest paid by one firm to another firm as it is already included in the profit of the firm which pays it.

(b) Income from entrepreneurship: It is a return of entrepreneur after paying all the other factors of production. It is of the following three types:

(i) Distributed Profit (Dividend): It is that part of total profit which is given to shareholders.

The thing to be noted here is that profit earned by one firm to another should not be included under this head because it is already included in the profit of the firm which pays it.

(ii) Undistributed Profit (Saving of private corporate sector or Retained £arnings):

It is that part of total profit which is not given to shareholders and kept as a reserve for future uncertainties.

(iii) Corporation Tax (Profit Tax): It is that part of total profit which is given by a firm to the government as Tax.

The concept of operating surplus is applicable to all producing enterprises, whether they belong to the private sector or to the government. The government enterprises also are expected to earn reasonable rate of profit on the funds invested.

But, operating surplus does not arise in the general government sector as they produce goods and services for the social welfare of the country and not for profit motive i.e., why rent, interest and profit are zero in general government sector.

3. Mixed Income: Income of own account workers (like farmers, doctors, barbers, etc.) and unincorporated enterprises (like small shopkeepers, repair shops) is known as mixed income. They do not maintain proper accounts. They do not generally hire factor services from the market rather use their own resources like land, labour, funds, etc. As the result of, it becomes difficult to classify their income distinctly among rent, wages, interest and profit.

NDPFC Compensation of employees (COE) + Operating surplus (OS) + Mixed Income (MY)

Method for Calculating National Income By Income Method:

If we want to calculate National Income by Income method, we have to add different factor incomes from the economy.

The addition of all these factor incomes gives us the calculation near by the National Income, i.e. Net Domestic Product at FC (NDPFC).

Important Note:

1. Profit earned by one firm to another should not be included because it is a part of intermediate consumption.
2. If Profit after tax is given and corporate tax is given, then by adding them we get profit. Profit after tax = 1000

Corporate tax =100 Profit =1100

3. If Profit before tax and corporate tax are given, then ignore corporate tax.

Profit before tax = 1000

Corporate tax =100 Profit = 1000

Steps for calculating national income by income method:

Step 1: To identify enterprises which employ primary factors (Land, Labour, Capital, enterprise).

Step 2: To classify various types of factor income like:

(a) Compensation of employees: The amount earned by employees from their employer, whether in cash or in kind or through any other social security scheme is known as compensation of employees.

(b) Operating Surplus: It is the sum of income from property and income from entrepreneurship.

(c) Mixed Income: Income of own account workers (like farmers, doctors, barbers, etc.) and unincorporated enterprises (like small shopkeepers, repair shops) is known as mixed income.

Step 3: To estimate amount of factor payments made by each producing unit.

Step 4: To add all factor incomes / payments within domestic territory to get domestic income, i.e., NDP_FC.

NDP_FC = Compensation of employees + Operating Surplus + Mixed Income Step 5: Addition of NFIA to NDP_FC to get NY, i.e., NNP_FC.

Precautions of income method.

(a) Avoid transfers: National income includes only factor payments, i.e., payment for the services rendered to the production units by the owners of factors. Any payment for which no service is rendered is called a transfer, not a production activity. Gifts, donations etc. are main examples. Since transfers are not a production activity it must not be included in national income.

(b) Avoid capital gain: Capital gain refers to the income from the sale of second hand goods and financial assets. Income from the sale of old cars, old house, bonds, debentures, etc. are some examples. These transactions are not production transactions. So, any income arising to the owners of such things is not a factor income.

(c) Include income from self-consumed output: When a house owner lives in his house, he does not pay any rent. But infact he pays rent to himself. Since, rent is a payment for services rendered, even though rendered to the owner itself, it must be counted as a factor payment.

(d) Include free services provided by the owners of the production units: Owners work in their own unit but do not charge salary. Owners provide finance but do not charge any interest. Owners do production in their own buildings but do not charge rent. Although they do not charge, yet the services have been performed. The imputed value of these must be included in national income.

How to Determine National Income By Expenditure Method And Its Numericals, Steps And Precautions:

National income determination by Expenditure method:

(a) “Production creates income, income creates expenditure”. If we want to calculate National Income by this method, we have to add different final expenditures from an economy.

(b) The addition of all those final expenditure gives us the calculation near by the National Income, i.e. GDP_MP.

Components of Expenditure Method

1. Government Final Consumption Expenditure (GFCE): The expenditure made by a general government on current expenditure on goods and services like public health, defence, law and order, education, etc. These goods and services generate no income because it is produce by a general government without any profit motive.

These goods and services are valued at their cost to the government as they are not sold to the citizen and have been produced for the social welfare of the citizens. So, GFCE = Intermediate consumption of government + Compensation of employees (wages and salaries in cash and in kind) by government + Direct purchases made abroad by government (purchases made by embassies and consulates located in foreign countries) + Consumption of fixed capital (depreciation) – Sale of goods and services by government.

2. Private Final Consumption Expenditure (PFCE): Private final consumption expenditure is defined as consumption expenditure by consumer households (household final consumption expenditure) and private NPISH (Non-profit Institution serving households) on all types of consumer goods.

PFCE = Household final consumption expenditure + Private non-profit Institution serving households final consumption expenditure.

The value of following items is measured for getting private final Consumption Expenditure.

(a) Purchases of currently produced goods and services in the domestic market by consumer households and NPISH.

(b) Direct purchases made abroad by resident households are added but direct purchases in domestic market by non-resident households and extra territorial bodies are deducted.

PFCE = Purchases of currently produced goods and services in the domestic Market by consumer households and NPISH households + direct purchases made abroad by resident households – direct purchases in domestic market by non¬resident households.

Note: If in the examination problem household final consumption expenditure is not given, it can be calculated as under

Household Final Consumption Expenditure = Personal disposable income – Personal (Household) Saving

3. Gross Domestic Capital Formation or Gross Investment or Investment Expenditure:

It refers to additions to the physical stock of capital during a period of time. It includes building machinery, Housing construction, construction of factories, etc. It has been classified into the following categories.

(a) Gross Domestic Fixed Capital Formation (GDFCF): It is the expenditure incurred on purchase of fixed assets. It is of three types:

(i) Gross Business Fixed Investment: It is the amount that the business units spend on purchase of newly produced capital goods like plant and equipments. Gross business fixed investment is the gross amount spent on newly produced fixed capital goods. When depreciation is deducted from it, we obtain Net Business fixed Investment.

Gross Business Fixed Investment = Net Business fixed Investment + Depreciation

(ii) Gross Residential Construction Investment: This is the amount spent on construction of flats and residential houses. The investment is said to be gross when depreciation is not deducted and Net when depreciation is deducted.

(iii) Gross Public Investment: This includes capital formation by government in the form of building of roads, bridges, schools, hospitals, etc. This investment is called Gross when depreciation is not deducted and Net when depreciation is subtracted.

(b) Change In Stock (Closing Stock – Opening Stock) Or Inventory Investment: It is the net change in inventories of final goods, finished goods, semi-finished goods and raw material. These are included as they represent currently produced goods, which are not included in the current sale of final output. It is a difference between closing stock and the opening stock of the year.

(c) Net Acquisition of Valuables: These are those high value durable goods like gold, silver, amtiques, etc. which are taken at market price.

GDCF = Gross domestic fixed capital formation (GDFCF) + Change in Stock (Closing Stock – Opening Stock) + Net acquisition of valuables

Or

GDCF = Gross Business Fixed Investment + Gross Residential Construction +

Gross Public Investment + Inventory Investment + Net Acquisition of Valuables

4. Net Export (Export – Import): It shows the difference between domestic spending

On foreign goods (i.e., imports) and foreign spending on domestic goods (i.e., exports).

Thus, the difference between exports and imports of a country is called Net Exports.

Net Exports = Export – Import

GDPMP = Government final consumption expenditure + Private final consumption expenditure + Gross domestic capital formation + Net export

Numerical Problems on Expenditure Method

       Money Chapter-3

Introduction:

This chapter is a detailed version of barter system and its difficulties, how money has overcome its drawbacks, money supply and its measures.

Barter System and Its Difficulties, Money and Functions of Money:

1. Barter system of exchange is a system in which goods are exchanged for goods.
2. For example, wheat may be exchanged for cloth; house for horses, etc., or a teacher may be paid wheat or rice as a payment for his/her services.
3. Such exchange exists in the C-C Economy (commodity to commodity exchange economy).

Note: In C-C Economy C stands for commodity. C-C economy is the one in which commodities are exchanged for commodities. C-C exchange refers to barter system of exchange. Hence, C-C Economy is an economy dominated by barter system of exchange.

4. Difficulties of barter system are:-Barter system as a system of exchange is faced with the following difficulties:

(a) Lack of double coincidence of wants:

(i) Barter is possible only if goods produced by two persons are needed by each other. It is double coincidence of wants.

(ii) Double coincidence of wants means that goods in possession of two different persons must be useful and needed by each other. It is the main basis of barter system of exchange. But it is rare.

(iii) It is difficult to find such a person every time. In barter system, exchange becomes quite limited.

(b) Lack of divisibility:

(i) In commodity exchange, difficulty of dividing the commodity arises.

(ii) For example, if a car is to be exchanged for a scooter, then car can not be divided. Similarly, animals can not be divided into smaller units.

(c) Difficulty in storing wealth:

(i) It is very difficult to store wealth for future use.

(ii) Most of the goods like wheat, rice, cattle etc. are likely to deteriorate with the passage of time or involve heavy cost of storage.

(iii) Further, the transfer of goods from one place to another place involves huge transport cost.

(iv) Transfer of immovable commodities (such as house, farm, land, etc.) becomes almost impossible.

(d) Absence of common measure of value:

(i) Different commodities are of different values. The value of a good or service means the amount of other goods and services it can be exchanged for in the market. There is no common measure of value under barter system.

(ii) In this situation, it is difficult to decide in what proportions are the two goods to be exchanged.

(e) Lack of standard of deferred payment: In a barter economy future payments would have to be stated in terms of specific goods or services. This leads to following problems:

(i) There could be disagreement regarding the quality of the goods or services to be repaid.

(ii) There would be disagreement regarding which specific commodities would be used for repayment.

5. Money: Money is something which is generally acceptable as a medium of exchange and can be converted into other assets without losing its time and value.
6. Functions of money: Functions of money can be summed up as follow:

“Money is a matter of the following four functions:

A medium, a measure, a standard, a store”

We can conclude these four functions under the following two functions:

(a) Primary function

(b) Secondary function

(a)Primary function or Main function: Primary function includes the most important functions of money, which it must perform in an economic system irrespective of time and place. The following two functions are included under this category.

(i) Medium of exchange

• Money when used as a medium of exchange helps to eliminate the basic limitation of barter trade, that is, the lack of double coincidence of wants.
• Individuals can exchange their goods and services for money and then can use this money to buy other goods and services according to their needs and convenience.
• Thus, the process of exchange shall have two parts: a sale and a purchase.
• The ease at which money is converted into other goods and services is called “liquidity of money”.

(ii) Measure of value /unit of account

• Another important function of money is that it serves as a common measure of value or a unit of account.
• Under barter economy there was no common measure of value in which the values of different goods could be measured and compared with each other. Money has also solved this difficulty.
• As Geoffrey Crowther puts it, “Money acts as a standard measure of value to which all other things can be compared.” Money measures the value of economic goods.
• Money works as a common denominator into which the values of all goods and services are expressed.
• When we express the values of a commodity in terms of money, it is called price and by knowing prices of the various commodities, it is easy to calculate exchange ratios between them.

(b) Secondary Functions

(i) Standard of deferred payments

• Credit has become the life and blood of a modern capitalist economy.
• In millions of transactions, instant payments are not made.
• The debtors make a promise that they will make payments on some future date. In those situations money acts as a standard of deferred payments.
• It has become possible because money has general acceptability, its value is stable, it is durable and homogeneous.

(ii) Store of value

• Wealth can be conveniently stored in the form of money. Money can be stored without loss in value.
• Savings are secured and can be used whenever there is a need.
• In this way, money acts as a bridge between the present and the future.
• Money means goods and services. Thus, money serves as a store of value.
• It is also known as asset function of money.

7. Characteristics or features of money:

(a) Durability: Money must be durable and not likely to deteriorate rapidly with frequent handling. Currency notes and coins are being used repeatedly and shall continue to do so for many years.

 (b) Medium of exchange: Money is the thing that acts as a medium of exchange for the sale and purchase of goods and services.

(c) Weight: Money must be light in weight. Paper money is better than metal coins because it is light in weight.

(d) Measure of value: It not only serves as medium of exchange but also acts as a measure of value. The value of all the goods and services is expressed in terms of money.

8. Money has overcome the drawbacks of barter system: Barter system makes the exchange process very difficult and highly inefficient. Money has overcome the drawbacks of barter system in the following manners:

 (a) Medium of exchange

(i) Under barter system, there is lack of double coincidence of wants.

(ii) With money as a medium exchange individuals can exchange their goods and services for money and then use this money to buy other goods and services according to their needs and conveniences.

(iii) A buyer can buy goods through money and a seller can sell goods for money.

(b) Measure of value

(i) Under barter system, there was no common measure of value. Money has also solved this difficulty.

(ii) As Geoffrey Crowther puts it, “Money acts as a standard measure of value to which all other things can be compared.” Money measures the value of economic goods.

(iii) Money works as a common denominator into which the values of all goods and services are expressed.

(iv) When we express the values of a commodity in terms of money, it is called price and by knowing prices of the various commodities, it is easy to calculate exchange ratios between them.

(c) Store of value

(i) Under barter system it is very difficult to store wealth for future use.

(ii) Most of the goods are perishable and their storage requires huge space and transportation cost.

(iii) Wealth can be conveniently stored in the form of money.

(iv) Money can be stored without loss in value.

(v) Money can easily be stored for future use.

(d) Standard of deferred payments

(i) Under barter system, transactions on deferred payments are not possible.

(ii) With money, the debtors make a promise that they will make payments on some future dates. In these situations money acts as a standard of deferred payments.

(iii) It has become possible because money has general acceptability, its value is stable, it is durable and homogeneous.

9. Legal definition of money:

(a) Legally, money is anything proclaimed by law as a medium of exchange.

(b) Paper notes and coins (together called currency) is money as a matter of law.

(c) Nobody can refuse its acceptance as medium of exchange.

(d) In other words, it is legal tender. It means people have to accept it legally for different payments. Currency is also called FIAT money because it commands ‘FIAT’ (order/authority) of the government.

10. Functional definition of money: Functional definition of money refers to money as anything that performs four basic functions,

(a) It serves as a medium of exchange.

(b) It serves as a standard unit of value.

(c) It serves as a means for future / contractual payments or standard of deferred payments.

(d) It serves as a store of value.

According to this, definition of money includes both notes and coins as well as chequeable deposits with the banks.

11. Narrow definition of money: Functional definition of money is a narrow definition of money. It includes only notes, coins and demand deposits as money. In other words, in its narrow definition, money includes only those things that function as money in terms of:

(a) Medium of exchange.

(b) Measure of value.

(c) Standard of future/Deferred payments.

(d) Store of value.

12. Broad definition of money:

(a) A broad definition of money also includes time deposits/term deposits with the banks or post offices as a component of money.

(b) These deposits can be converted into demand deposits on a short notice, and are “Near money assets”. Money assets and near money assets together make up a definition of money.

Money Supply and Measures of Money Supply

1. Money supply: The volume of money held by the public at a point of time, in an economy, is referred to as the money supply. Money supply is a stock concept.
2. Measures of money supply: On the recommendation of the second working group on money supply, the RBI presented four measures of money supply in its 1977 issues of RBI Bulletin, namely M₁, M₂, M₃ and M₄.

Measures of M₁ include:

(a) Currency notes and coins with the public (excluding cash in hand of all commercial banks) [C]

(b) Demand deposits of all commercial and co-operative banks excluding inter-bank deposits. (DD),

Where demand deposits are those deposits which can be withdrawn by the depositor at any time by means of cheque. No interest is paid on such deposits.

(c) Other deposits with RBI [O.D]

M1 = C + DD + OD

Where, other deposits are the deposits held by the RBI of all economic units except the government and banks. OD includes demand deposits of semi¬government public financial institutions (like IDBI, IFCI, etc.), foreign central banks and governments, the International Monetary Fund, the World Bank, etc.

Measures of M₂:

(i) M1 [C + DD + OD]

(ii) Post office saving deposits

Measures of M₃:

(i) M1

(ii) Time deposits of all commercial and co-operative banks.

Where, Time deposits are the deposits that cannot be withdrawn before the expiry of the stipulated time for which deposits are made. Fixed deposit is an example of time deposit.

Measures of M₄:

(i) M3

(ii) Total deposits with the post office saving organization (excluding national savings certificates).

3. High-powered money: High-powered money is money produced by the RBI and the government. It consists of two things: (a) currency held by the public and (b) Cash reserves with the banks.

Words that Matter

1. Barter system: Barter system of exchange is a system in which goods are exchanged for goods.
2. Double coincidence of wants: It means that goods in possession of two different persons must be useful and needed by each other.
3. Money: Money is something which is generally acceptable as a medium of exchange and can be converted into other assets without loosing its time and value.
4. Legal definition of money: Legally, money is anything proclaimed by law as a medium of exchange. Paper notes and coins (together called currency) is money as a matter of law.
5. FIAT Money: It is defined as a money which is under the ‘FIAT’ (order/authority) of the government to act as a money.
6. Functional definition of money: Functional definition of money refers to money as anything that performs four basic functions. (Medium of exchange, standard unit of value, standard of deferred payments, store of value)
7. Narrow definition of money: Functional definition of money is a narrow definition of money. It includes only notes, coins and demand deposits as money.
8. Broad definition of money: A broad definition of money also includes time deposits/ term deposits with the banks or post offices as a component of money.
9. Money Supply: The stock of money held by the public at a point of time, in an economy, is referred to as the money supply. Money supply is a stock concept.
10. High-powered money: It is money produced by the RBI and the government. It consists of two things: (i) currency held by the public and (ii) Cash reserves with the banks.
11. Demand deposits: These are the deposits that can be withdrawn by the depositor at any time by means of cheque. No interest is paid on such deposits.
12. Time deposits: These are the deposits that cannot be withdrawn before the expiry of the stipulated time for which deposits are made. Fixed deposit is an example of time deposit.
13. Other deposit measures of M₁: Other deposits are the deposits held by the RBI of all economic units except the government and banks. OD includes demand deposits of semi-government public financial institutions (like IDBI, IFCI, etc.), foreign central banks and governments, the International Monetary Fund, the World Bank, etc.

        Banking Chapter-4

Introduction:

This is a textual description of commercial bank, credit creation by commercial bank, central bank and its functions.

Commercial Bank and Credit Creation by Commercial Bank

1. Commercial bank is a financial institution which performs the functions of accepting deposits from the public and making loans and investments, with the motive of earning profit.
2. Process of money creation/deposit creation/credit creation by the commercial banking system.

(a) Let us assume that the entire commercial banking system is one unit. Let us call this one unit simply “banks’. Let us also assume that all receipts and payments in the economy are routed through the banks. One who makes payment does it by writing cheque. The one who receives payment deposits the same in his deposit account.

(b) Suppose initially people deposit Rs.1000. The banks use this money for giving loans. But the banks cannot use the whole of deposit for this purpose. It is legally compulsory for the banks to keep a certain minimum fraction of these deposits as cash. The fraction is called the Legal Reserve Ratio (LRR). The LRR is fixed by the Central Bank. It has two components. A part of the LRR is to be kept with the Central bank and this part ratio is called the Cash Reserve Ratio. The other part is kept by the banks with themselves and is called the Statutory Liquidity Ratio.

(c) Let us now explain the process, suppose the initial deposits in banks is Rs.1000 and the LRR is 10 percent. Further, suppose that banks keep only the minimum required, i.e., Rs.100 as cash reserve, banks are now free to lend the remainder Rs.900. Suppose they lend Rs.900. What banks do to open deposit accounts in the names of the borrowers who are free to withdraw the amount whenever they like.

• Suppose they withdraw the whole of amount for making payments.

(d) Now, since all the transactions are routed through the banks, the money spent by the borrowers comes back into the banks into the deposit accounts of those who have received this payment. This increases demand deposit in banks by?900. It is 90 per cent of the initial deposit. These deposits of Rs.900 have resulted on account of loans given by the banks. In this sense the banks are responsible for money creation. With this round, increased in total deposits are now Rs.1900 (=1000 + 900).

 (e) When banks receive new deposit of ?900, they keep 10 per cent of it as cash reserves and use the remaining Rs. 810 for giving loans. The borrowers use these loans for making payments. The money comes back into the accounts of those who have received the payments. Bank deposits again rise, but by a smaller amount of Rs.810. It is 90 per cent of the last deposit creation. The total deposits now increase to Rs.2710 (=1000 + 900 + 810). The process does not end here.

(f) The deposit creation continues in the above manner. The deposits go on increasing round after round but Deposit Creation By Commercial Banks each time only 90 per cent of the last round deposits. At the same time cash reserves go on increasing, each time 90 per cent of the last cash reserve. The deposit creation comes to end when the total cash reserves become equal to the initial deposit. The total deposit creation comes to Rs.10000, ten times the initial deposit as shown in the table.

It can also be explained with the help of the following formula:

3. Banks required to keep only a fraction of deposits as cash reserves Banks are required to keep only a fraction of deposits as cash reserves because of the following two reasons:

(a) First, the banking experience has revealed that not all depositors approach the banks for withdrawal of money at the same time and also that normally they withdraw a fraction of deposits.

(b) Secondly, there is a constant flow of new deposits into the banks. Therefore to meet the daily demand for withdrawal of cash, it is sufficient for banks to keep only a fraction of deposits as a cash reserve.

4. When the primary cash deposit in the banking system leads to multiple expansion in the total deposits, it is known as money multiplier or credit multiplier.

Central Bank and Their Functions

1. The central bank is the apex institution of a country’s monetary system. The design and the control of the country’s monetary policy is its main responsibility. India’s central bank is the Reserve Bank of India.
2. Functions of Central Bank.

(a) Currency Authority:

(i) The central bank has the sole monopoly to issue currency notes. Commercial banks cannot issue currency notes. Currency notes issued by the central bank are the legal tender money.

(ii) Legal tender money is one, which every individual is bound to accept by law in exchange for goods and services and in the discharge of debts.

(iii) Central bank has an issue department, which is solely responsible for the issue of notes.

(iv) However, the monopoly of central bank to issue the currency notes may be partial in certain countries.

(v) For example, in India, one rupee notes and all types of coins are issued by the government and all other notes are issued by the Reserve Bank of India.

(b) Banker, Agent and Advisor to the Government: Central bank everywhere in the world acts as banker, fiscal agent and adviser to their respective government.

(i) As Banker: As a banker to the government, the central bank performs same functions as performed by the commercial banks to their customers.

• It receives deposits from the government and collects cheques and drafts deposited in the government account.
• It provides cash to the government as resumed for payment of salaries and wages to their staff and other cash disbursements.
• It makes payments on behalf of the government.
• It also advances short term loans to the government.
• It supplies foreign exchange to the government for repaying external debt or making other payments.

(ii) As Fiscal Agent: As a fiscal agent, it performs the following functions:

• It manages the public debt.
• It collects taxes and other payments on behalf of the government.
• It represents the government in the international financial institutions (such as World Bank, International Monetary Fund, etc.) and conferences.

(iii) As Adviser

• The central bank also acts as the financial adviser to the government.
• It gives advice to the government on all financial and economic matters such as deficit financing, devaluation of currency, trade policy, foreign exchange policy, etc.

3. Banker’s Bank and Supervisor:

(a) Banker’s Bank: Central bank acts as the banker to the banks in three ways: (i) custodian of the cash reserves of the commercial banks; (ii) as the lender of the last resort; and (iii) as clearing agent.

(i) As a custodian of the cash reserves of the commercial banks, the central bank maintains the cash reserves of the commercial banks. Every commercial bank has to keep a certain percent of its cash reserves with the central bank by law.

(ii) As Lender of the Last Resort.

• As banker to the banks, the central bank acts as the lender of the last resort.
• In other words, in case the commercial banks fail to meet their financial requirements from other sources, they can, as a last resort, approach to the central bank for loans and advances.
• The central bank assists such banks through discounting of approved securities and bills of exchange.

(ii) As Clearing Agent

• Since it is the custodian of the cash reserves of the commercial banks, the central bank can act as the clearinghouse for these banks.
• Since all banks have their accounts with the central bank, the central bank can easily settle the claims of various banks against each other simply by book entries of transfers from and to their accounts.
• This method of settling accounts is called Clearing House Function of the central bank.

(b) Supervisor

(i) The Central Bank supervises, regulate and control the commercial banks.

(ii) The regulation of banks may be related to their licensing, branch expansion, liquidity of assets, management, amalgamation (merging of banks) and liquidation (the winding of banks).

(iii) The control is exercised by periodic inspection of banks and the returns filed by them.

4. Controller of Money Supply and Credit: Principal instruments of Monetary Policy or credit control of the Central Bank of a country are broadly classified as:

(a) Quantitative Instruments or General Tools; and

(b) Qualitative Instruments or Selective Tools.

(a) Quantitative Instruments or General Tools of Monetary Policy: These are the instruments of monetary policy that affect overall supply of money/credit in the economy. These instruments do not direct or restrict the flow of credit to some specific sectors of the economy. They are as under:

(i) Bank Rate (Discount Rate)

• Bank rate is the rate of interest at which central bank lends to commercial banks without any collateral (security for purpose of loan). The thing, which has to be remembered, is that central bank lends to commercial banks and not to general public.
• In a situation of excess demand leading to inflation,

-> Central bank raises bank rate that discourages commercial banks in borrowing from central bank as it will increase the cost of borrowing of commercial bank.

-> It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans, which discourages investment.

-> Again high rate of interest induces households to increase their savings by restricting expenditure on consumption.

-> Thus, expenditure on investment and consumption is reduced, which will control the excess demand.

• In a situation of deficient demand leading to deflation,

-> Central bank decreases bank rate that encourages commercial banks in borrowing from central bank as it will decrease the cost of borrowing of commercial bank.

-> Decrease in bank rate makes commercial bank to decrease their lending rates, which encourages borrowers from taking loans, which encourages investment.

-> Again low rate of interest induces households to decrease their savings by increasing expenditure on consumption.

-> Thus, expenditure on investment and consumption increase, which will control the deficient demand.

(ii) Repo Rate

• Repo rate is the rate at which commercial bank borrow money from the central bank for short period by selling their financial securities to the central bank.
• These securities are pledged as a security for the loans.
• It is called Repurchase rate as this involves commercial bank selling securities to RBI to borrow the money with an agreement to repurchase them at a later date and at a predetermined price.
• So, keeping securities and borrowing is repo rate.
• In a situation of excess demand leading to inflation,

-> Central bank raises repo rate that discourages commercial banks in borrowing from central bank as it will increase the cost of borrowing of commercial bank.

-> It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans, which discourages investment.

-> Again high rate of interest induces households to increase their savings by restricting expenditure on consumption.

-> Thus, expenditure on investment and consumption is reduced, which will control the excess demand.

• In a situation of deficient demand leading to deflation,

-> Central bank decreases Repo rate that encourages commercial banks in borrowing from central bank as it will decrease the cost of borrowing of commercial bank.

-> Decrease in Repo rate makes commercial bank to decrease their lending rates, which encourages borrowers from taking loans, which encourages investment.

-> Again low rate of interest induces households to decrease their savings by increasing expenditure on consumption.

-> Thus, expenditure on investment and consumption increase, which will control the deficient demand.

(iii) Reverse Repo Rate

• It is the rate at which the Central Bank (RBI) borrows money from commercial bank.
• In a situation of excess demand leading to inflation, Reverse repo rate is increased, it encourages the commercial bank to park their funds with the central bank to earn higher return on idle cash. It decreases the lending capability of commercial banks, which controls excess demand.
• In a situation of deficient demand leading to deflation, Reverse repo rate is decreased, it discourages the commercial bank to park their funds with the central bank. It increases the lending capability of commercial banks, which controls deficient demand.

(iv) Open Market Operations (OMO)

• It consists of buying and selling of government securities and bonds in the open market by Central Bank.
• In a situation of excess demand leading to inflation, central bank sells government securities and bonds to commercial bank. With the sale of these securities, the power of commercial bank of giving loans decreases, which will control excess demand.
• In a situation of deficient demand leading to deflation, central bank purchases government securities and bonds from commercial bank. With the purchase of these securities, the power of commercial bank of giving loans increases, which will control deficient demand.

 (v) Varying Reserve Requirements

• Banks are obliged to maintain reserves with the central bank, which is known as legal reserve ratio. It has two components. One is the Cash Reserve Ratio or CRR and the other is the SLR or Statutory Liquidity Ratio.

Cash Reserve Ratio:

-> It refers to the minimum percentage of a bank’s total deposits, which it is required to keep with the central bank. Commercial banks have to keep with the central bank a certain percentage of their deposits in the form of cash reserves as a matter of law.

-> For example, if the minimum reserve ratio is 10% and total deposits of a certain bank is Rs. 100 crore, it will have to keep Rs. 10 crore with the Central Bank.

-> In a situation of excess demand leading to inflation, Cash Reserve Ratio (CRR) is raised to 20 per cent, the bank will have to keep Rs.20 crore with the Central Bank, which will reduce the cash resources of commercial bank and reducing credit availability in the economy, which will control excess demand.

-> In a situation of deficient demand leading to deflation, cash reserve ratio (CRR) falls to 5 per cent, the bank will have to keep Rs. 5 crore with the central bank, which will increase the cash resources of commercial bank and increasing credit availability in the economy, which will control deficient demand.

(vi) The Statutory Liquidity Ratio (SLR)

• It refers to minimum percentage of net total demand and time liabilities, which commercial banks are required to maintain with themselves.
• In a situation of excess demand leading to inflation, the central bank increases statutory liquidity ratio (SLR), which will reduce the cash resources of commercial bank and reducing credit availability in the economy.
• In a situation of deficient demand leading to deflation, the central bank decreases statutory liquidity ratio (SLR), which will increase the cash resources of commercial bank and increases credit availability in the economy.
• It may consist of:

-> Excess reserves

-> Unencumbered (are not acting as security for loans from the Central Bank) government and other approved securities (securities whose repayment is guaranteed by the government); and

-> Current account balances with other banks.

(b) Qualitative Instruments or Selective Tools of Monetary Policy: These instruments are used to regulate the direction of credit. They are as under:

 (i) Imposing margin requirement on secured loans

• Business and traders get credit from commercial bank against the security of their goods. Bank never gives credit equal to the full value of the security. It always pays less value than the security.
• So, the difference between the value of security and value of loan is called marginal requirement.
• In a situation of excess demand leading to inflation, central bank raises marginal requirements. This discourages borrowing because it makes people gets less credit against their securities.
• In a situation of deficient demand leading to deflation, central bank decreases marginal requirements. This encourages borrowing because it makes people get more credit against their securities.

(ii) Moral Suasion

• Moral suasion implies persuasion, request, informal suggestion, advice and appeal by the central banks to commercial banks to cooperate with general monetary policy of the central bank.
• In a situation of excess demand leading to inflation, it appeals for credit contraction.
• In a situation of deficient demand leading to deflation, it appeals for credit expansion.

(iii) Selective Credit Controls (SCCs)

• In this method the central bank can give directions to the commercial banks not to give credit for certain purposes or to give more credit for particular purposes or to the priority sectors.
• In a situation of excess demand leading to inflation, the central bank introduces rationing of credit in order to prevent excessive flow of credit, particularly for speculative activities. It helps to wipe off the excess demand.
• In a situation of deficient demand leading to deflation, the central bank withdraws rationing of credit and make efforts to encourage credit.

Words that Matter

1. Commercial Bank: Commercial bank is a financial institution which performs the functions of accepting deposits from the public and making loans and investments, with the motive of earning profit.
2. Legal Reserve Ratio: It is the minimum ratio of deposits legally required to be kept by the commercial banks with themselves (Statutory Liquidity Ratio) and with the central bank (Cash reserve Ratio).
3. Money Multiplier or Credit Multiplier: When the primary cash deposit in the banking system leads to multiple expansion in the total deposits, it is known as money multiplier or credit multiplier.
4. Central Bank: The central bank is the apex institution of a country’s monetary system. The design and the control of the country’s monetary policy is its main responsibility.
5. Quantitative Instruments or General Tools of Monetary Policy: These are the instruments of monetary policy that affect overall supply of money/credit in the economy.
6. Qualitative Instruments or Selective Tools of Monetary Policy: The instruments which are used to regulate the direction of credit is known as Qualitative Instruments.
7. Bank rate: It is the rate of interest at which central bank lends to commercial banks without any collateral (security for purpose of loan).
8. Repo rate: It is the rate at which commercial bank borrow money from the central bank for short period by selling their financial securities to the central bank.
9. Reverse Repo rate: It is the rate at which the central bank (RBI) borrows money from commercial bank.
10. Open Market Operation: It consists of buying and selling of government securities and bonds in the open market by central bank.
11. Cash Reserve Ratio: It refers to the minimum percentage of a bank’s total deposits, which it is required to keep with the central bank.
12. Statutory Liquidity Ratio: It refers to minimum percentage of net total demand and time liabilities, which commercial banks are required to maintain with themselves.
13. Marginal requirement: Business and traders get credit from commercial bank against the security of their goods. Bank never gives credit equal to the full value of the security. It always pays less value than the security. So, the difference between the value of security and value of loan is called marginal requirement.
14. Moral suasion: It implies persuasion, request, informal suggestion, advice and appeal by the central banks to commercial banks to cooperate with general monetary policy of the central bank.
15. Selective Credit Controls (SCCs): In this method the central bank can give directions to the commercial banks not to give credit for certain purposes or to give more credit for particular purposes or to the priority sectors.

Aggregate Demand and Its Related Concepts Chapter-5

Introduction

This chapter gives an insight into the constructive key role of J.M. Keynes (John Maynard Keynes) during the period of 1929-1933 towards the rectification of great depression in America, emphasizing mainly on aggregate demand, aggregate supply, propensity to consume and save and its types; including related Numericals.

Aggregate Demand, Aggregate Supply and Three Components

1. Aggregate Demand:

(a) Aggregate demand refers to the total demand for final goods and services in an economy during an accounting year.

(b) Aggregate demand is aggregate expenditure on ex-ante (planned) consumption and ex-ante (planned) investment that all sectors of the economy are willing to incur at each income level.

Note: In terms of Keynes, aggregate demand refers to the total amount of money, which the buyers are ready to spend on purchase of goods and services, produced in an economy during a given period. It should be kept in mind that Keynes measured aggregate demand not in terms of physical goods and services but as a part of total income that society is ready to spend.

(c) Components of aggregate demand: The components of aggregate demand are:

(i) Private (or Household) consumption demand

• The total expenditure incurred by all the households of the country on their personal consumption is known as private consumption expenditure.
• Consumption demand depends mainly on disposable income and propensity to consume.

(ii) Private investment demand

• Private investment demand refers to the demand for capital goods by private investors.
• It is addition to the existing stock of real capital assets such as machines, tools, factory – building etc.
• Investments demand depends upon marginal efficiency of capital (Marginal efficiency of investment) and interest rate.
• Investment is of two types, Autonomous Investment and Induced investment, but in Keynes theory investment is assumed to be Autonomous.
• The basic difference between Induced Investment and Autonomous Investment

 (iii) Government demand for goods and services Its curve is upward sloping rises up to Right.

• In a modern economy, the government is an important buyer of goods and services.

It is income inelastic, i.e., it is not affected by change in income level. The volume of autonomous investment is the same at all levels of income.

Its curve is a straight line parallel to horizontal axis.

• The government demand may be on account of public needs for roads, schools, hospitals, power, and irrigation etc, for the maintenance of law and order and for defence.

(iv) Demand for net export (X – M)

• Net export represents foreign demand for goods and services produced by an economy.
• When exports exceed imports, net exports is positive and when imports exceed, net exports is negative.
• Exports and imports of a country are influenced by a number of factors such as foreign trade policy, exchange- rate, prices and quality of goods etc.

Thus, aggregate demand consists of these four types of demand.

However, for the sake of simplicity Keynes included only two types of demand,

-> Consumption demand (C)

-> Investment demand (I)

Aggregate demand can be explained with the help of AD schedule and AD curve.

2. Aggregate Supply:

(a) The concept of aggregate supply (ΔS) is related with the total supply of goods and services by all the producers in an economy. Four factor of production like land,

Labour, capital and enterprise are required for the production of goods and services. Producers pay rent to land, wages and salaries to labour, interest to capital and Profits to the entrepreneur for their services in production. This payment is factor- cost from producer’s point of view and factor-income from factor-owner angle.

(b) Thus, aggregate supply is the total amount of money value of goods and services, (which is paid to the factor of production against their factor services) that all the producers are willing to supply in an economy. In other words, it is the total cost of production of goods and services produced in a country or it is the value of net national product at factor cost (NNPFC). Thus, the main components of aggregate supply are:

 (c) Keynes assumed his economy to be a closed capitalist economy and whenever any economy is closed capitalist, then Net Factor Income from Abroad (NFIA) is 0. National Income (NNPFC) = Domestic Income (NDPFC) + Net Factor Income from Abroad (NFIA)

National Income (NNPFC) = Domestic Income (NDPFC) + 0

In short,

Aggregate Supply = NNPFC = NDPFC = Factor Income = Rent + Interest + Wages + Profit

(d) As we know income is either consumed or saved, hence for the sake of simplicity Keynes has regarded only two main constituents of aggregate supply:

Consumption Function (Propensity To Consume) And its types, Saving Function (Propensity To Save) And Its Types

1. Consumption function expresses functional relationship between aggregate consumption and national income.

Thus, consumption (C) is a function of income (Y). C = F (Y)

Where, C = Consumption; F = Function; Y = Disposable income Consumption at a point of time can be measured with the equation:

2. According to Keynes, as income increases consumption expenditure also increases but increase in consumption is smaller than the increase in income. In other words, consumption lags behind income. This is called Keynes’ Psychological law of Consumption. According to Keynes, propensity to consume of the people remains stable in the short period.
3. Break-even point refers to that point in the level of income at which consumption is just equal to income. In other words, whole of income is spent on consumption and there is no saving. Below this level of income, consumption is greater than income but above this level, income is greater than consumption.

In the given imaginary household schedule of consumption and saving, at annual income level of Rs.60, 000, consumption is Rs.60, 000 and in consequence there is no saving. This is break-even point.

It is evident from the table and diagram that:

(i) As the income increases, consumption also increases, but the increase in consumption remains less than the increase in income.

(ii) Income can be zero but consumption can never be zero in the economy.

(iii) When C > Y, saving are negative.

(iv) When C = Y, savings are zero. This is known as break-even point. This is shown by point E in the diagram. Thus break-even point indicates a point where consumption becomes equal to income or consumption curve cuts the income curve.

4. There are two types of propensity to consume:

(a) Average propensity to consume (APC)

(i) The ratio of aggregate consumption expenditure to aggregate income is known, as average propensity to consume. It indicates the percentage (or ratio) of income which is being spent on consumption. It is worked out by dividing total consumption expenditure (C) by total income (Y).

A Consumption (C)

 (ii) It can be explained with the help of following schedule and diagram:

(iii) Important Points for APC:

• When APC is more than 1: When APC is more than 1, consumption is more than national income, i.e. before the break-even point.
• APC = 1: When APC is equal to 1, consumption is equal to national income, which is known as to be break-even point.
• When APC is less than 1: When consumption is less than national income, i.e. beyond the break-even point.

(b) Marginal Propensity to consume (MPC):

(i) The ratio of change in consumption (C) to change in income (Y) is known as marginal propensity to consume. It indicates the proportion of additional income that is being spent on consumption.

 (ii) It can be explained with the help of following schedule and diagram:

 (iii) Important points for MPC:

• Value of MPC varies between 0 and 1: As we know that increase in income is either spent on consumption or saved for future use.
• MPC falls with the successive increase in income: It happens because as an economy becomes richer, it has the tendency to consume smaller percentage of each increment to its income.

5. (a) Propensity to save (or saving function) shows the functional relationship between aggregate savings and income.

It is evident from the saving-function schedule and diagram that as income increases saving also increases. Saving can be both negative and positive. Prior to break-even point saving is negative, at break-even point saving is zero and after the break-even point saving is positive.

(c) Important points for saving function:

(i) Starting Point of Saving Curve:

• Saving curve (SS) starts from point _c on the Y-axis, indicating that there is negative saving (equal to amount of autonomous consumption) when national income is zero. Note: The saving curve will have a negative intercept on Y-axis of the same magnitude as the consumption curve has positive intercept on the Y-axis. It happens because if consumption is positive at zero level of income, then there would be dis-savings of the same magnitude.
• Break-even point (S = 0).

Saving curve crosses the X-axis at point R which is known as break-even point as at this point saving is zero (or consumption is equal to income).

• Positive Saving: After the break-even point saving is positive.

6. Types of propensity to save

(a) Average propensity to save (APS):

(i) The ratio of aggregate saving to aggregate income is known as average propensity to save (APS). By dividing aggregate saving by aggregate income, we get APS. Symbolically,

 (ii) Important Points for APS:

• APS can never be 1 or more than one.

As saving can never be equal to or more than national income.

• APS can be 0: APS is 0 when income is equal to consumption i.e., saving = 0. This point is known as break-even point.
• APS can be negative or less than 1.

At income levels which are lower than the break-even point APS can be negative as there will be dis-savings in the economy.

• APS rises with increase in income.
• APS rises with the increase in income because the proportion of income saved keeps on increasing.

(b) Marginal Propensity to Save:

(i) The ratio of change in saving (ΔS) to change in income (ΔY) is called MPS. It is proportion of income saved out of additional (incremental) income. Symbolically,

Words that Matter

1. Aggregate demand: It is aggregate expenditure on ex-ante (planned) consumption and ex-ante (planned) investment that all sectors of the economy are willing to incur at each income level.
2. Induced Investment: It refers to the investment which is made with the motive of earning profit.
3. Autonomous Investment: It refers to the investment, which is made irrespective of level of income.
4. Aggregate Supply: Aggregate supply is the total amount of money value of goods and services, (which is paid to the factor of production against their factor services) that all the producers are willing to supply in an economy.
5. Consumption Function: Consumption function (Propensity to consume) expresses functional relationship between aggregate consumption and national income. Thus, consumption (C) is a function of income (Y).

C = F (Y) and C = C + b Y

6. Autonomous Consumption: It refers to minimum level of consumption i.e. (c), which is needed for survival, i.e., consumption at zero level of national income.
7. Keynes’ Psychological law of Consumption: According to Keynes, as income increases consumption expenditure also increases but increase in consumption is smaller than the increase in income. In other words, consumption lags behind income.
8. Break even Point: Break-even point refers to that point in the level of income at which consumption is just equal to income. In other words, whole of income is spent on consumption and there is no saving.
9. Average Propensity to Consume: The ratio of aggregate consumption expenditure to aggregate income is known as average propensity to consume.

APC=C/Y

10. Marginal Propensity to consume: The ratio of change in consumption (C) to change in income (Y) is known as marginal propensity to consume. It indicates the proportion of additional income that is being spent on consumption.

MPC=ΔC/ΔY

11. Saving Function: Saving function (Propensity to save) shows the functional relationship between aggregate savings and income.

S = f (Y) and S = — C + (1 — b) Y

12. Average Propensity to Save: The ratio of aggregate saving to aggregate income is known as average propensity to save (APS).

APS=S/Y

13. Marginal Propensity to Save: The ratio of change in saving (ΔS) to change in income (ΔY) is called MPS. It is proportion of income saved out of additional (incremental) income. Symbolically,

MPC= ΔS/ΔY

National Income Determination and Multiplier Chapter-6

Introduction

This chapter is a numerical determination of national income under Aggregate demand— Aggregate supply and saving—Investment approach. Concept of Multiplier, based numerical on it and its working is also highlighted.

National Income Determination under Aggregate Demand and Supply Approach and Saving, Investment Approach, Effective Demand

1. Determination of equilibrium level of national income

Or

Keynesian theory of income and employment

(a) It refers to that point which has come to be established under the given condition of aggregate demand and aggregate supply, and has tendency to stick to that level under this given condition:

Condition to get equilibrium level of NY

• AD = AS
• Investment = Saving

How is Investment = Saving?

Here,

AD = AS

C + I = C + S

I = C + S – C

I = S

(b) If due to some disturbance, we divert from that position, then the economic forces will work in such a manner so as to drive us back to the original position,

1. e., aggregate demand is equal to aggregate supply.

(c) Any movement from that point would be unstable. In short, it is a position of rest.

(d) It can be explained with the help of following schedule and diagram:

(e) Figure B is derived from figure A. In figure A at point P, income is equal to consumption, which is known as to be breakeven point. Corresponding to point P, we derive point P1; in figure B, where saving is equal to zero. In figure A, the equilibrium level of national income is attained at point E, where aggregate supply = aggregate demand. Corresponding to point E, we derive the point E1, where saving = investment.

2. Determination of equilibrium level of national income through Aggregate demand-Aggregate Supply Approach

(a) It refers to the point that has come to be established under the given condition of aggregate demand and aggregate supply, and has tendency to stick to that level under this given condition where Aggregate Demand = Aggregate Supply.

(b) If due to some disturbance, we divert from that position, the economic forces will work in such a manner so as to drive us back to the original position, i.e., aggregate demand is equal to aggregate supply.

(c) In the above mentioned figure, at point P, income = consumption, which is known as to be a break-even point. The equilibrium level of national income is attained at point E, where aggregate demand = aggregate supply.

(d) If due to some disturbance we divert from our position, like when AD > AS [at Y2], then, production will have to be increased to meet the excess demand. Consequently, national income will increase. As we know positive relationship exists between national income and consumption, so consumption will increase, which will thereby increase the aggregate demand till we reach the equilibrium.

(e) As against it, when AD < AS [at Y1], then there would be stockpiling and producers  will produce less. National income will fall and as a result consumption will start falling, which will thereby fall the aggregate demand till we reach the equilibrium.

3. (a) Ex-ante saving and ex-ante investment:

(i) In an economy what we plan (or intend or desire) to save during a particular period is called ex-ante saving.

(ii) Against it, what we plan (or intend or desire) to invest during a particular period is called ex-ante investment.

(b) Ex-post saving and ex-post investment.

(i) In an economy what we actually save or what is left after deducting consumption expenditure from income is called ex-post (or realized) saving.

(ii) As against it what we actually invest or what we actually add to the physical assets of an economy is called ex-post (or realized) investment.

4. Determination of equilibrium level of national income through Saving-Investment

Approach

(a) It refers to the point that has come to be established under the given condition of aggregate demand and aggregate supply, and has tendency to stick to that level under this given condition where Aggregate Demand (AD)= Aggregate Supply (AS). AD = AS

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

(b) If due to some disturbance, we divert from that position, the economic forces will work in such a manner so as to drive us back to the original position, i.e., Saving is equal to Investment.

(c) In the above figure, the equilibrium level of national income is attained at point E, where saving = investment which is derived from a point where AD = AS.

(d) If due to some disturbance we divert from our position like when investment > saving [at Y2], then production will have to be increased to meet the excess demand. Consequently, national income will increase leading to rise in saving until saving becomes equal to investment. It is here that equilibrium level of income is established because what the savers intend to save becomes equal to what the investors intend to invest.

(e) As against it, when saving > investment [at Y1], then there would be stockpiling and producers will produce less. .National income will fall and as a result saving will start falling until it becomes equal to investment. It is here the equilibrium level of income is derived.

5. Effective Demand: The level at which the economy is in equilibrium, i.e., where

Aggregate demand = aggregate supply, is called effective demand. It can also be

Explained with the help of the following table:

Paradox of Thrift, It’s Reasons with Numirical Example

1. The term thrift means savings and the paradox of thrift shows how an attempt by the economy as a whole to save more out of its current income will ultimately results in lower savings for the economy.
2. If all the people in the economy make an effort to save more, then the total savings of the community will not increase, on the contrary they will decrease. This is called the Paradox of thrift.
3. Reasons for “Paradox of thrift” to operate

(a) As we know that one person’s expenditure is another person’s income.

(b) If individual ‘A’ decides to save more by reducing his consumption expenditure, the income of individual ‘B’ will be less and individual ‘B’ in turn will spend less.

(c) Thus, if all individuals in the economy decide to save more, the income received by each individual will be less and overall income will fall and also lower will be the total savings.

4. Diagram Representation: The concept of paradox of thrift with the help of diagrams and mathematical illustration is as under: When Investment is Autonomous When Investment is induced

 (a) Paradox of thrift fails in keyne’s theory (when Investment is autonomous):

In figure a, society, households plan to save more at each income level. So, saving curve shifts up and left from S to. Equilibrium national income falls from Y to Yr the thing which has to be remembered is that savings is equal to autonomous investment, that is, remains unchanged.

(b) Paradox of thrift is possible when investment is induced: In figure B, we have induced investment function which makes the investment curve upward positively sloping. With the increase in savings, not only the equilibrium income falls, but also savings decline.

5. Numerical Illustration: Suppose the original savings function is given as,

S = -50 + 0.5Y and investment (I) = 25 + 0.25Y.

Equilibrium level of income will be attained at the level where

Saving = Investment! -50 + 0.5Y = 25 + 0.25Y

1. 25Y = 75 Y = 300

Therefore, savings at Y=300 will be S = -50 + 0.5 (300) = 100

Suppose, eveiy individual in the economy decides to save 25 more at each level of income. The new savings function will be

S2 = -50 + 25 + 0.5Y – -25 + 0.5Y.

The new equilibrium income will be attained at the level where

s2 = i

-25 + 0.5Y = 25 + 0.25Y 0.25Y = 50 Y = 200

Therefore, savings at Y = 200 will be S = -25 + 0.5 (200) = -25 + 100 = 75

Thus, when everybody in the economy decides to save more, the equilibrium level of income falls and the total savings also fall. This is called the paradox of thrift.

Elements in Understanding Investment (Marginal Efficiency of Investment and Market Rate of Interest), Investment Demand Function

1. Elements in Understanding Investment: A private investor’s demand for investment depends on two things:

(a) The rate of return on investment or M.E.I: The expected rate of return from’an additional unit of investment is called marginal efficiency of investment (M.E.I). It is defined as the expected rate of return of an additional unit of capital goods. M.E.I is very important factor in determining the investment demand. M.E.I. is determined by two factors.

(i) Supply Price: The cost of replacing the machine under consideration with a brand new machine is known its supply price. For example, if a machine of Rs.1 lakh is replaced in place of old machine, then Rs. 1 lakh is the supply price.

(ii) Prospective Yields: It refers to expected net returns (of all costs) from the capital asset over its lifetime. For example, if the given machine is expected to yield revenue of Rs. 10,000 and running expenditure is Rs.2000, the prospective yield will be, 10000 – 2000 = 8000.

(iii) Formula of Marginal efficiency of investment: In the given examples, marginal efficiency of investment will be,

(b) The Market Rate of Interest: It refers to cost of funds borrowed for financing the investment. There exists inverse relationship between rate of interest and investment demand. Higher interest implies lower level of investment demand.

(c) Decision whether to invest or not

(i) The investor goes on making additional investments until M.E.I becomes equal to the rate of interest. If M.E.I is greater than the rate of interest, the investors has to increase the investment and if the rate is higher than the M.E.I, no investment is to be made.

(ii) For example, if an entrepreneur has to pay 15% market rate of interest on the loan taken by him and he expected rate of profit i.e., M.E.I. is 30%, then he will surely go for the investment and will continue making investment till M.E.I. = Rate of Interest (ROI).

2. Investment demand function: Investment demand function is the relationship between rate of interest and investment demand. There exists inverse relationship between rate of interest and investment demand. Higher interest implies lower level of investment demand.

Concepts of Investment Multiplier

1. Investment Multiplier

Meaning: The ratio of change in national income (ΔY) due to a change in investment (ΔI) is known as multiplier (K).

Words that Matter

1. Ex-ante saving: In an economy what we plan (or intend or desire) to save during a particular period is called ex-ante saving.
2. Ex-ante Investment: In an economy, what we plan (or intend or desire) to invest during a particular period is called ex-ante investment.
3. Expost Saving: In an economy what we actually save or what is left after deducting consumption expenditure from income is called ex-post (or realized) saving.
4. Expost Investment: In an economy, what we actually invest or what we actually add to the physical assets of an economy is called ex-post (or realized) investment.
5. Effective Demand: The level at which the economy is in equilibrium, i.e., where aggregate demand = aggregate supply, is called effective demand.
6. Paradox of Thrift: The term thrift means savings and the paradox of thrift shows how an attempt by the economy as a whole to save more out of its current income will ultimately results in lower savings for the economy.
7. Marginal efficiency of Investment: The expected rate of return from an additional unit of investment is called marginal efficiency of investment (M.E.I). In other words, it is the expected rate of return of an additional unit of capital goods.
8. Supply Price: The cost of replacing the machine under consideration with a brand new machine is known its supply price.
9. Prospective Yields: It refers to expected net returns (of all costs) from the capital asset over its lifetime.
10. Market Rate of Interest: It refers to cost of funds borrowed for financing the investment. There exists inverse relationship between rate of interest and investment demand. Higher interest implies lower level of investment demand.
11. Multiplier: The ratio of change in national income (ΔY) due to change in investment (ΔI) is known as multiplier (K).

Excess Demand and Deficient Demand Chapter-7

Introduction

An illustration of meaning, diagram, reasons, impacts and measures to control excess demand (inflationary gap) and deficient demand (deflationary gap); basic definitions of full employment, over full employment, involuntary unemployment, voluntary unemployment is also dealt with in this chapter.

Excess Demand and Its Related Concepts

1. Excess Demand and Inflationary Gap:

(a) When in an economy, aggregate demand exceeds “aggregate supply at full employment level”, the demand is said to be an excess demand.

(b) Inflationary gap is the gap showing excess of current aggregate demand over ‘aggregate supply at the level of full employment’. It is called inflationary because it leads to inflation (continuous rise in prices).

(c) A simple example will further -clarify it. Let us suppose that an imaginary economy by employing all its available resources can produce 10,000 quintals of rice. If aggregate demand of rice is say 12,000 quintals, this demand will be called an excess demand, because aggregate supply at level of full employment of resources is only 10,000 quintals and the result of the gap of 2000 quintals will be called as inflationary gap. In the above diagram Inflationary gap is AB because at Full employment Y*, Aggregate demand (BY*) is greater than Aggregate Supply (AY*).

2. Reasons or causes for excess demand: The main reasons for excess demand are apparently the increase in the following components of aggregate demand:

(a) Increase in household consumption demand due to rise in propensity to consume.

(b) Increase in private investment demand because of rise in credit facilities.

(c) Increase in public (government) expenditure.

(d) Increase in export demand.

(e) Increase in money supply or increase in disposable income.

3. Impacts or effects of excess demand on price, output, employment:

(a) Effect on General Price Level: Excess demand gives a rise to general price level because it arises when aggregate demand is more than aggregate supply at a full employment level. There is inflation in economy showing inflationary gap.

(b) Effect on Output: Excess demand has no effect on the level of output. Economy is at full employment level and there is no idle capacity in the economy. Hence output can’t increase.

(c) Effect on Employment: There will be no change in thq. Level of employment also.

The economy is already operating at full employment equilibrium, and hence, there is no unemployment.

4. Measures to control the excess demand: We can control the excess demand with the help of the following policy:

(a) Monetary Policy

(b) Fiscal Policy

Let us discuss it in detail:

(a) Monetary Policy: Monetary policy is the policy of the central bank of a countiy to control money supply and availability of credit in the economy. The central bank can take the following steps:

(i) Quantitative Instruments or General Tools of Monetary Policy: These are the instruments of monetary policy that affect overall supply of money/credit in the economy. These instruments do not direct or restrict the flow of credit to some specific sectors of the economy. They are as under

• Bank Rate or Discount Rate (Increase in Bank Rate)

-> Bank rate is the rate of interest at which central bank lends to commercial banks without any collateral (security for purpose of loan). The thing, which has to be remembered, is that central bank lends to commercial banks and not to general public.

-> In a situation of excess demand leading to inflation

-> Central bank raises bank rate that discourages commercial banks in borrowing from central bank as it will increase the cost of borrowing of commercial bank.

❖ It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans, which discourages investment.

❖ Again high rate of interest induces households to increase their savings by restricting expenditure on consumption.

❖ Thus, expenditure on investment and consumption is reduced, which will control the excess demand.

• Repo Rate (Increase in Repo Rate):

-> Repo rate is the rate at which commercial banks borrow money from the central bank for short period by selling their financial securities to the central bank.

-> These securities are pledged as a security for the loans.

-> It is called Repurchase rate as this involves commercial bank selling securities to RBI to borrow the money with an agreement to repurchase them at a later date and at a predetermined price.

-> So, keeping securities and borrowing is repo rate.

-> In a situation of excess demand leading to inflation

❖ Central bank raises repo rate that discourages commercial banks in borrowing from central bank as it will increase the cost of borrowing of commercial bank.

❖ It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans, which discourages investment.

❖ Again high rate of interest induces households to increase their savings by restricting expenditure on consumption.

❖ Thus, expenditure on investment and consumption is reduced, which will control the excess demand.

• Reverse Repo Rate (Increase in Reverse Repo Rate):

-> It is the rate at which the central bank (RBI) borrows money from commercial bank.

-> In a situation of excess demand leading to inflation, Reverse repo rate is increased, it encourages the commercial bank to park their funds with the central bank to earn higher return on idle cash. It decreases the lending capability of commercial banks, which controls excess demand.

• Open Market Operations (OMO) (Sale of securities):

-> It consists of buying and selling of government securities and bonds in the open market by central bank.

-> In a situation of excess demand leading to inflation, central bank sells government securities and bonds to commercial bank. With the sale of these securities, the power of commercial bank of giving loans decreases, which will control excess demand.

• Increase in Varying Reserve Requirements or Legal Reserve Ratio:

-> Banks are obliged to maintain reserves with the central bank, which is known as legal reserve ratio. It has two components. One is the Cash Reserve Ratio or CRR and the other is the SLR or Statutory Liquidity Ratio.

-> Cash Reserve Ratio (Increase in CRR):

❖ It refers to the minimum percentage of a bank’s total deposits, which it is required to keep with the central bank. Commercial banks have to keep with the central bank a certain percentage of their deposits in the form of cash reserves as a matter of law.

❖ For example, if the minimum reserve ratio is 10% and total deposits of a certain bank is Rs.100 crore, it will have to keep Rs.10 crore with the central bank.

❖ In a situation of excess demand leading to inflation, cash reserve ratio (CRR) is raised to 20 per cent, the bank will have to keep Rs.20 crore with the central bank, which will reduce the cash resources of commercial bank and reducing credit availability in the economy, which will control excess demand.

-> Statutory Liquidity Ratio (Increase SLR):

❖ It refers to minimum percentage of net total demand and time liabilities, which commercial banks are required to maintain with themselves.

❖ In a situation of excess demand leading to inflation, the central bank increases statutory liquidity ratio (SLR), which will reduce the cash resources of commercial bank and reducing credit availability in the economy.

(ii) Qualitative Instruments or Selective Tools of Monetary Policy: These instruments are used to regulate the direction of credit. They are as under:

(i) Imposing margin requirement on secured loans (Increase):

• Business and traders get credit from commercial bank against the security of their goods. Bank never gives credit equal to the full value of the security. It always pays less value than the security.
• So, the difference between the value of security and value of loan is called marginal requirement.
• In a situation of excess demand leading to inflation, central bank raises marginal requirements. This discourages borrowing because it makes people get less credit against their securities.

(ii) Moral Suasion:

• Moral suasion implies persuasion, request, informal suggestion, advice and appeal by the central banks to commercial banks to cooperate with general monetary policy of the central bank.
• In a situation of excess demand leading to inflation, it appeals for credit contraction.

(iii) Selective Credit Control (SCC) [Introduce Credit Rationing]:

• In this method the central bank can give directions to the commercial banks not to give credit for certain purposes or to give more credit for particular purposes or to the priority sectors.
• In a situation of excess demand leading to inflation, the central bank introduces rationing of credit in order to prevent excessive flow of credit, particularly for speculative activities. It helps to wipe off the excess demand.

(b) Fiscal Policy: The expenditure and revenue policy taken by the general government to accomplish the desired goals is known as fiscal policy. A general government can take the following steps:

(a) Revenue Policy (Increase Taxes):

(i) Revenue policy is expressed in terms of taxes.

(ii) During inflation the government impose higher amount of taxes causing the decrease in purchasing power of the people.

(iii) It is so because to control excess demand we have to reduce the amount of liquidity from the economy.

(b) Expenditure Policy (Reduces Expenditure):

(i) Government has to invest huge amount on public works like roads, buildings, irrigation works, etc.

(ii) During inflation, government should curtail (reduce) its expenditure on public works like roads, buildings, irrigation works thereby reducing the money income of the people and their demand for goods and services.

(c) Increase in Public Borrowing/Public Debt:

(i) This measure means that government should raise loans from public and hence borrowing decreases the purchasing power of people by leaving them with lesser amount of money.

(ii) So, government should resort to more public borrowing during excessive demand.

(iii) Government should make long term debts more attractive so that public may use their excess liquidity amount of money in purchasing these bonds, which will reduce the liquidity amount of money in the economy and thereby inflation could be controlled

Deficient Demand and Its Related Concepts

1. Deficient Demand or Deflationary Gap:

(a) When in an economy, aggregate demand falls short of aggregate supply at full employment level, the demand is said to be a deficient demand.

(b) Deflationary gap is the gap showing Demand Deficient of current aggregate demand over ‘aggregate supply at the level of full employment’. It is called deflationary because it leads to deflation (continuous fall in prices).

(c) Let us suppose that an imaginary economy by employing all its available resources can produce 10,000 quintals of rice. If aggregate demand of rice is, say 8,000 quin Tals, this demand will be called a deficient demand and the gap of 2000 quintals will be called as deflationary gap. Clearly here equilibrium between AD and AS is at a point less than level of full employment. Keynes called it an under employment equilibrium.

2. Reasons or causes for deficient demand: The main reasons for deficient demand are apparently the decrease in four components of aggregate demand:

(a) Decrease in household consumption demand due to fall in propensity to consume.

(b) Decrease in private investment demand because of fall in credit facilities.

(c) Decrease in public (government) expenditure.

(d) Decrease in export demand.

(e) Decrease in money supply or decrease in disposable income.

3. Impacts or effects of deficient demand:

(a) Effect on General Price Level: Deficient demand causes the general price level to fall because it arises when aggregate demand is less than aggregate supply at full employment level. There is deflation in an economy showing deflationary gap.

(b) Effect on Employment: Due to deficient demand, investment level is reduced, which causes involuntary unemployment in the economy due to fall in the planned output.

(c) Effect on Output: Low level of investment and employment implies low level of output.

4. Measures to Control the deficient demand: We can control the deficient demand with the help of the following policies:

(a) Monetary policy

(b) Fiscal policy

Let us discuss it in detail:

(a) Monetary Policy: Monetary policy is the policy of the central bank of a country of controlling money supply and availability of credit in the economy. The central bank takes the following steps:

(i) Quantitative Instruments or General Tools of Monetary Policy: These are the instruments of monetary policy that affect overall supply of money/credit in the economy. These instruments do not direct or restrict the flow of credit to some specific sectors of the economy. They are as under:

• Bank Rate or Discount Rate (Decrease in Bank Rate):

-> Bank rate is the rate of interest at which central bank lends to commercial banks without any collateral (security for purpose of loan). The thing, which has to be remembered, is that central bank lends to commercial banks and not to general public.

-> In a situation of deficient demand leading to deflation,

❖ Central bank decreases bank rate that encourages commercial banks in borrowing from central bank as it will decrease the cost of borrowing of commercial bank.

❖ Decrease in bank rate makes commercial bank to decrease their lending rates, which encourages borrowers from taking loans, which encourages investment.

❖ Again low rate of interest induces households to decrease their savings by increasing expenditure on consumption.

❖ Thus, expenditure on investment and consumption increase, which will control the deficient demand.

• Repo Rate (Decrease Repo Rate):

-> Repo rate is the rate at which commercial banks borrow money from the central bank for short period by selling their financial securities to the central bank.

-> These securities are pledged as a security for the loans.

-> It is called Repurchase rate as this involves commercial bank selling securities to RBI to borrow the money with an agreement to repurchase them at a later date and at a predetermined price.

-> So, keeping securities and borrowing is repo rate.

In a situation of deficient demand leading to deflation,

❖ Central bank decreases Repo rate that encourages commercial banks in borrowing from central bank as it will decrease the cost of borrowing of commercial bank.

❖ Decrease in Repo rate makes commercial banks to decrease their lending rates, which encourages borrowers from taking loans, which encourages investment.

❖ Again low rate of interest induces households to decrease their savings by increasing expenditure on consumption.

❖ Thus, expenditure on investment and consumption increase, which will control the deficient demand.

• Reverse Repo Rate (Decrease Reverse Repo Rate):

-> It is the rate at which the central bank (RBI) borrows money from commercial bank.

-> In a situation of deficient demand leading to deflation, Reverse repo rate is decreased, it discourages the commercial bank to park their funds with the central bank. It increases the lending capability of commercial banks, which controls deficient demand.

• Open Market Operation (Purchase of Securities):

-> It consists of buying and selling of government securities and bonds in the open market by central bank.

-> In a situation of deficient demand leading to deflation, central bank purchases government securities and bonds from commercial bank. With the purchase of these securities, the power of commercial bank of giving loans increases, which will control deficient demand.

• Decrease in Varying Reserve Requirements:

-> Banks are obliged to maintain reserves with the central bank, which is known as legal reserve ratio. It has two components. One is the Cash Reserve Ratio or CRR and the other is the SLR or Statutory Liquidity Ratio.

-> Cash Reserve Ratio (Decrease):

❖ It refers to the minimum percentage of a bank’s total deposits, which is required to keep with the central bank. Commercial banks have to keep with the central bank a certain percentage of their deposits in the form of cash reserves as a matter of law.

❖ For example, if the minimum reserve ratio is 10% and total deposits of a certain bank is Rs. 100 crore, it will have to keep Rs.10 crore with the central bank.

❖ In a situation of deficient demand leading to deflation, cash reserve ratio (CRR) falls to 5 per cent, the bank will have to keep Rs. 5 crore with the central bank, which will increase the cash resources of commercial bank and increasing credit availability in the economy, which will control deficient demand.

-> The Statutory Liquidity Ratio (SLR) (Increase):

❖ It refers to minimum percentage of net total demand and time liabilities, which commercial banks are required to maintain with themselves.

❖ in a situation of deficient demand leading to deflation, the central bank decreases statutory liquidity ratio (SLR), which will increase the cash resources of commercial bank and increases credit availability in the economy.

(ii) Qualitative Instruments or Selective Tools of Monetary Policy: These Instruments are used to regulate the direction of credit. They are as under:

• Imposing margin requirement on secured loans (Decrease):

-> Business and traders get credit from commercial bank against the security of their goods. Bank never gives credit equal to the full value of the security. It always pays less value than the security.

-> So, the difference between the value of security and value of loan is called marginal requirement.

-> In a situation of deficient demand leading to deflation, central bank decreases marginal requirements. This encourages borrowing because it makes people get more credit against their securities.

• Moral Suasion:

-> Moral suasion implies persuasion, request, informal suggestion, advice and appeal by the central banks to commercial banks to cooperate with general monetary policy of the central bank.

> In a situation of deficient demand leading to deflation, it appeals for credit expansion.

• Selective Credit Controls (SCCs):

-> In this method the central bank can give directions to the commercial banks not to give credit for certain purposes or to give more credit for particular purposes or to the priority sectors.

-> In a situation of deficient demand leading to deflation, the central bank withdraws rationing of credit and make efforts to encourage credit.

2. Fiscal Policy: The expenditure and revenue policy taken by the general government to accomplish the desired goals is known as fiscal policy. A general government has to take the following steps:

(a) Revenue Policy (Decrease in Taxes):

(i) Revenue policy is expressed in terms of taxes.

(ii) During deflation the government will impose lower amount of taxes so that purchasing power of the people be increased.

(iii) It is so because to control deficient demand we have to increase the amount of liquidity in the economy.

(b) Expenditure Policy (Increase in Expenditure):

(i) Government has to invest huge amount on public works like roads, buildings, irrigation works, etc.

(ii) During deflation government should increase its expenditure on public works like roads, buildings, irrigation works thereby increasing the money income of the people and their demand for goods and services.

(c) Decrease in Public Borrowing / Public Debt:

(i) At the time of deficient demand public borrowing should be reduced.

(ii) People will have more money and more purchasing power.

(iii) In brief, during period of deficient demand government should adopt the pricing of deficit budget.

(iv) Old taken debts from public should be finished and paid back to increase money in the market.

Full Employment, Voluntary Unemployment and Involuntary Unemployment

1. Full employment:

(i) Full employment equilibrium refers to the situation where aggregate demand is equal to aggregate supply, and all those who are able to work and willing to work (at the existing wage rate) are getting work.

(ii) Full employment doesn’t means that there is no unemployment in an economy. Unemployment also exists at full employment level because of voluntary unemployment.

2. Voluntary unemployment:

(i) Voluntary unemployment refers to the situation when a person is unemployed because he is not willing to work at the existing wage rate, even when work is available.

(ii) Suppose, if the market wage rate for MBA in the industries is Rs.8,000 a month, but Some of the qualified MBA’s refuse to accept job at Rs.8, 000 a month, they will be considered as

Voluntarily unemployed.

3. Involuntary unemployment:

(i) Involuntary unemployment refers to a situation in which all able and willing persons to work at existing wage-rate do not find work.

Words that Matter

1. Excess Demand: When in an economy, aggregate demand exceeds “aggregate supply at full employment level”, the demand is said to be an excess demand.
2. Inflationary gap: It is the gap showing excess of current aggregate demand over ‘aggregate supply at the level of full employment’. It is called inflationary because it leads to inflation (continuous rise in prices).
3. Deficient demand: When in an economy, aggregate demand falls short of aggregate supply at full employment level, the demand is said to be a deficient demand.
4. Deflationary gap: It is the gap showing deficient of current aggregate demand over ‘aggregate supply at the level of full employment’. It is called deflationary because it leads to deflation (continuous fall in prices).
5. Monetary policy: It is the policy of the central bank of a country to control money supply and availability of credit in the economy.
6. Quantitative Instruments or General Tools of Monetary Policy: These are the instruments of monetary policy that affect overall supply of money/credit in the economy.
7. Qualitative Instruments or Selective Tools of Monetary Policy: These instruments are used to regulate the direction of credit.
8. Bank rate: It is the rate of interest at which central bank lends to commercial banks without any collateral (security for purpose of loan).
9. Repo rate: It is the rate at which commercial bank borrow money from the central bank for short period by selling their financial securities to the central bank.
10. Reverse repo rate: It is the rate at which the central bank (RBI) borrows moneyfrom commercial bank.
11. Open Market Operation: It consists of buying and selling of government securities and bonds in the open market by central bank.
12. Cash Reserve Ratio: It refers to the minimum percentage of a bank’s total deposits, which it is required to keep with the central bank.
13. Statutory Liquidity Ratio: It refers to minimum percentage of net total demand and time liabilities, which commercial banks are required to maintain with themselves.
14. Marginal requirement: Business and traders get credit from commercial bank against the security of their goods. Bank never gives credit equal to the full value of the security. It always pays less value than the security. So, the difference between the value of security and value of loan is called marginal requirement.
15. Moral suasion: It implies persuasion, request, informal suggestion, advice and appeal by the central banks to commercial banks to cooperate with general monetary policy of the central bank
16. Selective credit control: In this method the central bank can give directions to the commercial banks not to give credit for certain purposes or to give more credit for particular purposes or to the priority sectors.
17. Fiscal policy: The expenditure and revenue policy taken by the general government to accomplish the desired goals is known as fiscal policy.
18. Full employment equilibrium: It refers to the situation where aggregate demand is equal to aggregate supply, and all those who are able to work and willing to work (at the existing wage rate) are getting work.
19. Voluntary unemployment: It refers to the situation when a person is unemployed because he is not willing to work at the existing wage rate, even when work is available.
20. Involuntary unemployment: It refers to a situation in which all able and willing persons to work at existing wage-rate do not find work.

Government Budget and the Economy Chapter-8

Introduction

This is a descriptive chapter on government budget of Indian economy, wherein its objectives, importance, types, components, budget deficits and its types (Revenue, Fiscal, and Primary Deficit) and their implications are studied.

Chapter at a Glance

Government Budget and Its Related Concepts

1. A government budget is an annual financial statement showing item wise estimates of Expected revenue and anticipated expenditure during a fiscal year.

2. Budget has two parts:

(a) Receipts; and

(b) Expenditure.

3. Objectives of budget:

(a) Activities to secure a reallocation of resources:

(i) Private enterprises always desire to allocate resources to those areas of production where profits are high.

(ii) However, it is possible that such areas of production (like production of alcohol) may not promote social welfare.

(iii) Through its budgetary policy the government of a country directs the allocation of resources in a manner such that there is a balance between the goals of profit maximisation and social welfare.

(iv) Production of goods which are injurious to health (like cigarettes and whisky) is discouraged through heavy taxation.

(v) On the other hand, production of “socially useful goods” (like electricity, ‘Khadi’) is encouraged through subsidies.

(vi) So, finally government has to reallocate resources in accordance to social and economic considerations in case the free market fails to do or does so inefficiently.

(b) Redistributive activities:

(i) Budget of a government shows its comprehensive exercise on the taxation and subsidies.

(ii) A government uses fiscal instruments of taxation and subsidies with a view of improving the distribution of income and wealth in the economy.

(iii) A government reduces the inequality in the distribution of income and wealth by imposing taxes on the rich and giving subsidies to the poor, or spending more on welfare of the poor.

(iv) It reduces income of the rich and raises the living standard of the poor, thus, leads to equitable distribution of income.

(v) Expenditure on special anti poverty and employment schemes will be increased to bring more people above poverty line.

(vi) Public distribution system should be inferred so that only the poor could get foodgrains and other essential items at subsidised prices.

(vii) So finally, equitable distribution of income and wealth is a sign of social justice which is the principal objective of any welfare state in India.

(c) Stabilising activities:

(i) Free play of market forces (or the forces of supply and demand) are bound to generate trade cycles, also called business cycles.

(ii) These refer to the phases of recession, depression, recovery and boom in the economy. The government of a country is always committed to save the economy from business cycles. Budget is used as an important policy instrument to combat (solve) the situations of deflation and inflation.

(iv) By doing it the government tries to achieve the state of economic stability.

(v) Economic stability leads to more investment and increases the rate of growth and development.

(d) Management of public enterprises:

(i) A government undertakes commercial activities that are of the nature of natural monopolies; and which are established and managed for social welfare of the public.

(ii) A natural monopoly is a situation where there are economies of scale over a large range of output.

(iii) Industries which are potential natural monopolies are railways etc.

4. Importance of a budget:

(a) Today every country aims at its economic growth to improve living standard of its people. Besides, there are many other problems such as poverty, unemployment, inequalities in incomes and wealth etc. Government strives hard to solve these problems through budgetary measures.

(b) The budget shows the fiscal policy. Itemwise estimates of expenditure discloses how much and on what items, the government is going to spend. Similarly, itemwise details of government receipts indicate the sources from where the government intends to get money to finance the expenditure.

In this way budget is the most important instrument in hands of governments to achieve their objectives and there lies the importance of the government budget. Note: Fiscal year is the year in which country’s budgets are prepared. Its duration is from 1st April to 31st March.

5. Types of budget: It may be of two types:

(a) Balanced Budget

(b) Unbalanced Budget

Let us discuss them in detail:

(a) Balanced Budget: If the government revenue is just equal to the government expenditure made by the general government, then it is known as balanced budget.

(b) Unbalanced Budget: If the government expenditure is either more or less than a government receipts, the budget is known as unbalanced budget.

It may be of two types:

(i) Surplus budget

(ii) Deficit budget

Let us discuss them in detail:

(i) Surplus Budget: If the revenue received by the general government is more in comparison to expenditure, it is known as surplus budget.

In other words, surplus budget implies a situation where government income is in excess of government expenditure.

(ii) Deficit Budget: If the expenditure made by the general government is more than the revenue received, then it is known as deficit budget.

In other words, in deficit budget, government expenditure is in excess of government income.

1. Components of a government budget: Government budget, comprises of two parts—

(a) Revenue Budget and

(b) Capital Budget.

(a) Revenue Budget: Revenue Budget contains both types of the revenue receipts of the government, i.e., Tax revenue and Non tax revenue; and the Revenue expenditure.

(i) Revenue Receipts: These are the receipts that neither create any liability nor reduction in assets of the government. It includes tax revenues like income tax, corporation tax and non-tax revenue like fines and penalties, special assessment, escheat etc.

(ii) Revenue Expenditure: An expenditure that neither creates any assets nor cause reduction of liability is called revenue expenditure.

(b) Capital Budget: Capital budget contains capital receipts and capital expenditure of the government.

(i) Capital Receipts: Government receipts that either creates liabilities (of payment of loan) or reduce assets (on disinvestment) are called capital receipts. Capital receipts include items, which are non-repetitive and non-routine in nature.

(ii) Capital Expenditure: This expenditure of the government either creates physical or financial assets or reduction of its liability. Acquisition of assets like land, machinery, equipment, its loans and advances to state governments etc. are its examples.

2. Budget receipts (government receipt): Budget receipt refers to the estimated receipts of the government from various sources during a fiscal year. It shows the sources from where the government intends to get money to finance the expenditure. Budget receipts are of two types:

(a) Revenue receipts

(i) Meaning:

• Government receipts, which

-> Neither create any liabilities for the government; and

-> Nor cause any reduction in assets of the government, are called revenue receipts.

In revenue receipts both the conditions should be satisfied.

• Revenue receipts include items which are Repetitive and routine in nature.

(ii) Revenue receipts are further classified into:

• Tax Revenue:

-> Tax revenue refers to receipts from all kinds of taxes such as income tax, corporate tax, excise duty etc.

-> A tax is a legally compulsory payment imposed by the government on income and profit of persons and companies without reference to any benefit. Taxes are of two types: Direct taxes and Indirect taxes.

• Non-Tax Revenue:

-> Non-tax revenue refers to government revenue from all sources other than taxes.

-> These are incomes, which the government gets by way of sale of goods and services rendered by different government departments.

-> Components of Non-Tax Revenue:

♦ Commercial Revenue (Profit and interest):

♦ It is the revenue received by the government by selling the goods and services produced by the government agencies.

♦ For example, profit of public sector undertakings like Railways, BHEL, LIC etc.

♦ Government gives loan to State Government, union territories, private enterprises and to general public and earns interest receipts from these loans.

♦ It also includes interest and dividends on investments made by the government.

♦ Administrative Revenue: The revenue that arises on account of the administrative function of the government. This includes:

♦ Fee: Fee refers to a payment made to the government for the services that it renders to the citizens. Such services are generally in public interest and fees are paid by those, who receive such services. For example, passport fees, court fees, school fees in government schools.

♦ License Fee: License fee is a payment to grant a permission by a government authority. For example, registration fee for an automobile.

♦ Fines and penalties for an infringement of a law, i.e., they are imposed on law breakers.

♦ Special Assessment: Sometimes government undertakes developmental activities by which value of nearby property appreciates, which leads to increase in wealth. So, it is the payment made by owners of those properties whose value has appreciated. For example, if value of a property near a metro station has increased, then a part of developmental expenditure made by government is recovered from owners of such property. This is the value of special assessment.

♦ Forfeitures are in the form of penalties imposed by courts that a person needs to pay in the court of law for failing to comply with court orders.

♦ Escheat refers to the claim of the government on the property of a person who dies without having any legal heir or without leaving a will.

♦ External grants: Government receives financial help in the form of grants, gifts from foreign governments and international organisations (IMF, World Bank). Such grants and gifts are received during national crisis such as earthquakes, flood, war etc.

(b) Capital receipts:

(i) Meaning:

• Government receipts that either creates liabilities (of payment of loan) or reduce assets (on disinvestment) are called capital receipts.

In capital receipts any one of the conditions must be satisfied.

• Capital receipts include items which are non-repetitive and non-routine in nature,

(ii) Components:

• Borrowing (Domestic and External): Borrowings are made to meet the financial requirement of the country. A government may borrow money:

-> Domestically: General Public (By issuing government bonds in the open market). Reserve Bank of India.

-> Externally: Rest of the world (foreign government and international institutions)

• Recovery of Loans and Advances: Loans offered to others are assets of the government. It includes recovery of loans granted by the central government to state and union territory governments. It is a capital receipt because it reduces financial assets of the government. For example, The Government of India may give Rs. 1000 crore as a loan to The Government of Delhi. Here the value of asset is Rs. 1000 crore. When The Government of Delhi repaid Rs. 100 crore, the value of The Government of India assets reduces to Rs. 900 crore. Since, recovery of loan reduces the value of assets, it is termed as a capital receipts.
• Disinvestment: A government raises funds from disinvestment also. Disinvestment means selling whole or a part of the shares (i.e., equity) of selected public sector enterprises held by government. As a result, government assets are reduced.

Types of Taxes:

1. Direct Taxes: When (a) liability to pay a tax (Impact of Tax), and (b) the burden of that tax (Incidence of tax), falls on the same person, it is termed as direct tax. A direct tax is paid directly by the same person on whom it has been levied. It means a tax in which impact and incidence of tax falls on the same persons, then it is termed as direct tax. In other words, burden of a direct tax is borne by the person on whom it is imposed which means the burden cannot be shifted to others. Alternatively, the person from whom the tax is collected is also the person who bears the ultimate burden of the tax. Income tax and corporate (profit) tax are most appropriate examples of direct tax.
2. Indirect Tax: When (a) liability to pay a tax (Impact of tax) is on one person; and

(b) the burden of that tax (Incidence of tax), falls on the other person, it is termed as indirect tax. It means a tax in which impact and incidence of tax lie on two different persons, then it is termed as indirect tax. In other words, indirect taxes are the taxes of whose burden can be shifted to others. In case of an indirect tax, person first pays the tax but he is able to transfer the burden of the tax to others. For instance, sales tax is an indirect tax because indirect tax is collected by government from the seller of the commodity who in turn realizes the tax amount from the buyer by including it in the price of the commodity. Other examples of indirect taxes are excise duty, custom duty, entertainment tax, service tax etc.

3. Progressive Tax: A tax the rate of which increases with the increase in income and decreases with the fall in income is called a progressive tax. The higher is the income of a taxpayer, the higher is proportionate tax he pays. For example, in India income tax is considered a progressive tax because its rate goes on increasing with the increase in annual income. For example, presently (2012-2013) there is no tax up to annual income of Rs. 2,00,000 but the.rate of income tax increases with the increase in incomes. It is 10% on incomes between Rs. 2,00,000 and Rs. 5,00,000; 20% on incomes between Rs. 5,00,000 and Rs.10,00,000 and 30% on incomes above Rs. 10,00,000.
4. Proportional Taxation: A tax is called proportional when the rate of taxation remains constant as the income of the taxpayer increases.

Example: If tax rate is 10% and the annual income of a person is Rs. 2,00,000, then he will have to pay Rs. 20,000 per year as tax. If income rises to Rs. 3,00,000 per annum, then the tax liability will rise to Rs. 30,000 per year. In this case, burden of tax is more on the poor section as compared to rich section.

5. Regressive Tax: In a regressive tax system, the rate of tax falls as the tax base increases.

In this case, we find that (a) the amount of tax to be paid increases, and (b) the rate at which tax is to be paid falls.

Budget Expenditure & Its Related Concepts

1. Meaning: Budget expenditure refers to the estimated expenditure of the government on its “development and non-development programmes or “plan and non-plan programmes during the fiscal year.
2. Types:

(a) Plan and non-plan expenditure

(b) Revenue and capital expenditure

(c) Developmental and non-developmental Expenditure

(a) Plan and non-plan expenditure:

(i) Plan Expenditure: Plan expenditure refers to that expenditure which is incurred by the government to fulfill its planned development programmes. This includes both consumption and investment expenditure by the government or Planning Commission of a country. Expenditure on agriculture, industry, public utilities, health and education etc. are examples of plan expenditure.

(ii) Non-Plan Expenditure: This refers to all such government expenditures which are beyond the scope of its planned development programmes. For instance, no government can escape from its basic function of protecting the lives and properties of the people. For this government has to spend on police, judiciary, military etc. In short, expenditure other than expenditure related to current Five-year plan is treated as non-plan expenditure.

(b) Revenue and capital expenditure:

(i) Revenue Expenditure: An expenditure that (a) neither creates any assets (b) nor causes any reduction of liability.

In revenue expenditure both the conditions should be satisfied.

Examples of revenue expenditure are: salaries of government employees, interest : payment on loans taken by the government, pensions etc.

(ii) Capital Expenditure: An expenditure that either create assets for the government [equity or shares) of the domestic, or multinational corporations purchased by the government), or cause reduction in liabilities of the government, [repayment of loans reduces liability of the government).

In capital expenditure any one of the above conditions must be satisfied.

Thus, it refers to expenditure that leads to creation of assets and reduction in liabilities. Such expenditure is incurred on long period development.

Conclusion: A basic difference between capital expenditure and revenue expenditure is that the capital expenditure is incurred on creation or acquisition of assets, whereas, the revenue expenditure is incurred on rendering services.

For example: Expenditure on construction of a hospital building is capital expenditure, but expenditure on medicines, salaries of doctors etc. for rendering services by the hospital is revenue expenditure.

(c) Developmental and non-developmental Expenditure:

(i) Developmental Expenditure: Developmental expenditure is the expenditure on activities which are directly related to economic and social development of the country. This includes expenditure on education, health, agriculture, transport, roads, rural development etc. This also includes loans given by the government to enterprises like Sahara for the purpose of development.

(ii) Non-developmental Expenditure: Non-developmental expenditure of the

government is the expenditure on the essential general services of the government. This includes expenditure on defence, payment of old age pension, collection of taxes, interest on loans, subsidies etc.

Deficits and Implications of These Deficits

1. Budget deficit:

(a) Meaning:

(i) Budgetary deficit refers to the excess of total budgeted expenditure (both revenue expenditure and capital expenditure) over total budgetary receipts (both revenue receipt and capital receipt).

(ii) In other words, when sum of revenue receipts and capital receipts fall short of the sum of revenue expenditure and capital expenditure, budgetary deficit is said to occur. Symbolically,

Budgetary Deficit = Total Expenditure – Total Receipts

(b) Types:

(i) Revenue deficit, (ii) Fiscal deficit and (iii) Primary deficit

2. Revenue deficit:

(a) Meaning:

(i) Revenue deficit refers to the excess of revenue expenditure of the government over its revenue receipts. Symbolically,

Revenue Deficit = Total Revenue Expenditure – Total Revenue Receipts

(ii) The government of India budget for the year 2012-2013, total expenditure is Rs. 12,42,263 crore against total revenue receipts of Rs. 8,78,804 crore. As a result there is revenue deficit of Rs. 3,63,459 (12,42,263-8,78,804) crore, which is 3.6% of GDP.

(b) Implications of revenue deficit:

(i) Revenue deficit indicates dis-savings on government account because the government has to make up uncovered gap.

(ii) Revenue deficit implies that the government has to cover this uncovered gap by drawing upon capital receipts either through borrowing or through sale of its assets.

(iii) Since government is using capital receipts to generally meet consumption expenditure of the government, it leads to an inflationary situation in the economy.

(c) Measures to reduce revenue deficit are:

(i) Government should reduce its unproductive or unnecessary expenditure.

(ii) Government should increase its receipts from various sources of tax and non-tax revenue.

3. Fiscal deficit:

(a) Meaning:

(i) Fiscal deficit is defined as excess of total expenditure over total receipts (revenue and capital receipts) excluding borrowing. In the form of an equation:

(ii) Fiscal deficit is a measure of total borrowings required by the government.

(iii) Fiscal deficit indicates capacity of a country to borrow in relation to what it produces. In other words, it shows the extent of government dependence on borrowing to meet its budget expenditure.

(iv) Another point to be noted here is that as the government borrowing increases, its liability in future to repay loan with interest also increases leading to a higher revenue deficit. Therefore, fiscal deficit should be as low as possible.

(v) Fiscal deficit for the year 2012-2013 is 4,89,890 crore which is 4.9% of GDP.

(b) Implications of fiscal deficit:

(i) Causes Inflation: An important component of government borrowing includes borrowing from the Reserve Bank of India. This invariably implies deficit financing or meeting deficit requirements of the government by way of printing more currency. This is a dangerous practice, though very convenient for the government. It increases circulation of money and causes inflation.

(ii) Increase in Foreign Dependence: Government also borrows from rest of the world. It increases our dependence on other countries. Foreign borrowing is often associated with economic and political interference by the lender countries. It increases our economic slavery.

(iii) Financial Burden for Future Generation: Borrowing implies accumulation of financial burdens for the future generations. It is for future generations to repay loans as well as the mounting interest thereon.

(iv) Deficits Multiply Borrowings: Payment of interest increases revenue expenditure of the government, causing an increase in its revenue deficit. Thus, a vicious circle is set wherein the government takes more loans to repay earlier loans, which is called Debt Trap.

4. Primary deficit:

(a) Meaning:

(i) Primary deficit is defined as fiscal deficit minus interest payments.

Primary Deficit = Fiscal Deficit – Interest Payments

(ii) The government of India budget for the year 2012-2013, fiscal deficit is 4,89,890 crore and Interest Payment is 3,11,996 crore. As a result, primary deficit is 1,77,894 crore, which is 1.8% of GDP.

(b) Implications of primary deficit: While fiscal deficit shows borrowing requirement of the government for financing the expenditure inclusive of interest payments, primary deficit reflects the borrowing requirements of the government for meeting expenditures other than interest payments on earlier loans.

Words that Matter

1. Government Budget: A government budget is an annual financial statement showing itemwise estimates of expected revenue and anticipated expenditure during a fiscal year.
2. Balanced Budget: If the government revenue is just equal to the government expenditure made by the general government, then it is known as balanced budget.
3. Unbalanced budget: If the government expenditure is either more or less than a government receipts, the budget is known as Unbalanced budget.
4. Surplus Budget: If the revenue received by the general government is more in comparison to expenditure, it is known as surplus budget.
5. Deficit Budget: If the expenditure made by the general government is more than the revenue received, then it is known as deficit budget.
6. Budget receipt: It refers to the estimated receipts of the government from various sources during a fiscal year.
7. Budget expenditure: It refers to the estimated expenditure of the government on its “development and non-development programmes or “plan and non-plan programmes during the fiscal year.
8. Revenue Budget: Revenue Budget contains both types of the revenue receipts of the government, i.e., Tax revenue and Non tax revenue ; and the Revenue expenditure.
9. Revenue Receipts: Government receipts, which

(a) Neither create any liabilities for the government; and

(b) Nor cause any reduction in assets of the government, are called revenue receipts.

10. Tax Revenue: Tax revenue refers to receipts from all kinds of taxes such as income tax, corporate tax, excise duty etc.
11. Tax: A tax is a legally compulsory payment imposed by the government on income and profit of persons and companies without reference to any benefit.
12. Non-tax revenue: It refers to government revenue from all sources other than taxes called non-tax revenue.
13. Revenue Expenditure: An expenditure that (a) Neither creates any assets (b) nor causes any reduction of liability.
14. Capital Budget: Capital budget contains capital receipts and capital expenditure of the government.
15. Capital Receipts: Government receipts that either creates liabilities (of payment of loan) or reduce assets (on disinvestment) are called capital receipts.
16. Capital Expenditure: Government expenditure of the government which either creates physical or financial assets or reduction of its liability.
17. Direct Tax: When (a) liability to pay a tax (Impact of Tax), and (b) the burden of that tax (Incidence of tax), falls on the same person, it is termed as direct tax.
18. Indirect Tax: When (a) liability to pay a tax (Impact of tax) is on one person; and (b) the burden of that tax (Incidence of tax), falls on the other person, it is termed as indirect tax.
19. Progressive Tax: A tax the rate of which increases with the increase in income and decreases with the fall in income is called a progressive tax.
20. Proportional Taxation: A tax is called proportional when the rate of taxation remains constant as the income of the taxpayer increases.
21. Regressive Tax: In a regressive tax system, the rate of tax falls as the tax base increases.
22. Plan expenditure: It refers to that expenditure which is incurred by the government to fulfill its planned development programmes.
23. Non-Plan Expenditure: This refers to all such government expenditures which are beyond the scope of its planned development programmes.
24. Developmental Expenditure: Developmental expenditure is the expenditure on activities which are directly related to economic and social development of the country.
25. Non-developmental expenditure: Non-developmental expenditure of the government is the expenditure on the essential general services of the government.
26. Budgetary deficit: It refers to the excess of total budgeted expenditure (both revenue Expenditure and capital expenditure) over total budgetary receipts (both revenue receipt and capital receipt).

27. Revenue Deficit: Revenue deficit refers to the excess of revenue expenditure of the government over its revenue receipts.
28. Fiscal deficit: It is defined as excess of total expenditure over total receipts (revenue and capital receipts) excluding borrowing. Fiscal deficit indicates capacity of a country to borrow in relation to what it produces. In other words, it shows the extent of government dependence on borrowing to meet its budget expenditure.
29. Debt Trap: A vicious circle set wherein the government takes more loans to repay earlier loans, which is called Debt Trap.
30. Primary deficit: It is defined as fiscal deficit minus interest payments.

Foreign Exchange Rate Chapter-9

Introduction

This chapter defines the meaning of foreign exchange and related terms, how foreign exchange rate is determined, study of foreign exchange rate regimes (fixed and flexible exchange rate) and their differences; thereafter hybrid systems of exchange rate and operation of foreign exchange market.

Foreign Exchange and Its Related Concepts

1. Foreign exchange refers to all the currencies of the rest of the world other than the domestic currency of the country. For example, in India, US dollar is the foreign exchange.
2. The rate at which one currency is exchanged for another is called Foreign Exchange Rate.

In other words, the foreign exchange rate is the price of one currency stated in terms of another currency. For example, if one U.S dollar exchanges for 60 Indian rupees, then the rate of exchange is 1$ = Rs. 60 or 1 Rs = 1/60 or 0.0166 U.S. dollar.

3. Foreign exchange market is the market where the national currencies are converted, exchanged or traded for one another.
4. Functions of a foreign exchange market

(a) Transfer Function: Transfer function refers to transferring of purchasing power Among countries.

(b) Credit Function: It implies provision of credit in terms of foreign exchange for the export and import of goods and services across different countries of the world.

(c) Hedging Function: Hedging function pertains to protecting against foreign exchange risks. Where Hedging is an activity which is designed to minimize the risk of loss.

5. Sources of demand of foreign exchange:

The demand (or outflow) of foreign exchange comes from the people who need it to make payments in foreign currencies. It is demanded by the domestic residents for the following reasons:

(a) Imports of Goods and Services: When India imports goods and services, foreign exchange is demanded to make the payment for imports of goods and services.

(b) Tourism: Foreign exchange is demanded to meet expenditure incurred in foreign tours.

(c) Unilateral Transfers Sent Abroad: Foreign exchange is required for making unilateral transfers like sending gifts to other countries.

(d) Purchase of Assets in Foreign Countries: It is demanded to make payment for purchase of assets, like land, shares, bonds, etc. in foreign countries.

(e) Repayment of loans to Foreigners: As and when we have to pay interest and repay the loans to foreign lenders, we require foreign exchange.

(d) Speculation: Demand for foreign exchange arises when people want to make gains from appreciation of currency.

6. Reasons for ‘Rise in Demand’ for Foreign Currency:

The demand for foreign currency rises in the following situations:

(a) When price of a foreign currency falls, imports from that foreign country become cheaper. So, imports increase and hence, the demand for foreign currency rises. For example, if price of 1 US dollar falls from Rs. 60 to Rs. 55, then imports from the USA will increase as American goods will become relatively cheaper. It will raise the demand for US dollar.

(b) When a foreign currency becomes cheaper in terms of the domestic currency, it promotes tourism to that country. As a result, demand for foreign currency rises.

(c) When price of a foreign currency falls, its demand rises as more people want to make gains from speculative activities.

7. Demand curve of foreign exchange is downward sloping:

(a) Demand curve of foreign exchange slopes downwards due to inverse relationship between demand for foreign exchange and foreign exchange rate.

(b) In figure, demand for foreign exchange (US dollar) and rate of foreign exchange are shown on the horizontal axis and vertical axis respectively.

(c) The demand curve [US$] is downward sloping. It means that less foreign exchange is demanded as the exchange rate increase

(d) This is due to the fact that rise in the price of foreign exchange increases the rupee cost of foreign goods, which make them more expensive. As a result, imports decline. Thus, the demand for foreign exchange also decreases.

8. Sources of supply of foreign exchange: The supply (inflow) of foreign exchange comes from the people who receive it due to the following reasons.

(a) Exports of Goods and Services: Supply of foreign exchange comes through exports of goods and services.

(b) Tourism: The amount, which foreigners spend in the home country, increases the supply of foreign exchange.

(c) Remittances (unilateral transfers) from Abroad: Supply of foreign exchange increases in the form of gifts and other remittances from abroad.

(d) Loan from Rest of the world: It refers to borrowing from abroad. A loan from U.S. means flow of U.S. $ from U.S. to India, which will increase supply of Foreign exchange.

(e) Foreign Investment: The amount, which foreigners invest in our home country, increases the supply of foreign exchange.

(f) Speculation: Supply of foreign exchange comes from those who want to speculate on the value of foreign exchange.

9. Reasons of‘rise in supply’ of foreign currency: The supply of foreign currency rises in the following situations:

(a) When price of a foreign currency rises, domestic goods become relatively cheaper. It induces the foreign country to increase their imports from the domestic country. As a result, supply of foreign currency rises. For example, if price of 1 US dollar rises from Rs. 60 to Rs. 65, then exports to USA will increase as Indian goods will become relatively cheaper. It will raise the supply of US dollars.

(b) When price of a foreign currency rises, foreign direct investment (FDI). From rest of the world increases, which will increase the supply for foreign exchange.

(c) When price of a foreign currency rises, supply of foreign currency also rises as people want to make gains from speculative activities.

10. Supply curve of foreign exchange is upward sloping:

(a) Supply curve of foreign exchange slopes upwards due to positive relationship between supply for foreign exchange and foreign exchange rate, which means that supply of foreign exchange increases as the exchange rate increases.

(b) This makes home country’s goods become cheaper to foreigners since rupee is depreciating in value. The demand for our exports should therefore increase as the exchange rate increases.

(c) The increased demand for our exports will translate into greater supply of foreign exchange. Thus, the supply of foreign exchange increases as the exchange rate increases.How Foreign Exchange Is Determine, Disequilibrium Conditions under Exchange Rate

1. Determination of foreign exchange rate:

(a) Exchange rate in a free exchange market is determined at a point, where demand for foreign exchange is equal to the supply of foreign exchange.

(b) Let us assume that there are two countries – India and U.S.A – and the exchange rate of their currencies i.e., rupee and dollar is to be determined. Presently, there is floating or flexible exchange regime in both India and U.S.A. Therefore, the value of currency of each country in terms of the other currency depends upon the demand for and supply of their currencies.

(c) In the above diagram, the price on the vertical axis is stated in terms of domestic currency (that is, how many rupees for one US dollar). The horizontal axis measures the quantity demanded or supplied.

(d) In the above diagram, the demand curve [D$] is downward sloping. This means that less foreign exchange is demanded as the exchange rate increases. This is due to the fact that the rise in price of foreign exchange increases the rupee cost of foreign goods, which make them more expensive. As a result, imports decline. Thus, the demand for foreign exchange also decreases.

(e) The supply curve [S$] is upward sloping which means that supply of foreign exchange increases as the exchange rate increases.This makes home country’s goods become cheaper to foreigners since rupee is depreciating in value. The demand for our exports should therefore increase as the exchange rate increases.The increased demand for our exports translates into greater supply of foreign exchange. Thus, the supply of foreign exchange increases as the exchange rate increases.

2. Disequilibrium conditions under equilibriun exchange rate:

(a)Change in demand:

(i) Increase in demand for dollar: An increase in the demand for US dollar in India will cause the demand curve to shift to D1$ and the exchange rate rises to P1$. Note that increase in the exchange rate means that more rupees are required to buy one US dollar. When this occurs, Indian rupee is said to be depreciating.

(b) Change in Supply

(i) Increase in supply for dollar: An increase in the supply of US dollar causes the supply curve to shift to S1$ and exchange rate falls to P1$. In this case, rupee cost of US dollar is decreasing and the Indian rupee is said to be appreciating.

(ii) Decrease in demand for dollar: A decrease in the demand for US dollar in India will cause the demand curve to shift to D1$ and the exchange rate falls to P1$. Note that decrease in the exchange rate means that less rupees are required to buy one US dollar. When this occurs, Indian rupee is said to be appreciating.

(ii) Decrease in supply of dollar: A decrease in the supply of US dollar causes the supply curve to shift to S1$ and exchange rate rises to P1$. In this case, rupee cost of US dollar is increasing and the Indian rupee is said to be depreciating.

Exchange Rate Regimes (Fixed, Flexible and Managed Floating Exchange Rate and Their Merits and Demerits)

Types of exchange rate regimes:

1. Fixed exchange rate system (Pegged exchange rate system):

(a) Meaning:

(i) The system of exchange rate in which exchange rate is officially declared and fixed by the government is called fixed exchange rate system.

(ii) When domestic currency is tied to the value of foreign currency, it is known as pegging.

(iii) To maintain stability in fixed exchange rate system, government buy foreign currency when exchange rate appreciates and sell foreign currency when exchange rate depreciate. This process is called Pegging operation, i.e., all efforts made by the central bank to keep the rate of exchange stable.

Note:

(i) Fixed exchange rate is not determined by the forces of demand and supply in the market. Such a rate of exchange has been associated with Gold Standard System during 1880-1914.

(ii) According to this system, value of every currency is determined in terms of gold. Accordingly, ratio between gold values of the two countries was fixed as exchange rate between those currencies.

(iii) For example, Value of one dollar = 100 Gms of gold.

Value of a rupee = 5 gms of gold

Then, 1 dollar = 100/5 = Rs. 20

(b) Merits of fixed exchange rate system:

(i) Stability: It ensures stability, in the international money market/exchange market. Day to day fluctuations are avoided. It helps formulation of long term economic policies, particularly relating to exports and imports.

(ii) Encourages international trade: Fixed exchange rate system implies low risk and low uncertainty of future payments. It encourages international trade.

(iii) Co-ordination of macro policies: Fixed exchange rate helps co-ordination of macro policies across different countries of the world. Long term economic policies can be drawn in the area of international trade and bilateral trade agreements.

(c) Demerits of fixed exchange rate system:

(i) Huge international reserves: Fixed exchange rate system is often supported with huge international reserves of gold. This is because different currencies are directly or indirectly convertible into gold.

(ii) Restricted movement of capital: Fixed exchange rate restricts the movement Of capital across different parts of the world. Accordingly, international growth process suffers.

(iii) Discourages venture capital: Venture capital in the international money market refers to investments in the purchase of foreign exchange in the international money market with a view to earn profits. Fixed exchange rate system discourages such investments. Fixed exchange rate discourages venture capital in the international money market.

(d) Devaluation of currency: Devaluation refers to decrease in the value of domestic currency in terms of foreign currency by the government. It is a part of fixed exchange rate.

(e) Revaluation of currency: Revaluation refers to increase in the value of domestic Currency by the central government. It is a part of fixed exchange rate.

2. Flexible exchange rate (floating exchange rate system):

(a) Meaning:

(i) The system of exchange rate in which value of a currency is allowed to float freely as determined by demand for and supply of foreign exchange is called flexible exchange rate system.

(ii) Under this system, the central banks, without intervention, allow the exchange rate to adjust to equate the supply and demand for foreign currency.

(iii) The foreign exchange market is busy at all times by changes in the exchange rates.

(b) Merits of flexible exchange rate system:

(i) No need for international reserves: Flexible exchange rate system is not to be supported with international reserves.

(ii) International capital movements: Flexible exchange rate system enhances movement of capital across different countries of the world. This is due to the fact that member countries are no longer required to keep huge international reserves.

(iii) Venture capital: Flexible exchange rate promotes venture capital in foreign exchange market. Trading in international currencies itself becomes an important economic activity.

(c) Demerits of flexible exchange rate system:

(i) Instability: It causes instability in the international money market. Exchange rate tends to fluctuate like price of goods in the commodity market.

(ii) International trade: Instability in foreign exchange market causes instability in the area of international trade. It becomes difficult to draw long period policies of exports and imports.

(iii) Macro policies: While fixed exchange rate helps coordination of macro policies, flexible exchange rate makes it a difficult proposition. Day to day fluctuations in exchange rate makes bilateral trade agreements a difficult exercise.

(d) Currency depreciation:

(i) Currency depreciation refers to decrease in the value of domestic currency in terms of foreign currency. It makes the domestic currency less valuable and more of it is required to buy a foreign currency. It is a part of flexible exchange rate.

(ii) For example, rupee is said to be depreciating if price of $1 rises from? 60 to Rs. 65.

(iii) Effect of depreciation of domestic currency on exports: Depreciation of domestic currency means a fall in the price of domestic currency (say, rupee) in terms of a foreign currency (say, $). It means, with the same amount of dollars, more goods can be purchased from India, i.e., exports to USA will increase as they will become relatively cheaper.

(e) Currency appreciation:

(i) Currency appreciation refers to increase in the value of domestic currency in terms of foreign currency. The domestic currency becomes more valuable and less of it is required to buy a-foreign currency. It is a part of flexible exchange rate.

(ii) For example, Indian rupee appreciates when price of $1 falls from Rs. 60 to Rs. 55.

(iii) Effect of appreciation of domestic currency on imports: Appreciation of domestic currency means a rise in the price of domestic currency (say, rupee) in terms of a foreign currency (say, $). Now, one rupee can be exchanged for more $, i.e., with the same amount of money, more goods can be purchased from the USA. It leads to increase in imports from the USA as American goods will become relatively cheaper.

3. Managed floating rate system:

(a) Managed floating exchange rate is a mixture of a flexible exchange rate (the float part) and a fixed exchange rate (the Managed part).

(b) In other words, it refers to a system in which foreign exchange is determined by free market forces (demand and supply forces), which can be influenced by the intervention of the central bank in foreign exchange market.

(c) Under this system, also called Dirty floating, central banks intervene to buy or sell foreign currencies in an attempt to stabilize exchange rate movements in case of extreme appreciation or depreciation.

Kinds of Foreign Exchange Rate (Spot and Forward Market)

1. Spot market for foreign exchange:

(a) If the operation is of daily nature, it is called spot market or current market.

(b) The exchange rate that prevails in the spots market for foreign exchange is called spot rate.

(c) In other words, spot rate of exchange refers to the rate at which foreign currency is available on the spot.

2. Forward market for foreign exchange:

(a) A market for foreign exchange for future delivery is known as forward market.

(b) Exchange rate that prevails in a forward contract for purchase or sale of foreign exchange is called forward rate.

(c) Thus, forward rate is the rate at which a future contract for foreign currency is bought and sold.

Other Types of Exchange Rate System

1. Wider band System:

(a) It is a system that allows wider adjustment in the fixed exchange rate system.

(b) It allows adjustment upto 10% around the “parity” between any two currencies in the internationahmoney market.

(c) For example, if one US dollar is fixed as equal to fifty Indian rupees, 10% revision (upward or downward) is to be allowed in this exchange rate of 1: 50. Exchange rate may be revised as,

1: 60 + 10% = 1: 66 or as 1: 60 – 10% = 1 : 54

2. Crawling peg system:

(a) It allows “small” but regular adjustments in the exchange rate for different currencies.

(b) Not more than (+) 1% adjustment is allowed at a time. Indeed, it is a small adjustment.

(c) But it can crawl, i.e., it can be repeated at regular intervals.

Some Important Terms

1. Nominal exchange rate (NER): The number of units of domestic currency required to purchase a unit of foreign currency is called nominal exchange rate. Thus, $1 = Rs. 60. It may move to $1 = Rs. 65, and so on.
2. Nominal effective exchange rate (NEER):

(a) The concept is useful for an aggregative analysis. A nation has to deal with a number of countries, and hence a number of currencies.

(b) For example, during a period Indian rupee may be losing value against the American dollar, but it may be gaining value against Euro.

(c) Therefore, we would be interested in knowing what is happening in aggregate to our rupee i.e., is it gaining or losing.

(d) For this purpose, we prepare a basket of all the currencies which we are interested in, and find out the average of the changes in these currencies in a given period. This gives us the nominal effective exchange rate (NEER).

(e) So, finally NEER is the measure of average relative strength of a given currency with respect to other currencies without eliminating the effect of change in price.

3. Real exchange rate (RER): RER is the exchange rate which is calculated after eliminating the effects of price change. Therefore, RER is based on constant prices.
4. Real effective exchange rate (REER): REER is the measure of average relative strength of a given currency with respect to other currencies after eliminating the effects of price change.
5. Parity value: In the context of exchange rate in foreign exchange market, parity value refers to the value of one currency in terms of the other for a given basket of goods and services. If a U.S. dollar buys 50 times the goods and services in India, compared to a rupee, the parity value of a US dollar should be 50 : 1. Accordingly, the exchange rate between rupee and a US dollar ought to be Rs. 50 : 1$. Any change in the parity value would imply a corresponding change in exchange rate.

Words that Matter

1. Foreign exchange: It refers to all the currencies of the rest of the world other than the domestic currency of the country. For example, in India, US dollar is the foreign exchange.
2. Foreign Exchange Rate: The rate at which one currency is exchanged for another is called Foreign Exchange Rate.
3. Foreign exchange market: It is the market where the national currencies are converted, exchanged or traded for one another.
4. Hedging function: Hedging function pertains to protecting against foreign exchange risks, where Hedging is an activity which is designed to minimize the risk of loss.
5. Fixed exchange rate system: The system of exchange rate in which exchange rate is officially declared and fixed by the government is called fixed exchange rate system.
6. Pegging: When domestic currency is tied to the value of foreign currency, it is known as pegging.
7. Pegging operations: It refers to all efforts made by the central government to keep the rate of exchange stable.
8. Venture capital: Venture capital in the international money market refers to investments in the purchase of foreign exchange in the international money market with a view to earn profits.
9. Devaluation: It refers to decrease in the value of domestic currency in terms of foreign currency by the government. It is a part of fixed exchange rate.
10. Revaluation: It refers to increase in the value of domestic currency by the central government. It is a part of fixed exchange rate.
11. Flexible Exchange Rate: The system of exchange rate in which value of a currency is allowed to float freely as determined by demand for and supply of foreign exchange is called flexible exchange rate system.
12. Currency depreciation: It refers to decrease in the value of domestic currency in terms of foreign currency. It makes the domestic currency less valuable and more of it is required to buy a foreign currency. It is a part of flexible exchange rate.
13. Currency appreciation: It refers to increase in the value of domestic currency in terms of foreign currency. The domestic currency becomes more valuable and less of it is required to buy a foreign currency. It is a part of flexible exchange rate.
14. Managed floating exchange rate: It is a mixture of a flexible exchange rate (the float part) and a fixed exchange rate) the Managed part).
15. Spot Rate: If the operation is of daily nature, it is called spot market or current market.
16. Forward Rate: A market for foreign exchange for future delivery is known as forward market.
17. Nominal Exchange Rate (NER): The number of units of domestic currency required to purchase a unit of foreign currency is called nominal exchange rate.
18. Nominal Effective Exchange Rate (NEER): It is the measure of average relative strength of a given currency with respect to other currencies without eliminating the effect of change in price.
19. Real Exchange Rate (RER): It is the exchange rate which is calculated after eliminating the effects of price change. Therefore, RER is based on constant prices.
20. Real Effective Exchange Rate (REER): It is the measure of average relative strength of a given currency with respect to other currencies after eliminating the effects of price changes.
21. Parity value: It refers to the value of one currency in terms of the other for a given basket of goods and services.

Balance of Payment Chapter-10

Introduction

This chapter gives a detailed account of balance of payment of an economy, it structure and categorisation into current and capital account. Thereafter explaining balance of trade and its differences with the balance of payment, autonomous items, accommodating items and their differences, disequilibrium in balance of payment.

Balance of Payment, Its Structure and Components

1. The balance of payments of a country is a systematic record of all economic transactions between its residents and residents of the foreign countries during a given period of time.

Note: Economic transactions are the transactions which cause transfer of value. In the context of foreign transactions value is transferred by the residents of one country to the residents of other country. Example: when exports of goods or services are made by country A to country B, value (= export receipts) is transferred by country B to country A. Between the countries, value is transferred in terms of foreign exchange (i.e. payments are received and made in terms of foreign exchange).

2. Structure of balance payment accounting

(a) Transactions are recorded in the balance of payments accounts in double-entry book keeping.

(b) Each international transaction undertaken by country will results in a credit entry and debit entry of equal size.

(c) As international transactions are recorded in double entry accounting, the BOP accounting must always balance i.e., total amount of debits must be equal to total amount of credits.

(d) The balancing item Errors and omissions must be added to “balance” the BOP accounts.

(e) By convension, debit items and credit items are entered with a minus sign and plus sign respectively.

(f) Transactions in BOP are classified into the following five major categories:

(i) Goods and services account

(ii) Unilateral transfer account

(iii) Long-term capital account

(iv) Short-term private capital account

(v) Short-term official capital account

For each of these given categories, specific types of transactions are shown as debits or credits. This is shown in below table:

The above five categories are also divided into the following two major categories of accounts in the BOP account statement:

3. Current Account (Category-I, Category-II):

(a) Meaning: Current account records imports and exports of goods and services and unilateral transfers.

(b) Components of Current Account: The main components of Current Account are:

(i) Export and Import of Goods (Merchandise Transactions or Visible Trade):

A major part of transactions in foreign trade is in the form of export and import of goods (visible items). Payment for import of goods is written on the negative side (debit items) and receipt from exports is shown on the positive side (credit items). Balance of these visible exports and imports is known as balance of trade (or trade balance).

(ii) Export and Import of Services (Invisible Trade): It includes a large variety of non-factor services (known as invisible items) sold and purchased by the residents of a country, to and from the rest of the world. Payments are either received or made to the other countries for use of these services. Services are generally of three kinds:

(a) Shipping,

(b) Banking, and

(c) Insurance – Payments for these services are recorded on the negative side and receipts on the positive side.

(iii) Unilateral or Unrequisted Transfers to and from abroad (One sided Trans¬actions): Unilateral transfers include gifts, donations, personal remittances and other ‘oneway’ transactions. These refer to those receipts and payments, which take place without any service in return. Receipt of unilateral transfers from rest of the world is shown on the credit side and unilateral transfers to rest of the world on the debit side.

(iv) Income receipts and payments to and from abroad: It includes investment income in the form of interest, rent and profits.

4. Capital Account (Category-Ill, Category-IV, Category-V):

(a) Meaning: Capital account is that account which records all such transactions between residents of a country and rest of the world which cause a change in the asset or liability status of the residents of a country or its government.

(b) Components of Capital Account: The main components of capital account are:

(i) Loans: Borrowing and lending of funds are divided into two transactions:

• Private Transactions

-> These are transactions that are affecting assets or liabilities by individuals, businesses, etc. and other non-government entities. The bulk of foreign investment is private.

-> For example, all transactions relating to borrowings from abroad by private sector and similarly repayment of loans by foreigners are recorded on the positive (credit) side.

-> All transactions of lending to abroad by private sector and similarly repayment of loans to abroad by private sector is recorded as negative or debit item.

• Official Transactions

-> Transactions affecting assets and liabilities by the government and its agencies.

-> For example, all transactions relating to borrowings from abroad by government sector and similarly repayment of loans by foreign government are recorded on the positive (credit) side.

-> All transactions of lending to abroad by government sector and similarly repayment of loans to abroad by government sector is recorded as negative or debit item.

Private and official transactions borrowing are of two components:

(i) Commercial borrowings, referring to borrowing by a country (including government and private sector) from international money market. This involves market rate of interest without considerations of any concession,

(ii) Borrowings as External Assistance, referring to borrowing by a country with considerations of assistance. It involves lower rate of interest compared to that prevailing in open market

(iii) Foreign Investment (Investments to and from abroad): It includes:

• Investments by rest of the world in shares of Indian companies, real estate in India, etc. Such investments from abroad are recorded on the positive (credit) side as they bring in foreign exchange.
• Investments by Indian residents in shares of foreign companies, real estate abroad, etc. Such investments to abroad be recorded on the negative (debit) side as they lead to outflow of foreign exchange

‘Investments to and from abroad’ includes two types of investments:

-> Foreign Direct Investment (FDI)

It refers to purchase of an asset in rest of the world, such that it gives direct control to the purchaser over the asset.

For example, (i) acquisition of a firm in the domestic country by a foreign country’s firm (ii) transfer of funds from the parent company abroad to the subsidiary company in the domestic country.

-> Portfolio Investment

Portfolio Investment refers to the purchase of financial asset by the foreigners that does not give the purchaser control over the asset. A foreign Institutional Investment (FII) is also a part of portfolio investment.

For instance, purchase of shares of a foreign company, purchase of foreign government’s bonds, etc. are treated as portfolio investments.

(iii) Change in Foreign Exchange Reserves

• The foreign exchange reserves are the financial assets of the government held in
• Central bank. A change in reserves serves as the financing item in India’s BOP.
• So, any withdrawal from the reserves is recorded on the positive (credit) side and any addition to these reserves is recorded on the negative (debit) side.
• It must be noted that ‘change in reserves’ is recorded in the BOP account and not ‘reserves’.

Balance Of Payments and Its Types

1. Balance: It means difference between the sum of credits and sum of debits. The BOP account records three balances:

(a) Balance of trade

(b) Balance on current account

(c) Balance on capital account

2. Balance of trade: The term “balance of trade” denotes the difference between the exports and imports of goods in a country. Balance of trade refers to the visible items only. It is the difference between the value of merchandise (goods) exports and imports.

Balance of Trade = Export of visible goods – Import of visible goods.

3. Balance on current account: It is the difference between sum of credits and sum of debits on current account.

Balance on Current Account = Sum of credits on current account – Sum of debits on current account

4. Balance on capital account: It is the difference between sum of credits and sum of debits on capital account.

Balance on capital account = Sum of credits on capital account – Sum of debits On capital account

Autonomous and Accommodating Items, Deficit in Balance of Payment and Disequilibrium in Balance of Payment

1. Autonomous items

(a) Autonomous items refer to those international economic transactions in the current account and capital account which take place due to some economic motive such as profit maximisation.

(b) These transactions are independent of the state of BOP account.

(c) These items are also known as ‘above the line items’.

(d) For example, if a foreign company is making investments in India with the aim of earning profit, then such a transaction is independent of the country’s BOP situation.

2. Accommodating items

(a) Accommodating items refer to the transactions that are undertaken to cover deficit or surplus in autonomous transactions, i.e., such transactions are determined by net consequences of autonomous transactions.

(b) These items are also known as ‘below the line items’.

(c) For example, if there is a current account deficit in BOP, then this deficit is settled by capital inflow from abroad. The sources used to meet a deficit in BOP, are: (i) Foreign exchange reserves; (ii) Borrowings from IMF or foreign monetary authorities.

3. Deficit in BOP

(a) The balance of payments of a country is a systematic record of all economic transactions between the residents of foreign countries during a given period of time.

(b) The transaction in the balance of payment account can be categorized as autonomous transactions and accommodating transactions.

(c) Autonomous transactions are transactions done for some economic consideration such as profit.

(d) When the total inflows on account of autonomous transactions are less than total outflows on account of such transactions, there is a deficit in the balance of payments account.

(e) Suppose, the autonomous inflow of foreign exchange during the year is $500, while the total outflow is $600. It means that there is a deficit of $100.

4. Disequilibrium in Balance of Payments: There are a number of factors that cause disequilibrium in the balance of payments showing either a surplus or deficit. These causes are:

(a) Economic Factors

(i) Large scale development expenditure that may cause large imports.

(ii) Cyclical fluctuations in general business activity such as recession or depression.

(iii) High domestic prices may result in imports.

(b) Political Factors: Political factors instability may cause large capital outflows and hamper the inflows of foreign capital.

(c) Social Factors: Changes in tastes, preference and fashions of the people bring disequilibrium in BOP by inflowing imports and exports.

Words that Matter

1. Balance of payment: The balance of payments of a country is a systematic record of all economic transactions between its residents and residents of the foreign countries during a given period of time.
2. Current account: It records imports and exports of goods and services and unilateral transfers.
3. Capital account: Capital account is that account which records all such transactions between residents of a country and rest of the world which cause a change in the asset or liability status of the residents of a country or its government.
4. Foreign Direct Investment: It refers to purchase of an asset in rest of the world, such that it gives direct control to the purchaser over the asset.
5. Portfolio Investment: It refers to the purchase of financial asset by the foreigners that does not give the purchaser control over the asset.
6. Balance: It means difference between the sum of credits and sum of debits.
7. Balance of trade: The term “balance of trade” denotes the difference between the exports and imports of goods in a country. Balance of trade refers to the visible items only.
8. Balance on Current Account: It is the difference between sum of credits and sum of debits on current account.

Balance on Current Account = Sum of credits on current account – Sum of debits on current account

9. Balance on Capital Account: It is the difference between sum of credits and sum of debits on capital account.

Balance on capital account = Sum of credits on capital account – Sum of debits on capital account

10. Autonomous items: It refer to those international economic transactions in the current account and capital account which take place due to some economic motive such as profit maximisation.
11. Accommodating items: It refer to the transactions that are undertaken to cover deficit or surplus in autonomous transactions, i.e., such transactions are determined by net consequences of autonomous transactions.