Ncert XII Macro Economics

U N I T- I
INTRODUCTION
CHAPTER
INTRODUCTION
TO
Economic decisions of individual

households or firms are guided by their
rational behaviour in a given market
situation. Here, in our pursuit to study
the logic of consumption or production
decision, we limit our analysis to the
determinants of choice and preferences
of households or firms, respectively.
Though the study of individual decision
units is a necessary aspect of our
enquiry into the rationale of their
economic behaviour, it is by no means
a sufficient condition for a complete
study. So, there has to be another level
of study in which the enquiry is
directed to understand the general
economic conditions in the economy. It
is this distinction between the exercises
to understand and interpret the
behaviour of individual units on the one
hand and the general state of the
economy on the other establishes the
basic difference between the subject
matter of microeconomics and
macroeconomics.
Now, what is macroeconomics all
about? In simple terms it is the study
of the economy as a whole. Everyone is
interested in knowing what is
MACROECONOMICS
happening in the economy. Perhaps, it

is the concern about the rate of
inflation, level of unemployment, decline
in the agricultural and industrial
output, fluctuations in business
activities, accumulation of foreign
exchange reserves, capital market
changes, recession in the world
economy and so on.
These are macroeconomic events
that engage the attention of governments, economists, entrepreneurs and
even ordinary people, as all of them
receive the impact of these
macroeconomic events. To understand
the forces behind the overall economic
performance, we need concepts and
theoretical frameworks and empirical
measurements to assess performance
in the given reference year. The subject
of macroeconomics accomplishes
this objective.
Macroeconomic concepts are not
often simple and direct; on the contrary,
in microeconomics concepts such as
price, profit, cost, quantity, etc. are
intuitive and easy to understand. So,
there is nothing difficult in
comprehending a basket of apples as
INTRODUCTION
TO
MACROECONOMICS
an output and its price. But in

macroeconomics, we have a variety of
problems in the stage of definition itself.
While it is relatively easy to define and
measure individuals income, it is not
so in the case of aggregate income and
output. The scope of macroeconomics
could be further made clear if we
attempt to distinguish it from
microeconomics.
Microeconomics and
Macroeconomics
In microeconomics we study the
individual household, individual firm
or small groupings of firms. If we study
one automobile firm or the automobile
industry it is microeconomic approach;
but when we take up the entire
manufacturing sector, we are in the area
of macroeconomics. In this sense,
macroeconomics
studies
the
aggregates of an economic system. We
need to make a separate study of these
economic aggregates because what is
true at the individual level need not be
true at the aggregate level.
Just imagine a case wherein a
single farmer produces paddy or wheat.
In terms of individual rationality, this
farmer has to produce as much output
as possible to reach the maximum level
of profit. This is perfectly logical insofar
as an individual farm is concerned. But,
what if all the farmers produce
maximum output in their respective
farms? For the economy as a whole, this
would create more problems than
good. There may be excess supply of
paddy or wheat relative to demand.
Government will have to intervene, as it
happens in India, to take away a part

of the output to prevent prices falling
to an unremunerative level for the
farmers. Therefore, what is a good and
proper decision at the individual level
need not be so at the aggregate level. It
is to understand this difference that a
separate study of economic aggregates
is designed in macroeconomics.
Given all the aggregates such as
total employment, output, income, etc.
it is essential to find the
interrelationship between them. Does
an increase in national output mean an
increase in employment? Can the value
of foreign exchange rate be fixed in
terms of domestic countrys prices? We
will obtain meaningful explanations for
the working of the economy only if we
systematically work out the
interrelationships between the
aggregates. Hence, it is said that
macroeconomics is also the study of
relations between economic aggregates.
Basically, macroeconomics is concerned
with aggregate level of output, income
and spending for all goods and services.
In contrast, microeconomics deals
with output of individual firm and with
the spending by a single household.
Microeconomics is primarily concerned
with the allocation of resources by a
single firm or household.
Whatever microeconomics takes as
given is what macroeconomics considers
as the prime variable, whose size and
value are to be determined.
Alternatively, what microeconomics
takes as variable is considered to be
given in macroeconomics. For instance,
aggregate output of the economy is
taken as given in microeconomics but
INTRODUCTORY MACROECONOMICS
in macroeconomics aggregate output is

an important variable. Similarly,
macroeconomics takes the distribution
of output, for example, as given, but in
microeconomics it is an important
variable.
Consider our example of a farmer
given earlier. An individual farmer is
hardly conscious of the aggregate
output of paddy or wheat. He is
primarily concerned with his own
output in his farm. Similarly, when
government decides its policy of
procurement, it considers only the state
of the aggregate output of paddy or
wheat and not that of any individual
farmer. The same thing is true of a
single manufacturing firm as against
the aggregate manufacturing output.
Although microeconomics and
macroeconomics areas seem to be
rigidly distinct, it is not always so in
practice. Both areas of economic
analysis are interdependent. We seek to
explain economic behaviour of
individual units in the context of the
state of the economy.
That is, a microeconomic decision
by an individual unit has to necessarily
have a macroeconomic context. The
consumption plans of households for
instance cannot be independent of the
taxation of personal income and
commodities. Similarly, microeconomic
variables may exert their influence on
macroeconomic variables. For instance,
aggregate savings and investment are
usually influenced by or a function of
the pattern of savings at the micro level,
1
namely households and firms.

Therefore, micro and macroeconomic
analyses are not mutually exclusive
categories. Each of them attempts to
focus its attention on one aspect that
the other does not. While it is the price
system and resource allocation that
occupies the centre stage in
microeconomics, the twin areas of
income
deter mination
and
stabilisation and growth of the
economy
for m
the
core
of
macroeconomics. In such a context,
there is an inevitable interlink between
these two major branches of economics.
Which branch of economics
assumes primacy and receives
maximum attention of economists
depends on whether we need a study
of the part or the whole. Individual
rationality in economic behaviour is an
important area of study insofar as we
are concerned with demand and supply
forces in the market. On the other hand,
in the formulation of policies for
arresting fluctuations in the economys
performance and for attaining higher
growth, macro analysis assumes its
importance.
Emergence of Macroeconomics
Interest in macroeconomics deepened
after the emergence of the Keynesian
Revolution. 1 In the pre-Keynesian
economic theory there was no
recognition of economic crises. This is
because the Classical economics, which
was the ruling doctrine then, did not
provide an explanation for a major
John Maynard Keynes published the book General Theory of Employment, Interest and Money
(Macmillan: London, 1936) in which he questioned the basis of the then existing macroeconomics
of the Classical School.
INTRODUCTION
TO
MACROECONOMICS
setback to the economy. Classical

economists strongly believed in the
automatic adjustment of the markets
so that the system will always be in
equilibrium, and that the shocks (that
is, disturbances in markets) are only
temporary. This contention of the
Classical economists was challenged
when the Great Depression occurred in
1929. The system failed to automatically
correct the crisis situation and therefore
the failure of the Classical doctrine paved
the way for Keynesian theory. This is the

starting point of the present day
macroeconomic approach, which is
applied extensively in policy-making.
There are many variants of Keynesian
approach as the subject of
macroeconomics evolved since Keynes
contribution.
We may now embark upon learning
macroeconomics, concentrating on the
Keynesian approach to the structure
and working of the macro economy.
EXERCISES
1.
2.
3.
4.
What is microeconomics?
What do you understand by macroeconomics?
Distinguish between micro and macroeconomics.
Give examples of macroeconomic variables.
UNIT-II
NATIONAL INCOME AND RELATED
AGGREGATES : BASIC CONCEPTS
AND MEASUREMENT
CHAPTER
STRUCTURE OF THE MACRO ECONOMY :

CIRCULAR FLOW OF NATIONAL INCOME
Macroeconomics, as pointed out earlier,
deals with the study of aggregates
expressed in terms of aggregate income,
output, employment, expenditure,
exports and imports and so on. In order
to determine the actual performance
level of the economy, we need to follow
a framework of measurement
procedures to find these aggregates and
eventually we must interpret the
macroeconomic behaviour in terms of
movements in these aggregate
measures. National income accounting
facilitates the measurement of macro
aggregates for a given economy.
Accounting is believed to be a
necessary exercise for any economic
unit to know its performance. An
individual unit such as a Household or
a Firm maintains its own accounting
information since it is interested to
know its financial position at the end of
an accounting period. 1 Important
decisions concerning savings,
investment and tax payments are all

made by the unit after an analysis of
the accounting information available
to it.
At the macro level, accounting
assumes an even greater significance as
the information is used for a review of
the economys performance during the
year under study. On the basis of this
appraisal national governments have to
formulate their policy programmes to
maximize the welfare of people. This is
the basic purpose of national income
accounting as it renders possible a set
of procedures for measurement of
income and output at the aggregate
level. This means that we are, in fact,
measuring the macroeconomic activities
in the economy for a particular year.
Accounting for transactions by
individual units is relatively a less
complicated and a simple process as
compared to macro economic
accounting of aggregate output and
An accounting period or a financial year often does not coincide with a calendar year. Ordinarily,
a financial year refers to, for example, April 1, 2004 to March 31, 2005.
income for the economy as a whole. It is

a rather difficult and complex procedure
to quantify the macro variables for
accounting purpose. It is not adequate
to merely look at the macroeconomic
aggregates but it is also equally
important to learn the techniques of
measuring these aggregates. Therefore,
national income accounting has evolved
as a branch of study in its own right.
Primarily, there are two basic
functions of national income accounting:
the first, is to identify specific economic
achievements of a country and the
second, is to provide an objective basis
of evaluation and review of policies
under implementation. Hence, national
income accounts data not only help us
to measure macroeconomic aggregates
but also enable us to understand,
analyse and interpret the working of the
economy as well. This is precisely the
reason why the road map to the subject
of macroeconomics begin with a study
of national income accounting.
Uses of National Income Accounting
There are some principal uses of
national income accounting. They may
be stated as follows:
1. National income accounting shows
as to how the national income is
shared among the various factors
of production;
2. National income statistics indicate
the specific contributions of
individual sectors and their growth
over time;
2
3. National income accounting helps

to find out structural changes in the
economy.
4. National income accounting
provides the information for
assessment of the economys
strengths and failures.
5. National income statistics enable
comparisons to be made in respect
of standard of living, distribution of
income and actual composition of
national income over time.
6. National income accounts facilitates
comparison of output among
nations.
Hence, the national income data may
be viewed as a monetary manifestation
of material results of human activity in
the economy. They provide standards by
which economic achievement of policies
could be partly judged in modern times.
Structure of the Macro Economy
Circular flow2 of macroeconomic
activity
National income accounting calls for an
understanding of the structure of the
macro economy. The conceptual basis
of measurement of national income
begins with a depiction of the interrelated manner in which economic
activities are organised in an economy.
A pictorial illustration of this interdependence between the major sectors
of economic activity is called the circular
flow of income and product. This
Flow refers to change in an economic variable over time. Income and product are flow concepts.
This may be distinguished from stock variable which means that there is no change over time.
For example, wealth is a stock concept.
STRUCTURE
OF THE
MACRO ECONOMY
AND
NATIONAL INCOME ACCOUNTING
simply means that every economic

decision of a sector is in response to that
of another. Therefore, macro economy
is in effect a system of interrelationships
between the decision-makers in every
sector of the economy.
The circular flow of income involves
two basic principles:
(a) In any exchange process, the seller
or producer receives the same
amount that the buyer or consumer
spends; and
(b) Goods and services3 flow in one

direction and money payments to
acquire these, flow in the return
direction, thereby causing a circular
flow. So, the output or product or
real flow from the seller to the buyer
necessarily creates the income or
payment or money flow from the
buyer to the seller.
We shall now explain this two-way
process of mutual dependence for
different sectors of the economy. This
Clip 2.1
Circular Flow of Income and Product
The inspiration for the exposition of macro economy through a Circular
Flow of Income and Product appears to have originated from the writings
of Physiocrats a group of French economists who lived in 18th century.
Physiocrats strongly believed in the existence of a natural order to guide
the working of the economy and hence according to them, there should not
be any kind of intervention by the Government in economic activities. They
advocated the policy of Laissez faire which means non-interference or
minimal interference of the governments in trade and other economic
activities and accorded primacy to agriculture as such. Prominent among
the Physiocrats was Francois Quesnay who propounded what is called the
Tableau Economique in 1758. This economic table contains the concept
of circulation of wealth and a schematic presentation of the distribution of
agricultural output between all classes of society. Though this economic
table was recognised as the crowning achievement of Physiocrats, this
table was not explained by Adam Smith or those belonging to the classical
school of economics. It was Karl Marx who rediscovered this table in the
mid-19th century.
A good is a tangible object (such as a can of fruit juice or a television) that has economic
value. A service, on the contrary, is an intangible product (such as advertising) that has
economic value.
10
would be a helpful pre-requisite to

understand the concepts used in the
accounting of national income as such.
Circular Flow in a Simple Two-sector
Model
To begin with, let us make the following
assumptions with regard to a simple
economy with only two sectors of
economic activity.
There are only two sectors in the
economy, namely, Households and
Firms.
Households supply factor services
to Firms.
Firms hire factor services from
households.
Households spend their entire

income on consumption.
Firms sell all that is produced to the

Households.
There is no intervention of
government or foreign trade.
Such an economy as described above

has two types of markets. First, market
for goods and services Product
market; and second, market for factors
of production Factor market.
The economic interdependence
between Households and Firms in this
simple economy can be observed as
follows:
(i) Household sector has the

endowment of factors of production
(land, labour, capital and
entrepreneurial ability) and sell
them to the Firms that produce
goods and services, using these
factor inputs. The Firms, in turn, sell
4
goods and services thus produced
to the Household sector for its
consumption. Therefore, whatever
the Firms produce, is consumed by
the Households.
This type of interaction
between Firms and Households
can be described as the real flows,
as it involves flow of goods and
services.
(ii) Exchange of goods and services
between Households and Firms in
response to acquiring factor services
from Households corresponds to
flows of income and expenditure of
these two sectors. That is, Firms pay
the Households in the nature of
wages for labour services, interest
for capital, rent for land and profits
to entrepreneurship. These are
called factor payments by Firms
and factor incomes by Households.
This income, in turn, is used by
Households to incur expenditure on
buying consumer goods and
services produced by firms.
Firms may produce either producer goods (capital goods used for making other goods) or consumer
goods that is, goods meant for only consumption as such. Consumer goods can further be
classified into durable and non-durable variety depending upon whether they have short or
long span of life in their use to the consumers. A washing machine or an air-conditioner may be
called durable good while food items will fall under the category of non-durable or perishable
good, as they do not last long.
STRUCTURE
OF THE
MACRO ECONOMY
AND
This flow of money payments

and expenditure can be described as
money flows.
So, in the circular flow diagram
(Fig. 2.1), we can recognise two real
flows and two money flows.
As a result we can derive the following,
in the case of our simple economy:
1. Total production of goods and
services by firms = Total
consumption of goods and services
by Household Sector
11
2. Factor Payments by Firms =

Factor Incomes of Household
Sector
3. Consumption expenditure of
Household sector = Income of Firm
sector
4. Hence, Real flows of production and
consumption of Firms and
Households = Money flows of
income and expenditure of Firms
and Households
enditure on fin
= Exp
al g
t
u
ood
tp
u
a
n
d
s
sa
servic
good
fo
l
a
e
o
nd
s
in
F
e
u
se
l
a
Mo
es
ne
ic
rv
PRODUCT MARKET
Firms
or
sh
i
ct
Fa
Households
Se
rvi
ce s
r
eu
n
e
r
r ep
t
n
s
To
e
fit
ta l
labour, capita l,
o
r
p
i nc
ome
est+
= rent +wages+ i nte r
: lan
d,
FACTOR MARKET
Fig 2.1: The Circular Flow of Income in a Two-sector Economy
12
This simple circular flow highlights

the following interrelationships between:
Factor Market and Product Market
Output flow and Income flow
Business
production
and
Consumer spending
Each sector is seen in its dual role:
that of the buyer and seller. This
perpetuates the circular flow between
the two sectors.
Circular Flow of Income with
Financial System
A wide variety of financial institutions
and markets constitute the financial
system 5 in our economy. Financial
institutions are primarily intermediaries
between savers and investors, or lenders
and borrowers. They are specialise in
their respective areas of financial
function. Development economists point
out the significance of financial
development of an economy as a
concomitant outcome of economic
development. Therefore, understanding
the macroeconomic activity will be
incomplete without the inclusion
of financial system in our circular
flow model.
So far, in our presentation of circular
flow of income, we have not considered
the role of saving and investment. This
is mainly due to the reason that we
have assumed that the two sectors
Households and Firms are balanced
spenders (that is, they neither have a
surplus nor deficit). Once we relax this
assumption a financial system to which
5
Households and Firms can lend and

from which they can borrow would
become relevant.
Households are the net lenders.
This is possible due to generation of
personal savings, which is the difference
between household income and
consumption. Firms are net borrowers
since they have to finance new
investment in plant and equipment. All
lendings and borrowings are
channelled through the financial
system. So long as lending is equal to
the borrowing, that is, leakage is equal
to the injection, the circular flow will
continue indefinitely (Fig.2.2).
Financial institutions pay interest to
the savers as their funds are placed with
them for a period of time under a
contract. Firms pay dividend and
interest for the sums they have borrowed
from the financial markets in the form of
shares, bonds and public deposits.
Financial institutions, through their role
of intermediation, enable funds transfer
from ultimate lenders to ultimate
borrowers. Saving and investment
process create better prospects for capital
formation, thanks to the operations of
financial institutions and markets.
Financial system is therefore very
important to the working of the modern
economy. But it is sometimes believed
that money and finances are only a
cover over the production of goods and
services. But we cannot dismiss the
Here we assume that Households and Firms save part of their income, which constitutes a leakage
from the circular flow of income. The saved amount is made available in the financial system. Firms
borrow for purposes of investment, which becomes injection into the circular flow.
STRUCTURE
OF THE
MACRO ECONOMY
AND
13
PRODUCT MARKET
of final goods and s
ervi
value
y
e
ces
n
o
ds
o
o
a
g
n
r
d
e
M
s
m
e
u
r
vice
ons
s
al c
n
i
F
Savings
Savings
Financial
System
Firms
Households
Borrowings
Borrowings
Factor Se rvi ces

Factor Paymen ts
FACTOR MARKET
Fig 2.2: Circular Flow of Income in a Two-sector economy with Financial System
funds flow between sectors as

unimportant. Finance as some
economists have held, is only a
lubricant that makes the economy to
work smoothly.
Government6
Whatever has been presented in the
foregoing section leads us to the
conclusion that under the two-sector
model, the value of total output flow in
our simple economy is equal to the total
value of factor incomes and the value
of personal consumption flow. Let us
now expand the two-sector model and
obtain a three-sector model with the
6
inclusion of the Government sector.

Economic interrelationships between
Households and the Government on the
one hand and Firms and Government
on the other are very important from
the point of view of the role of
Government as regulator and as an
agent of promoting general welfare of
the people of the country.
All the changes which are
necessitated by inclusion of Government
sector are shown in Fig. 2.3. In order to
make the analysis simple, now onwards
we will see only monetary flows.
Government purchases goods and
services from Firms and labour services
from Households. Government collects
Government purchases of goods and services are included in the circular flow. Other flows include
tax payments by households to government and transfer payments by governments to households.
Savings
ngs
Borr
owi
T
Su a
bs
m
er
n
s
ice
rv
me
nt
se
Borrowings
Financial
System
Pay
ym
Firms
nt
s
T ra
f
ns
T
fer
ax
Pa
es ents
Savings
Pa
ym
r
cto
a
F
gs
vin
s
s
xe die
i
Sa
G ov
nt
Government
Sector
s
ase
h
c
r
Pu
or
14
Households
Borrowings
Co
e
nsu
ur
mpt i on Expend it
Fig 2.3: The Circular Flow of Income in a Three-sector Economy
taxes from Households and Firms in

order to finance its expenditure. The
government makes transfer payments
to the Households in the form of social
security, scholarships, etc. It also gives
subsidies to the Firms for various
purposes. In India, subsidies are given
to small industries, export units, and
other priority sectors of our economy.7
External Sector
We now need to study the international
dimension of macroeconomic activity
because international economic
environment affects output and
employment in the domestic economy.
The external sector is also called the
Rest of the World (ROW) sector and this
7
8
is connected with circular flow of

domestic economy (Fig. 2.4). The
domestic economy and the rest of the
world are connected through
international trade and capital flows.
One countrys exports are another
countrys imports. This import and
export of goods and services ultimately
decide what the domestic economy
gains or loses in the international trade.
Home economy enjoys a trade surplus
when there is excess of exports over
imports; it suffers a trade deficit when
the opposite happens.8
The four -sector model of the
economy demonstrates the overall
macro economic condition of income
and output in the following identity:
All taxes are leakages and all government expenditures are injections into the circular flow.
Note that imports are leakages and exports are injections into the circular flow of income in the economy.
p
ei
External
Sector
i tu
re
al e
on o m
i
t
sf
r na Inc
an
r
I nte
l T t)
na (Ne
o
i
t
r na
I nte
pt i on Expend
In
co
me
ce
vi
Su
er
Financial Savings
System Borrowings Households
nsu
m
en
fo
rE
ts
xp
for
ert
Im
s
por
ts
me
nt
s nts
xe m e
y
c
Re
ym
Pa
ts
Co
fo
Tra
rS
ns
fer Ta
Pa
Pay
Borrowings
s
ing
r
cto
Fa
Savings
Firms
Pay
me
nt
s
Government
Sector
t
en
m
es s
ax idie
s
15
er
Sav
Go
ve
rn
se
cha
r
Pu
AND
Fa
ct
or
MACRO ECONOMY
ngs
OF THE
Borr
owi
STRUCTURE
Fig 2.4 : The Circular Flow of Income in a Four-sector Economy
Y C + I + G + (X M)
Producing sectors
Wherein
G = Government Purchases
Y = Income or output
C = Private Consumption Expenditure
on Consumer goods
I= Investment expenditure by
X M = Net exports (Where, X = Exports,

M = Imports)
The science of national income
accounting is based on this identity.
SUMMARY
l
l
l
l
l
Structure of the macro economy is given by the circular flow of income and
output.
National income accounting has its foundation in the circular flow model.
National income accounting has several uses for economic policy and
research.
Circular flow of income can be depicted in two-sector, three-sector and
four-sector models.
National income accounting provides the standards by which economic
activity of a country could be assessed.
16
EXERCISES
1.
2.
3.
4.
5.
6.
7.
What are the uses of national income accounting?

What is the principle of circular flow of income and product?
Explain the circular flow in two-sector economy.
Explain the circular flow in three-sector economy.
Explain the circular flow in four-sector economy.
With the help of a circular flow model, show that income and product
flows are equal.
Explain the concepts of leakages and injections in the circular
flow of income.
CHAPTER
NATIONAL INCOME ACCOUNTING:

CONCEPTS AND MEASUREMENT
The structure of the macro economy has
been portrayed in the circular flow of
output and income as dealt with in the
previous chapter. This circular flow
depiction of macroeconomic activities
provides logical foundation for the
concepts and measurement of national
income aggregates. A strikingly unique
feature of national income concepts is
that they are quantifiable and are not
abstract ones. Hence, they render as
much precision as feasible in the
national income statistics, given the
limitations in the estimation of national
income aggregates and in the
construction of national income
accounts. There have been many
attempts in the past to evolve methods
of national income accounting and these
efforts have contributed to the system
that we have at present. In this chapter,
we shall present principal methods to
measure national income aggregates. It
is pertinent at this juncture to remind
ourselves of an important observation
made in respect of the circular flow of
macroeconomic activities. We have, in
that context, stated that the value of
aggregate output equals the value of

aggregate income, which in turn must
equal to the aggregate expenditure.
Based on this, national income
measurement can be categorised into
three approaches : output or product
approach, income approach and
expenditure approach. All these must,
in principle, yield the same result.
Measuring Gross Domestic Product
Let us first take up the measurement
of the value of all that is produced in
the economy. This is expressed as Gross
Domestic Product. Here, the
measurement procedure is actually
three-fold. We use the product method,
the income method and the expenditure
method to compute the Gross Domestic
Product. As this aggregate is held to be
very important for macroeconomic
assessment, greater attention is called
for in the computation of this measure.
Gross Domestic Product : The Output
Approach
Gross Domestic Product (GDP) is a
summary statistic, which is widely used
by economists and policy analysts to
18
assess the rate of growth of an economy

during a year. GDP is generally
recognised to be the primary measure.
GDP is defined as the market value
of all final goods and services produced
by the factors of production located in
the country during a period of one year.
A key phrase in this definition is final
goods and services which require some
elaboration.
Final goods are those that are meant
for final use by consumers or firms. These
goods are not required to enter into
further stages of production or resale to
change their form and content. They are
finished goods meant only for final
consumption and investment.
Measurement of GDP includes only
the aggregate value of final goods. Also,
from a development perspective, the
strength of an economy is seen in its
capability of producing final goods and
services.
It may be useful at this stage to draw
a distinction between final goods and
intermediate goods. The latter are not
taken into account in the measurement

of GDP.
Inter mediate goods are those
goods that are used to produce other
goods and therefore they always move
from one stage of production to another
in the manufacture of a final product.
Let us now show the difference
between final and intermediate goods with
the example of producing an automobile.
The industrial process to
manufacture an automobile involves
materials such as steel, paint, rubber,
foam, plastic, glass, cables, battery, etc.
and a variety of component parts. All
these items are produced by the
respective firms only to be used in the
production of another product; in our
example it is the automobile. But once
the process of producing an automobile
starts, all these are converted into
integral parts of an automobile. So,
these goods are not important in their
own right; they are just a means to an
end. Such goods are called intermediate
goods. The automobile that is produced
Clip 3.1
PIONEERS IN NATIONAL INCOME ANALYSIS
In the contemporary world now, national income concepts and accounting methods
are widely recognised and applied to measure the economic performance of countries.
However, these concepts and methods became popular only a few decades ago.
Simon Kuznets
A seminal contribution to the field of National Income and

Product Accounts (NIPA) made by Simon Kuznets (19011985)
set the trend of using national income aggregates to measure
the direction of growth of economies. He was a great pioneer in
this field and due to his research efforts, the first national
income figures for the US economy was published in 1934 as
an official document of the US Senate. This helped immensely
to understand the severe impact of the Great Depression in
1929. His monumental book of two exhaustive volumes, National
Income and its Composition, 1919-1938 (New York; NBER, 1941)
NATIONAL INCOME ACCOUNTING : CONCEPTS
AND
MEASUREMENT
19
earned him the worldwide recognition. This was followed by two of his landmark
contributions, namely, National Product since 1869 (New York; NBER, 1947) and
Economic Growth of Nations : Total Output and Production Structure (Cambridge Mt,
Harvard University Press, 1971). For his contributions, Kuznets was honoured
with the Nobel Prize in 1971 in recognition of his empirical interpretation of
economic growth.
Richard Stone
V.K.R.V. Rao
Another important contribution in this field is that of

Richard Stone (1913-1991). Stone worked with John
Maynard Keynes as a research assistant. Stone during the
early 1940s prepared a statistical profile of the British
economy. After the World War II, Stone headed a United
Nations project to develop standard national income
accounting model.
In India, prior to 1947, the estimation of national income
was attempted by individual economists and scholars for
specific years.
P.C. Mahalanobis
D.R. Gadgil
Among these, the most systematic work was that of V.K.R.V. Rao in his book
National Income in British India 1931-32 (London; MacMillan 1940), which formed
the basis of national income estimation in the post-independence period. In
1949, the Government of India formed the National Income Committee under
the Chairmanship of P.C. Mahalanobis, with V.K.R.V. Rao and D.R. Gadgil as
members. From then onwards the national income estimation has been steadily
strengthened. Now, the Central Statistical Organization (CSO) is entrusted with
the task of publishing National Accounts Statistics (NAS).
in the final stage of the assembly line is

the final good.
Hence, the rationale for not taking
into account the value of intermediate
goods in the measure of GDP is to avoid
the problem of double counting. That
is, no product should be counted two

or more times. Double counting will
only exaggerate or over-estimate the
value of GDP.
The procedure by which we eliminate
the values of intermediate goods from GDP
20
is through the method of value added.

This is discussed in the following section.
Concept and Measurement of Value
Added
The concept of value added is very basic
to the measure of GDP. Value-added is
defined as the difference between total
value of output of a firm and value of
inputs bought from other firms. It thus
measures the value, which the firm
concerned has added by its process
of production.
Most goods go through multiple
stages of production. This means that
a goods value increases at each stage

until its final value is obtained in the
last stage. It follows therefore that the
value of final good will have to be equal
to the sum of the value-added at each
stage of production. This is shown with
a numerical illustration in Table 3.1.
Consider the production and sale
of a cake to the Household sector for
final consumption. The process of
production starts with a farmer raising
wheat crop and harvesting it. Since we
are starting with the stage of wheat
cultivation, let us not go into the
backward production linkages of the
Table 3.1 : Numerical Illustration of GNP Measurement

using Value Added Method
Stage I
Stage II
Stage III
Stage IV
(Wheat)
(Flour)
(Cake at Bakery)
(Cake at Retailer)
Farmer
Baker Browns
Retailer Greens
Blacks Purchases Miller Whites
from other firms
None
Rs. 2.00
Value Added Rs. 1.00 Purchases Rs. 1.00 Purchases Rs. 1.50 Purchases
from Farmer
from Miller
from Baker
Rs. 0.50
Value
Added
Value
Added
Rs. 0.50
Value
Added
Rs. 0.50
Value of Final
good = Rs.2.50
Break-up of
value added
= 0.20
Profit
= 0.60
Wages
= 0.05
Rent
= 0.05
Interest
Depreciation = 0.02
Property and = 0.08
sales taxes
+
+
+
+
+
+
Total (in Rs.) 1.00
+ 0.50
0.25
0.10
None
0.10
0.02
0.03
+
+
+
+
+
0.40
0.70
None
0.01
0.09
0.10
+ 0.50
+ 0.28
+ 0.05
+ None
+ 0.02
+ 0.07
+ 0.08
+ 0.50
= 0.33
= 1.45
= 0.05
= 0.18
= 0.20
= 0.29
Sum of value
added
2.50
AND
farmer. Therefore, the farmers valueadded in the cultivation stage will be

just the value of his output as such (that
is one rupee). In the second stage, the
miller buys the wheat from the farmer
and grinds it into flour, and sells it to
the baker for Rs.1.50. By this, he adds
a value of 50 Paise. The baker makes
the cake and sells it to the retailer for
Rs. 2.00, thereby adding a value of 50
paise. The retailer who buys the cake
from the baker sells it to the final
consumer for Rs. 2.50, thereby adding
a value of 50 paise. This means that the
value of the final good, namely, the cake
is Rs. 2.50 at the retail store. This final
value of the cake is the sum of the value
added from the stage of cultivation to
that of retail sale at the shop, that is,
total value added equals Rs.1.00 + 50
Paise + 50 Paise + 50 Paise = Rs. 2.50.
On the other hand, if we had
included the value of all the
intermediate stages, preceding the retail
sale, cakes value would have increased
manifold, due to the problem of double
- counting. That is, wheat would have
been counted four times, floor three
times and baked items twice. This is the
reason why we take the final value of
the output as a sum of all values added
in producing a good.
This procedure of value added
method demonstrated for an individual
product is applied at the aggregate level
for the measurement of GDP.
Concepts of Value Added
(i) Value of output by a Firm = Sales +
Change in Stock
(ii) Value Added = Value of output
Intermediate goods cost
MEASUREMENT
21
(iii) Net-value added at Market Price =

Gross value added at Market price
Consumption of fixed capital
(Depreciation)
(iv) Net-value added at Factor Cost =
Net value added at Market Prices
Net indirect taxes (Net Indirect Taxes
= Indirect Taxes subsidies)
(v) Net value added at factor cost = Total
Factor Income
Now, let us look into the
computation of value added as shown
in the illustration below:
Example 1: From the following data
calculate the value added by Firm A and
Firm B.
(Rs. in Lakhs)
(i) Closing stock of Firm A
20
(ii) Closing stock of Firm B
15
(iii) Opening stock of Firm A
5
(iv) Opening stock of Firm B
10
(v) Sales by Firm A
300
(vi) Purchases by Firm A from
100
Firm B
(vii) Purchases by Firm B from
80
Firm A
(viii) Sales by Firm B
250
(ix) Import of raw material
50
by Firm A
(x) Exports by Firm B
30
As first step calculate the value of
output for each Firm. Then find the
value added.
Step 1. Value of output of Firm A
= Sales + Change in stock
(Closing stock Opening stock)
= 300 + (20 5)
= Rs. 315 lakhs
Step 2. Value added by Firm A
= Value of output purchases
22
from Firm B imports by

Firm A
= 315 100 50
= Rs. 165 lakhs
Repeat the same procedure for Firm B
Step 3. Value of output of Firm B
= Sales + Change in stock
(Closing stock Opening stock)
+ Exports by Firm B
= 250 + (15 10) + 30
= Rs. 285 lakhs
Step 4. Value added by Firm B
= Value of output purchases
from Firm A
= 285 80
= Rs. 205 lakhs
Gross Domestic Product : As Sum of
Expenditure
GDP can be measured by taking into
account all final expenditures in the
economy. There are three distinct types
of expenditure as they are committed
by Households, Firms and Government
respectively. These expenditures are
classified into following types :
(i) Private Consumption
Expenditure
(ii) Investment Expenditure
(C)
(I)
(iii) Government Purchases of

(G)
Goods and Services
(iv) Net Exports
(X M)
Let us discuss these items of final
expenditures with respect to the sectors
concerned.
(i) Private Consumption expenditure
The private consumption component of
GDP measures the money value of
goods and services that are purchased

by households and non-profit
institutions for current use during a
time period. Considering the fact that
consumption expenditure is a
significant part of GDP, it requires
special attention by economists and
government. Private consumption is the
demand for consumer goods and
services. While goods are tangibles,
(that is, you can see a car) the services
are intangibles (that is, you cannot see
a service such as car insurance).
Further in the case of goods,
consumption or use of a good can be
separated from the place of its
production and can be separated in
time, that you can consume or use a
good at your convenient place or time.
But services should necessarily be used
at the time and place in which they are
produced. For instance, banking service
will take place at the place and time
specified by the banker and customers
utilise their banking facilities accordingly.
Consumption can be divided into
three sub-categories such as,
consumer services, consumer nondurable goods and consumer durable
goods. Non-durable goods are used up
immediately or within a short span of
time. Durable goods in contrast could
be used for a longer period of time.
Food items are non-durable
consumption goods whereas furniture,
stereo equipment, washing machines
are durable consumption goods. But
usually this distinction is based only
on the given length of time within which
consumer goods are used. Durability
does not imply a state of permanence.
AND
Durable goods also have their limited

period of use value, after which they are
given up. Private final consumption will
include expenditure on all these three
categories mentioned here.
(ii)
Investment
Investment is an addition to the stock of

capital during a period. The Gross
Private Domestic Investment shows the
aggregate value in this regard. Unlike
the intermediate goods which are used
up entirely in the process of making
other goods, capital is only partially
depleted in making other goods. That
is, a steel mill may have a useful life of
say, 50 years. In providing steel in any
one year, only a small portion (1/50th)
of the mill is used. This using up of
capital is called depreciation.
Depreciation is the value of the existing
capital stock that has been consumed
or used up in the process of producing
output. Usually an asset is depreciated
at a predetermined rate and monetary
value is assigned to the rate of
depreciation of a physical asset in
one year. This is also described as
capital consumption allowance1. When
investment is expressed as Gross
Investment or Net Investment it means
whether investment has or has not been
adjusted against depreciation. Gross
term includes depreciation while Net
term is obtained after deducting the
depreciation amount.
Investment component could be
classified under four categories : they are
(a) Business fixed investment
1
MEASUREMENT
23
(b) Inventory investment

(c) Residential construction investment
(d) Public investment
(a) Business Fixed Investment (BFI) is
the amount spent by business units on
purchase of newly produced plant and
equipment. The two measures of BFI are
Gross Business Fixed Investment (GBFI)
and Net Business Fixed Investment
(NBFI). Gross Business Fixed investment
is the gross amount spent on newly
provided plant and equipment, that is,
capital goods. If depreciation is
deducted from it, then we obtain Net
Business Fixed Investment.
The inclusion of capital goods in the
final product along with the goods and
services produced by them would
involve double counting. For this reason
it is important to make provision for
depreciation. If in every year we deduct
from investment (and therefore from
domestic product) the amount by which
capital stock has been used up over the
year, then over the whole lifespan of the
capital good, we will have deducted
from the domestic product the whole
value of the capital good. In this way
we will have avoided counting in the
domestic product both the asset and
the goods produced by it and so shall
have avoided double counting. BFI is
usually the result of a conscious
decision by firms to augment their
productive capacity.
(b) Inventory Investment is the net
change in inventories of final goods
The usage of fixed assets lead to their wear and tear; so, we must provide for consumption of
fixed capital as a prerequisite in accounting the product.
24
awaiting sale, semi-finished goods, or

of materials used in the production
process (inputs). These must be
included since they represent currently
produced output not included in the
current sales of final output.
Changes in inventory are usually
the result of unintentional short run
deviations between supply and
demand. Stock changes play a crucial
role in income determination. For
example, if there is a sudden doubling
of the demand for television sets, it is
unlikely that the production of them will
also double overnight. So, the first effect
of the increase in demand relative to
supply will be a fall in the inventory of
television sets normally held in the
economy (inventory that is held by the
producer, wholesaler or retailer), in the
attempt to satisfy the sudden increase
in demand. This process will continue
until production is augmented to
match the increased demand.
Conversely, a sudden fall in demand will
lead to a rise in inventories of television
sets until production adjusts itself to
the lower level of demand.
(c) Residential Construction Investment
is the account spent on the building of
housing units. This is also expressed
in terms of either gross or net depending
on whether depreciation has been
subtracted or not.
(d) Public Investment includes all
capital formation carried out by the
government such as building of roads,
hospitals, schools etc. This is also given
in gross or net value depending on
whether depreciation has been
subtracted or not.
Now the investment component as

a whole can be thought of in the
following two ways :
Gross Investment = Gross Business
Fixed Investment + Gross Residential
Construction Investment + Gross Public
Investment + Inventory Investment
Net Investment = Net Business Fixed
Investment + Net Residential
Construction Investment + Net Public
Investment + Inventory Investment
As pointed out earlier, the difference
between gross investment and net
investment is depreciation.
(iii) Gover nment Purchases of
Goods and Services
This component summarises the
government spending on goods and
services. Remember that government
purchases is a proxy measure for
government output.
As a matter of fact, government
purchases from private producers
would be intermediate goods and
government wages and salaries would
be part of the income side of the
national accounts. Instead of doing this
we take the government purchases as
part of the final product.
In the above we have understood
government as a producer of goods and
services. This is an important function
of the government. At the same time we
should also be aware of another function
of government that is, making
payments to certain categories of people
or firms to compensate them as a matter
of its social obligation. This is called
Government Transfers, which refer to the
AND
total value of payments made by

government sector towards households
and firms as income supplements and
subsidies respectively. This is also known
as Transfer Payments, and they are not
counted in the GDP because there is no
production of goods due to them.
Transfer Payments are basically welfareoriented expenditures of the
Government.
(iv) Net Exports
This is the difference between Exports (X)
and Imports (M) of a country, that is
(X M).
Based on the expenditure flows
in the economy, Gross Domestic
Product is the total value of the sum
of consumption and investment
expenditure along with government
purchases and net exports.
In other words
GDP = C + I + G + (X M)
Where,
C
= Consumption expenditure by
households
I
= Investment expenditure by firms
= Government purchases of goods

and services.
X-M = Net Exports.

Gross Domestic Product : A Measure
of Income
The third approach to the measurement
of GDP is to compute it by addition of all
factor incomes generated in the
production of goods and services.
Because each rupee of goods and
services produced is matched by a rupee
of income, we can arrive at the same
figure for GDP on the income side as we
MEASUREMENT
25
did on the product side. While measuring

GDP we must include only those income
flows that originate with the production
of the goods and services within the
particular time period.
The components of factor income are:
1. Employee compensation
2. Profits
3. Rent
4. Interest
5. Mixed income
Now let us look into the details of
each one of these.
1. Employee Compensation
Compensation to employees in the form
of wages, salaries and benefits makes
up the largest single component of
income generated with production of
GDP. Wages and salaries are payable
in cash, kind or both.
2. Profits
Profits are the reward the owners of
firms receive for being in business.
Firms desire to earn profits is the main
motivating force behind production in
a market economy.
3. Rent
Rental income is, for example, income
earned by owners of rental housing. The
meaning of rent in the national income
accounts is that it is a charge for the
temporary use of some capital asset.
4. Interest
Households both receive and pay
interest. We include in GDP only the net
interest, that is the difference between
interest amount paid and the interest
income received by households.
26
5. Mixed Income
Mixed income will include the income of
own account workers and profits and
dividends of unincorporated enterprises.
In other words, it may be called as mixed
income of the self employed.
All the above mentioned components
of income measure of the GDP have an
important implication for the economy
as such. Their relative share in GDP
shows the manner in which each of
these income flows changes overtime.
It is possible to show by way of an
illustration as to how the sum of value
added is equal to the total of the above
types of income earned during the
process of production. This is shown
in Table 3.1
GDP as measured by the
aggregation of factor incomes is also
called as Gross Domestic Income (GDI).
Gross National Product
After getting GDP we can add Net Factor
Income from abroad to estimate the
value of Gross National Product (GNP).
How is Net Factor Income from Abroad
defined? What are included in it?
Net Factor Income from Abroad is
the difference between the factor income
received from the rest of the world, i.e.
abroad for rendering factor services, and
the income paid for factor services
rendered by non-residents inside the
domestic territory of the country. As we
know that factor incomes include
compensation to employees and income
from property and entrepreneurship,
then Net Factor Income from abroad is
the difference with respect to these items
received by residents abroad and given
to non-residents working in the

domestic territory during a given
accounting year. Hence, the components
of Net Factor Income from abroad are :
(i) Net compensation to employees
(ii) Net income from property and
entrepreneurship, which includes
rent, interest, dividends, etc.
(iii) Net retained earnings of resident
companies abroad
Hence,
Gross Domestic Product + Net Factor
Income from abroad = Gross National
Product
Now we may distinguish between
Gross National Product and Gross
Domestic Product. The difference
between the two arises from Net Factor
Income from Abroad. Note that the
(X M) component of GDP represents
only goods and services other than
factor incomes.
Real and Nominal GNP
Having presented the measurement of
GNP it remains to be seen as how the
changes in the GNP value are expressed
in relation to price level changes as price
changes affect the value of the national
income aggregates. For this we must
explain the two ways of computing
national income data at current market
prices and constant prices.
Current Market Prices
If the GNP (or any other related
aggregates) is measured in terms of
current market prices, then it is referred
to as Nominal GNP. Since the nominal
GNP measures the value of currently
produced goods and services at market
AND
prices, GNP will change when either the

overall price level changes or when the
actual volume of production changes
or when both change simultaneously.
Constant Prices
However, for certain purposes we may
want to have a measure of output that
changes only when the quantity of goods
produced changes. This measure of only
quantity change, not prices, is the method
of using constant prices. Accordingly,
GNP that is computed at constant prices
will be called the Real GNP. Usually,
under this method GNP value is
expressed in terms of prices prevailing in
a year chosen to be the base year.
Real GNP has the following
advantages:
(a) It is useful in finding out the effect of
increased production of goods and
services on the real development
capacity of the economy in general.
But the nominal GNP cannot show
this as we cannot segregate the
change in output alone, since, the
current market prices in terms of
which it is measured prevent such
an exercise;
(b) Real GNP also enables one to make
a year-to-year comparison of the
changes in the growth of output of
goods and services. An expansion
phase of the economy is a period of
rising real GNP. On the contrary a
recession is a period in which real
GNP falls consecutively; and
MEASUREMENT
27
(c) Real GNP is also often used in

making international comparisons
of economic performance across the
countries.
Having explained the concepts of
Nominal and Real GNP, let us proceed
to know the method by which we obtain
the value of Real GNP through the
constant prices.
The purpose of using constant
prices is to eliminate the effect of price
changes. For this, we are supposed to
express the value of current years GNP
(Nominal GNP) in terms of prices
prevailing during a reference year in the
past, which is called the Base year. That
is, the account for the value of current
years GNP as if the price level is same
as that of the base year. As you may be
aware that the price level is usually
measured by the Wholesale Price Index
or the Consumer Price Index Number.2
If the GNP in the current year is
valued at current market prices, it will
not be possible for us to find out how
much of the increase in GNP is due to
increase in prices (inflation) and how
much of the increase is due to an
increase in the production of goods and
services. To know whether GNP
increase actually means an increase in
the output of goods and services, we
must eliminate the effect of price
increases.
We shall explain, through the
following illustration, the calculation of
An index number is a representative number to decode the changes in price level. The consumer
price index number is used to represent the average change over time in the prices paid by the
final consumer of a specified group of goods or services.
28
nominal GNP and real GNP as well as

GNP deflator (Table 3.2).
Let us assume that our imaginary
economy has only three final goods :
Oranges - Consumption good
Computers - Capital good
and Government purchases of cloth.
Let us take up the calculation

of nominal GNP through the
expenditure approach. Let us therefore
find out the expenditure on each good
and obtain the total expenditure at
current prices.
Consumption expenditure (oranges)
is Rs. 4452, investment (computers) is
Table 3.2: Nominal GNP, Real GNP and the GNP Deflator
Current Period
Item
Quantity
Price
(Rs)
Oranges
4,240 Kgs. 1.05 per kg.
Computers
5
2100 each
Government
1,060
1 per
Purchases
meters
meter
of Cloth
Base Period
Expenditure
(Rs)
Price
(Rs)
Expenditure
(Rs)
4,452
10,500
1,060
1 per Kg
2000 each
1 per meter
4,240
10,000
1,060
Nominal GNP 16,012
Real GNP
15,300
Deflators for the current period

GNP Deflator =
Nominal GNP 100 Rs.16012

=
100 = 104.7
Real GNP
Rs.15300
Consumption Expenditure Deflator
Investment Deflator =
Government Purchases =
Current period consumption

expenditure
Base period consumption
expenditure
100 =
Rs. 4452
100 = 105.0
Rs.4240
Current period investment

Rs. 10500
100 =
100 = 105.0
Base period investment
Rs.10000
Current period Government
purchases
Base period Government
purchases
100 =
Rs. 1060
100 = 100.0
Rs.1060
AND
Rs. 10,500, and government expenditure

is Rs. 1,060, so the nominal GNP is Rs.
16012.
Now, let us calculate real GNP. This
is, as mentioned before, calculated by
valuing the current period quantities at
the base period prices. Accordingly, the
consumption expenditure is Rs. 4240,
investment is Rs.10,000 and government
expenditure is Rs.1,060. So the real
GNP is Rs.15,300.
Finally, the concept of GNP deflator
requires explanation. The GNP deflator
MEASUREMENT
29
measures the average level of the prices of

all the goods and services that make up
GNP. It is calculated as the ratio of nominal
GNP to real GNP, multiplied by 100.
In the above example, we divide
nominal GNP (Rs.16,012) by real GNP
(Rs. 15,300) and multiply the results by
100. We obtain GNP deflator as 104.7.
It is also possible to calculate
deflator for specific expenditures as we
would like to know the real value of
these expenditures. This is also shown
in Table 3.2.
GNP
MP
et
)n
in
di
ct
re
ta
s
xe
FC
-d
ep
re
c
ia
tio
(
)
ne
ti
nd
ire
ct
ta
xe
s
GDP
NNPFC
FC
(-)
d
ep
re
c
ia
tio
n
()net income
from abroad
ne
ti
nd
ir e
ct
ta
xe
s
()net income
from abroad
(
)
ne
ti
nd
ire
ct
ta
xe
s
NDPMP
()
GNP
GDPMP
d
e
pr
ec
i
at
io
n
()net income
from abroad
(
)
(-)net income from

abroad
(pr
)d
e
n
io
at
ec
i
NNPMP
NDPFC
Fig 3.1: Relationships between Different aggregates of National Income3

3
Wilfred Beckerman, An Introduction to National Income Analysis, 3rd Edition, Universal Book
Stall, New Delhi, 1999.
30
Important
Aggregates
National
Accounts
Gross National Product is the core

concept of national income accounting.
From this several other measures are
derived, each having its specific purpose
to interpret the performance of a given
economy. All these concepts and
measures are interrelated which is
shown in Figure 3.1. From this, we may
observe eight major national accounts
concepts as given below and they may
be derived following the direction given
in the diagram.
1. GNP at Market Prices (GNPMP)4 =
Value of all the final goods and
services produced in the economy
+ Net Factor Income from Abroad
2. NNP at Market Prices (NNPMP) =
GNPMP Depreciation
3. GDP at Market Prices (GDPMP) =
GNPMP Net Factor Income from
Abroad
4. NDP at Market Prices (NDPMP ) =
GDPMP Depreciation
4
5. GNP at Factor Cost (GNPFC) = GDPMP

+ Net Factor Income from Abroad
Net Indirect taxes
6. NNP at Factor Cost (NNP FC ) =
GNPFC Depreciation
7. GDP at Factor Cost (GDPFC) = GDPMP
Net Indirect taxes
8. NDP at Factor Cost (NDPFC)= GDPFC
Depreciation
National 5 Disposable Income
In addition to the above, we may also
include the concept of National
Disposable Income. National Disposable
Income is the income from all sources to
the residents of a nation for spending on
consumption as well as saving during a
year. It is given by the following :
National Disposable Income
= NNPMP + Other Current Transfers
from the rest of the world6
This is the maximum available income
for a country. National Disposable
Income for a country is what the
Personal Disposable Income (Personal
Income Personal Taxes) is for an
individual.
A particular value may be expressed at Market Prices or at Factor Cost. If a quantity is expressed
in terms of its current prices it is referred to as market price. Suppose the total value added is
computed on the basis of current prices of inputs then we may call this as value added at Market
Prices. On the other hand, if the value added is arrived at by adding the payments to factors
(land, labour, capital and entrepreneurship) such as rent, wages, interest and profit, (as was
done in Table 3.1) then it is described as value added at Factor Cost. In the same manner, all the
concepts of national income may be shown either at market prices or at factor costs.
It may be necessary to give the meaning of Domestic and National used in National Income
aggregates. Domestic here simply means domestic territory. So, domestic product would imply
the value of all goods and services produced by the normal residents of a country. National
refers to the addition of the net factor income from abroad to the domestic product.
Current transfers from the rest of the world may include gifts, cash, consumer goods and even
military equipment.
AND
The above definitions may be

understood as general principles of how
these measures are conceptualised. In
practice each country follows its own
method of compilation and hence
definition of specific items, which
constitute an aggregate measure, will
be different from others. In India, the
national accounts are prepared in
accordance with System of National
Accounts (SNA) since 1975.
Subsequently, there has been a
significant improvement in the
statistical statements in terms of
database and coverage. Presently the
SNA 1993 is being used.
Concepts of National Product and
National Income: A Summary
GNPMP = Value of all final goods and
services produced in the
economy+Net factor income
from abroad
NNPMp = GNPMp Depreciation
GDPMp = GNPMp Net factor income
from abroad
NDPMp = GDPMp Depreciation
GNPFc = GNPMp Net indirect taxes
NNPFc = GNPFc Depreciation =
National income
GDPFc = GDPMp Net indirect taxes
NDPFc = GDPFc Depreciation
Three Methods of Measurement of
National Product
(i) Expenditure Method
GNP Mp = Personal consumption
expenditure + Gross Investment
(Gross business fixed investment +
Inventory investment + Gross
residential construction investment
+ Gross public investment) +
MEASUREMENT
31
Government purchases of goods and

services + Net exports (Exports imports)
+ Net factor income from abroad.
(ii) Income Method
GNPMp = Employee compensation
(wages and salaries + employers
contribution towards social
security schemes) + profits + rent +
interest + mixed income +
depreciation + net indirect taxes
(Indirect taxes Subsidies) + Net
factor income from abroad.
(iii) Value Added Method
GNPMp = (Value of output in primary
sector intermediate consumption
of primary sector) + (value of output
in secondary sector intermediate
consumption of secondary sector)
+ (value of output in tertiary sector
intermediate consumption of
tertiary sector) + Net factor income
from aboard.
The following numerical examples will
help us to understand various national
income aggregates.
calculate the Gross National Product at
Market Price through the Expenditure
Method
(Rs. in crores)
i. Inventory Investment
10
ii. Exports
20
iii. Net factor income from abroad (5)
iv. Personal consumption
350
expenditure
v. Gross residential
30
construction investment
vi. Government purchases of
goods and services
100
vii. Gross public investment
20
viii. Gross business fixed
30
investment
ix. Imports
10
32
Solution:
GNPMp =
Personal consumption
= 350
expenditure
+ Gross Investment
= 90
which include:
Gross Business Fixed
= 30
Investment
Gross Residential
= 30
Construction Investment
Gross public Investment
= 20
Inventory Investment
= 10
+ Government purchases of
= 100
goods and services
+ Net exports
= 10
which include:
Exports
= 20
Imports
= 10
+Net Factor Income From Abroad = 5
GNPMp
= 545
So, GNPMp is Rs. 545 crores.
Market Price via the Income method
(Rs. in crores)
i. Wages and Salaries
700
ii. Rent
100
iii. Depreciation
50
iv. Net factor income from abroad 10
v. Mixed income
400
vi. Subsidies
100
vii. Profits
400
viii. Indirect taxes
300
ix. Employers contribution
50
to social security schemes
x. Interest
40
Solution:
Employee Compensation which
include
= 750
Wages & Salaries
= 700
Employers contribution to = 50
social security schemes
+ Profits
= 400
+ Rent
= 100
+ Interest
= 40
+ Mixed Income
= 400
+ Depreciation
= 50
+ Net Indirect taxes which
= 200
include
Indirect taxes
= 300
Subsidies
= 100
+ Net Factor Income from Abroad = 10
=1930.
GNPMp
So the GNPMp is Rs.1930 crores
Market Price via the Value Added method
(Rs. in croroes)
i. Value of output in primary 1,000
sector
ii. Net factor income from abroad 20
iii. Value of output in tertiary sector 700
iv. Intermediate consumption
400
in secondary sector
v. Value of output in secondary 900
sector
vi. Intermediate consumption in 500
primary sector
vii. Intermediate consumption in 300
tertiary sector
Solution:
Value of output in primary sector = 1,000
Intermediate consumption of
primary sector
= 500
+ Value of output in secondary = 900
sector
Intermediate consumption in = 400
secondary sector
+ Value of output in tertiary
= 700
sector
Intermediate consumption
= 300
of tertiary sector
+ Net factor income from abroad = 20
= 1380
GNPMP
So, GNPMp is Rs. 1380 crores.
AND
MEASUREMENT

calculate the GNP, GDP, NNP, NDP at both
factor cost and market prices.
(Rs. in crores)
i. Gross Investment
90
ii. Net exports
10
iii. Net indirect taxes
5
iv. Depreciation
15
v. Net factor income from abroad 5
vi. Personal consumption
350
expenditure
vii. Government purchases of
100
goods and services
So, GDPFC
h) NDPFC
Solution:
a) GNPMP =
Personal consumption expenditure =
+ Gross investment
=
+ Government purchases of
=
goods and services
+ Net exports
=
+ Net factor income from abroad =
GNPMP
350
90
100
10
5
= 545
So, GNPMP is Rs. 545 crores

b) NNPMP
= GNPMP Depreciation
= 545 15 = 530
So, NNPMP
= Rs. 530 crores
c) GDPMP
= GNPMP Net Factor
Income from Abroad
= 545 (5) = 545 + 5
= 550
So, GDPMP
= Rs. 550 crores
= GDPMP Depreciation
d) NDPMP
= 550 15 = 535
So, NDPMP
= Rs. 535 crores
= GNPMp Net indirect
e) GNPFC
taxes
= 545 5 = 540
So, GNPFC
= Rs. 540 crores
f) NNPFC
= GNPFC Depreciation
= 540 15 = 525
So, NNPFC
= Rs. 525 crores
g) GDPFC
= GDPMp Net indirect
taxes
= 550 5 = 545
So, NDPFC
33
=
=
=
=
Rs. 545 crores

GDPFC Depreciation
545 15 = 530
Rs. 530 crores
Items that are Excluded from GNP

Measurement
It may be recalled that GNP is the
measure of the value of the final goods
and services produced in one year. But
in reality many transactions occur in
the economy that have either nothing
to do with the final goods and services
produced or that they are non-market
activities or illegal activities whose
measurement has its own limitations,
both conceptual and empirical. We shall
now enumerate a few of these
transactions that are excluded in the
estimation of GNP.
1. Purely Financial Transactions
There are three generate types of purely
financial transactions. They are
(a) Buying and Selling of securities
(b) Government Transfer Payments
(c) Private Transfer Payments
Now, let us examine these
transactions in detail.
(a) Buying and selling of securities
In the financial markets as shown
earlier in circular flow model, 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.
In the case of bonds, it is
acknowledging a debt transaction.
There is no production activity but only
exchange of funds for financial claims.
Trading in financial instruments does
34
not imply production of final goods and

services. As such these are not included
in the GNP.
(b) Government Transfer Payments
As defined earlier, transfer payments
are payments for which no goods or
services are provided in exchange.
Pension payments, Employees social
security measures, adhoc assistance
due to certain exigencies like floods,
drought, etc. and subsidies are
examples for government transfer
payments. As there is no production of
final goods and services in response to
transfer payments, the transfer
payments are not included in the GNP.
(c) 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 also not
included in the GNP.
2. Transfer of Used Goods
GNP refers to the value of the final goods
and services produced in a given year.
Hence, goods produced in the previous
time period cannot be included in the
GNP. For instance, when a person buys
a used car, it cannot be recognized in
GNP measurement as the car was
produced in an earlier year. Spending
on a used car simply reflects a change in
the ownership of a pre-existing output.
3. Non-market Goods and Services
Many final goods and services are not
acquired through regular market
transaction vegetables can be grown

in the backyard instead of bought in
the super market, or an electrical fault
can be repaired by the house owner
himself or herself instead of hiring an
electrician. These are examples of nonmarketed goods and services that have
been consumed without using
organised markets. But GNP includes
only those transactions that occur
through market activities. Barter
transactions and production for selfconsumption by household are not
included in the GNP. It is in this context,
there is a debate as to whether
housewives services should be included
or not. If so, how do we value their
services at current market prices?
4. Illegal Activities
GNP does not include trade in illegal
goods and services even though they
are final products and are purchased
in market transactions. Activities such
as smuggling, gambling, crime for hire,
drug trafficking, illegal arms sale are
some cases in point.
These illegal activities create an
underground economy wherein
production is unreported or
unaccounted either because it is
unlawful or those involved want to
evade the government tax-net. As a
result these illegal and concealed
transactions create a huge volume of
unaccounted money that is popularly
called the black money. Black money
is the main driving force of
underground economy or parallel
economy. As in the case of non-market
goods, it is difficult to fix exact market
AND
value for transactions in the

underground economy. Technically, as
per the law of the land, these activities
are classified under economic offenses.
Hence their exclusion from GNP.
5. The Value of Leisure
Leisure is regarded as an economic
good. It may be that, other things being
equal, more leisure is better than less
leisure. When the levels of income
increase, the resultant state of affluence
would induce people to prefer more
leisure than less of it. This means that
with higher economic security the richer
segment of our society would cut down
their work effort, which in turn means
producing less GNP. But that would not
imply or suggest that people become
worse off than before. In fact, choice of
more leisure is simply an increase in
utility. However, it would be very
difficult to measure the intangible item
like leisure and include it in the GNP.
Nevertheless, in a modern economy,
there is wide range of business
opportunities to provide for leisure time
activities. So, though leisure as such
cannot be measured, the services
provided by the business sector to
capture the demand for leisure-time
activities could be brought under final
services for inclusion in the GNP.
Leisure-time activities are in great
demand from the middle and richer
classes of society.
However, leisure per se cannot be
brought within the treatment of national
accounts mainly because there is no
valuation possible and imputing value
is both difficult and not useful for any
analysis.
MEASUREMENT
35
Does GNP Measure Economic

Welfare?
For a very long period of time
economists have used GNP quite
uncritically as the principal measure of
economic growth and development.
Maximisation of national income was
taken synonymous with maximisation
of growth; hence rising GNP is good and
declining GNP is bad for the economy.
But a whole range of questions
concerning it are being raised these
days. They are such as, what is or ought
to be growth? What happens to
distribution of income and wealth with
an increase of GNP? What does an
increasing GNP do to the use of nonrenewable natural resources? Is there
a necessary association between
increase in national income and
national welfare? Can the increase in
national income accomplish good
quality of life and human development?
All these and other questions have been
researched into in the recent past and
at present GNP measure is under close
scrutiny by economists and policy
makers. In recent times more and more
economists have shown keen interest to
critically look at GNP as the indicator of
growth and development of a nation.
Measurement of GNP is subject to
the rules of national income accounting.
These rules may rigidly classify
production activities to be included in
or excluded from GNP. Hence GNP as a
statistic can be misleading as the basis
of overall development of an economy.
Therefore, the main question that needs
to be discussed is : Does the GNP
measure economic welfare?
36
J.R. Hicks once wrote that, The

purpose of income calculation... is to
give people an indication of the
amount they can consume without
impoverishing themselves7.
In the contemporary economies,
particularly in the developing
countries, we are confronted with the
serious issue of inequality in the
income distribution, environmental
degradation, and deterioration in the
quality of life. All these and related
problems have not only introduced
gaps between different classes of people
in terms of their social and economic
status but also between nations,
involving categorisation such as
developed, developing, less developed
and least developed countries.
It is beyond the scope of this
chapter to probe into the development
debates over the questions narrated
above. Suffice it to say that increase in
GNP as the sole objective of development

will be counter productive. It is
important to test whether growth in
GNP results in equitable distribution of
income, sustainable development and
good quality of life for people. The
process of development must create
sustainable
societies
without
endangering the natural resources and
ecological systems.
Therefore, attempts to enhance GNP
at any cost may create economic bads
such as poverty and pollution. This
requires an alternate measure, which
would allow GNP to measure human
welfare. Some economists have suggested
the concept of green GNP. Such a green
GNP would help attain a sustainable use
of the natural environment and equitable
distribution of the benefits of
development. It may be useful to debate
these issues related to GNP.
SUMMARY
l
l
l
l
l
l
l
l
Circular flow of income forms the basis for measurement of macroeconomic

activities.
Product approach, Income approach and Expenditure approach are three
ways in which Gross National Product can be measured.
In the product approach, only the final goods and services are included to
facilitate the aggregation of the value added by the producing units.
Income approach is concerned with summation of factor incomes which in
turn must equal to total value added. Hence product is also income in
national accounts.
Aggregate expenditure is obtained by adding all expenditures on
consumption, investment and government purchases of goods and services.
Real GNP and Nominal GNP are outlined by taking the value of national
product at constant prices and current prices respectively.
GNP deflator is used to measure the average level of the prices of all goods
and services.
Purely financial transactions, government and private transfers, used goods,
illegal activities, non-market goods, etc. do not get included in the GNP.
J.R.Hicks, Value and Capital, Oxford University Press, 1975, Page 172.
AND
MEASUREMENT
37
EXERCISES
Section I
1. Define:
(i) GNP at market prices
(ii) NNP at market prices
(iii) GNP at factor cost
(iv) NNP at factor cost.
2. Define the concept of value added.
3. Show how the sum of value added is equal to sum of factor incomes.
4. What is the difference between final good and intermediate good?
5. What is depreciation?
6. What are the components of aggregate expenditure?
7. What are factor incomes?
8. What is meant by double counting? Why should it be avoided?
9. What are transfer payments?
10. Explain the meaning of non-market activities.
11. What is called Green GNP?
12. Differentiate between national income at current price and constant
price.
13. Define: (a) Nominal GNP and (b) Real GNP
14. What is a GNP deflator?
15. Give reasons for not including leisure in GNP.
Section II
16.
17.
18.
19.
20.
21.
Explain product and income approaches to measure national income.

Explain the value-added method with the help of an example.
What are the items that are excluded from GNP? Give reasons.
Does GNP measure national welfare?
Explain the components of factor income.
Explain the following terms:
(a) Business fixed investment
(b) Inventory investment
(c) Residential construction investment
(d) Public investment.
Section III
22. Calculate the value added by Firm A and Firm B from the following
data:
(Rs. in lakhs)
(i) Purchase by Firm A from the Rest of the world
(ii) Sales by Firm B
(iii) Purchases by Firm A from Firm B
30
90
50
38
(iv)
(v)
(vi)
(vii)
(viii)
(ix)
(x)
Sales by Firm A
Exports by Firm A
Opening stock of Firm A
Closing stock of Firm A
Opening stock of Firm B
Closing stock of Firm B
Purchases by Firm B from Firm A
110
30
35
20
30
20
50
23. Calculate value added by Firm X and Firm Y from the following data:
(Rs. in lakhs)
(i) Sales by Firm X
100
(ii) Sales by Firm Y
500
(iii) Purchases by households from Firm Y
300
(iv) Exports by Firm Y
50
(v) Change in stock of Firm X
20
(vi) Change in stock of Firm Y
10
(vii) Imports by Firm X
70
(viii) Sales by Firm X to Firm Y
250
(ix) Purchases by Firm Y from X
200
24. From the following data calculate the Net National Product at Market
Prices by (a) Expenditure Method (b) Income Method:
(Rs. in Crores)
(i) Personal consumption expenditure
700
(ii) Wages and salaries
700
(iii) Employers contribution to social security schemes 100
(iv) Gross Business fixed investment
60
(v) Gross Residential construction investment
60
(vi) Gross public investment
40
(vii) Inventory investment
20
(viii) Profits
100
(ix) Government purchases of goods and services
200
(x) Rent
50
(xi) Exports
40
(xii) Imports
20
(xiii) Interest
20
(xiv) Mixed income
100
(xv) Net factor income from abroad
10
(xvi) Depreciation
20
(xvii) Subsidies
10
(xviii) Indirect taxes
20
25. From the following data calculate the Gross Domestic Product at Factor
Cost by (a) Expenditure Method (b) Income Method:
(Rs. in Crores)
(i) Personal consumption expenditure
700
(ii) Wages and salaries
700

(iii)
(iv)
(v)
(vi)
(vii)
(viii)
(ix)
(x)
(xi)
(xii)
(xiii)
(xiv)
(xv)
(xvi)
(xvii)
(xviii)
AND
MEASUREMENT
Employers contribution to social security schemes 100

Gross business fixed investment
60
Profits
100
Gross residential construction investment
60
Government purchases of goods and services
200
Gross public investment
40
Rent
50
Inventory investment
20
Exports
40
Interest
20
Imports
20
Net factor income from abroad
10
Mixed income
100
Depreciation
20
Subsidies
10
Indirect taxes
20
26. From the following data calculate the Gross Domestic Product at Market
Prices:
(Rs. in crores)
(i) Value of output in primary sector
2,000
(ii) Intermediate consumption of secondary sector 800
(iii) Intermediate consumption of primary sector
1000
(iv) Net factor income from abroad
30
(v) Net indirect taxes
300
(vi) Value of output of tertiary sector
1,400
(vii) Value of output of secondary sector
1,800
(viii) Intermediate consumption of tertiary sector
600
39
U N I T - III
DETERMINATION OF INCOME
EMPLOYMENT
AND
CHAPTER
AGGREGATE DEMAND AND AGGREGATE

SUPPLY IN MACROECONOMICS
Introduction
It is an established principle in
macroeconomics that the aggregate
demand and the aggregate supply
together determine the level of aggregate
output of goods and services, aggregate
employment and the general price level
in an economy. Therefore, as the first
step, the meaning of the concepts of
aggregate demand and aggregate
supply are explained below.
Aggregate Demand
Aggregate demand is the total demand
for goods and services in the economy.
The aggregate demand is usually
related to the price level. An inverse
relationship could be assumed between
these two variables. That is, the greater
the price level the lower the aggregate
demand and vice versa.1 Figure 4.1
shows the aggregate demand curve.
In the Figure 4.1, the curve AD is the
aggregate demand curve. The X-axis
1
measures the output of goods and

services. The Y-axis measures the
price level.
Aggregate Supply
Aggregate supply is the total supply of
goods and services in the economy. In
respect of aggregate supply there is no
such clear-cut relationship with the
price level. In macroeconomics we have
two different kinds of aggregate supply
concepts based on two different sets of
assumptions. They are: (a) the Classical
concept of aggregate supply, and (b) the
Keynesian concept of aggregate supply.
We shall take up these two concepts one
by one.
Classical Concept of Aggregate
Supply
In the Classical2 concept, the aggregate
supply is perfectly inelastic with
respect to the price level. This means
that changes in the price level have no
Explanation of specific reasons for the downward sloping nature of the aggregate demand curve
is beyond the scope of this book. It may be dealt with during higher studies in economics.
The Classical school of economics ranged from Adam Smith in the 18th century to A. C. Pigou in
20th century. The Classical approach to macroeconomics (all writings on macroeconomics prior
to that of John Maynard Keynes) believed that the economy would normally be in a state of fullemployment equilibrium. The reason for this belief was their acceptance of Says law of markets.
Says law, in brief, maintained the impossibility of any deficiency in aggregate demand.
42
Price level
Price level
AS
AD
Q*
Output
Output
Fig 4.1: Aggregate Demand Curve
Fig 4.2: Classical Aggregate Supply Curve
effect on the aggregate supply. The

classical aggregate supply curve is
shown in Figure 4.2.
The X-axis measures the output.
The Y-axis measures the price level.
The curve AS is the aggregate supply
curve. Q* is the full-employment level
of output of goods and services. The
aggregate supply curve is a vertical
line at the full-employment level of
output. This means that changes in the
price level have no effect on the
aggregate supply.
The full-employment level of output
of goods and services is the largest
output that the economy is capable of
producing, when all resources are fully
employed. However, under the state of
full-employment, there could be a
situation of temporary unemployment
which is known as frictional
unemployment.3
The long tradition of the Classical
school of economics believed that the
aggregate supply would always be at

the full-employment level. The
theoretical foundation of this concept
of aggregate supply was based upon
the assumptions of (a) Says law of
markets and (b) wage-price flexibility.
Says Law of Markets

Says law of markets (named after the 18th
century French economist Jean Baptiste
Say) was one of the main propositions of
Classical theory (Clip 4.1). Says law states
that supply creates its own demand. If
goods are produced then there will
automatically be a market for them. This
means that there cannot be a general
overproduction or glut in an
economy that is based on a market
system of production and exchange.4
Correspondingly, there cannot be a
deficiency in aggregate demand.
Say felt that people do not work for
the sake of doing work, because work
is considered to be unpleasant. People
Frictional unemployment is a temporary unemployment of people who move between jobs. Since
it takes time for a person to switch from one job to another, at any one point of time, there will
be a short period of temporary unemployment, which is called frictional unemployment.
Gardner Ackley, Macroeconomics, Collier Macmillan, 1978
AGGREGATE DEMAND
AND
AGGREGATE SUPPLY
IN
work only in order to obtain goods and

services that yield satisfaction or utility.
In an economy that is characterised
by division of labour and exchange of
goods and services, people do not
produce all the goods and services they
wish to consume. Instead, they produce
only those goods and services in which
they are relatively the most proficient,
and exchange the surplus (over their
own needs) for the produce of others.
In such a system, the very act of
production is itself the demand for other
goods. The amount demanded of other
goods is equal to the value of the
surplus goods (that is the quantity of
goods over and above that required for
self-consumption) that each man
MACROECONOMICS
43
produces. Therefore, each persons

production constitutes his or her
demand for other goods; hence, for the
entire community, aggregate demand
equals aggregate supply. Says law
implies that an increase in output will
generate an equal increase in income
and spending. Thus, income and
product can always be at fullemployment level. Output will only be
limited at the point where, for every
individual, the satisfaction of a little
more leisure outweighs the sacrifice of
a little more goods that could have
been obtained. At this point, any
unemployment will be voluntary i.e.
people consciously decide not to work
at the prevailing wage rate.
Clip 4.1
THE LIFE OF JEAN BAPTISTE SAY
Jean Baptiste Say (1767 1832) was a statesman in the reign
of Napoleon Bonaparte, a businessman, and an economist. He
founded the French Classical School of Economics, which had
notable names such as Frederic Bastiat amongst its followers.
Say wrote a book titled Treatise on Political Economy in 1803,
which found widespread fame, ran into five editions, and was
used as a textbook in the American colleges of the times.
He began lecturing on Political Economics in 1816 and published
his Catechism of Political Economy in 1817. In 1819, he was
appointed to the Chair of Industrial Economy at the
Conservatoire National des Arts et Mtiers. In 1828 he published a six-volume
book titled A Complete Course in Practical Political Economy. In 1831, he was
appointed as Professor of Political Economy at the College de France, a post he
held until his death in 1832.
Say was partly responsible for the introduction of the concept of an
entrepreneur into economic theory, and also the division of the fundamental
factors of production into three land, labour and capital. His greatest claim to
fame was his loi des dbouches or law of markets. His law became famous
when J. M. Keynes accused the Classical economists of being misled by accepting
it as the mainstay of their macroeconomic theory.
44
According to this approach, the

full-employment level of income and
product are ensured by full flexibility
in wages and prices. Therefore, the
market automatically adjusts itself to
full-employment output. We shall
explain below the meaning of wageprice flexibility.
Wage-price Flexibility
Wage-price flexibility means that (real)
wages5 and prices are flexible, that is,
they can increase or decrease freely and
quickly. The effect of wage-price
flexibility is that the market for labour
and the markets for goods and services
will always be in equilibrium, i.e.
demand will be equal to supply in all
markets.
Suppose that the market for labour
(or for a good or service) is in
disequilibrium due to condition of
excess demand (or excess supply).
Wage-price flexibility will enable the
wage rate (or the price) to increase
(decrease) in order to eliminate the
excess demand (excess supply), and
thus bring the market back into
equilibrium by equating demand and
supply.
Wage flexibility ensures that the
market for labour is always in
equilibrium, i.e. supply of labour
equals demand for labour. This means
that everyone who wants employment
at the prevailing wage rate gets it thus
5
ensuring full employment. Price

flexibility ensures that the markets for
all goods and services are in equilibrium
in every market the supply equals
demand. This means that the aggregate
supply of all goods and services equals
the aggregate demand for all goods and
services.
Thus, Says law of markets and
wage-price flexibility ensures automatic
market adjustment so that the economy
always produces the full-employment
level of output. Thus, the Classical
aggregate supply curve is a vertical line
at the full-employment level of output.
It is perfectly inelastic with respect to
prices, that is, output is always constant
at the full-employment level regardless
of the prevailing price level (Fig. 4.2).
Keynesian Concept of Aggregate
Supply
In the Keynesian approach, the
aggregate supply is perfectly elastic
with respect to the price level. This
means that the firms are willing to
produce any amount of output at the
prevailing price level.
The Keynesian approach developed
against the background of the Great
Depression of the 1930s. The Great
Depression witnessed falling levels of
output, prices and employment (see
Appendix 4.1).
Keynes understood aggregate
supply to be perfectly elastic with
Real wages refer to the purchasing power of workers wages in terms of goods and services. It
is measured by the ratio of the money wage rate to the price level as measured by some price
index. See the glossary for the meaning of the terms price level and price index. In the Classical
framework, the real wage rate is equal to the marginal product of labour.
AGGREGATE DEMAND
AND
AGGREGATE SUPPLY
IN
respect to price, that is, the producers

were willing to supply any amount of
goods and services at the fixed price
level. The theoretical foundations of the
perfectly elastic aggregate supply
curve were the assumptions of (a) wageprice rigidity and (b) constant marginal
product of labour. This is quite opposite
to the principles of Classical economics.
Wage-price rigidity meant that
(money) wages and prices were rigid,
i.e. they were not free to increase or
decrease. Constant marginal product of
labour meant that every increment of
labour employed produced the same
increment to output.
Rigid wages when coupled with
constant marginal product of labour
lead to rigid prices. This is because
each unit increment to output costs the
same to produce. The cost of
production of each additional unit of
output is the incremental quantity of
labour employed to produce that
additional unit of output, multiplied by
the wage rate. Since marginal product
of labour is constant, every additional
unit of output requires the same
increment in labour employed. Thus,
constant marginal product of labour
and constant wage rate means that the
cost of production of the incremental
unit of output is also constant. Since
production is carried out at constant
cost, the aggregate supply curve is
perfectly elastic with respect to prices
i.e. output can be expanded till the full
employment level without any change
in the price level.
Once the full-employment level of
output has been reached, no further
MACROECONOMICS
Price level
45
AS
Q*
Output
Fig 4.3: Keynesian aggregate

supply curve
increases in production are possible

since all resources have been fully
employed. At this point, the aggregate
supply curve becomes perfectly
inelastic with respect to price. The
Keynesian aggregate supply curve is
The X-axis measures the level of
output. The Y-axis measures the price
level. Q* is the full-employment level of
output. The Keynesian aggregate
supply curve is perfectly elastic with
respect to prices until the fullemployment level of output. Once the
full-employment level of output has
been reached, no further increases in
production are possible since all
resources have been fully employed.
At this point, the aggregate supply
curve becomes perfectly inelastic with
respect to price.
Now, one implication of wage rigidity
is that it may hinder the attainment of
full-employment. If wages are rigid at
some level where the supply of labour is
greater than the demand for labour, then
there will be involuntary unemployment
to the extent of the excess supply of
46
labour. Involuntary unemployment

occurs when those who seek
employment at the going wage rate do
not get it. The rigid wage rate, due to its
failure to adjust downward in order to
eliminate the excess supply of labour, is
thus hindering full employment. If fullemployment cannot be attained (due to
the rigidity of wages, and therefore the
presence of involuntary unemployment),
then the economy will not be able to
produce the full-employment level
of output.
Having now introduced the concept
of aggregate demand and the two
concepts of aggregate supply, we may
now analyse the concept of
macroeconomic equilibrium.
Equilibrium
The equilibrium between aggregate
demand and aggregate supply occurs,
when at a particular price level, the
aggregate demand is equal to the
aggregate supply. At equilibrium, the
total output of goods and services
produced equals the total demand for
those goods and services. The particular
price level at which equilibrium occurs
is known as the equilibrium price level.
The level of aggregate employment
corresponding to the equilibrium level
of aggregate supply is the equilibrium
level of employment.
This equilibrium may be of two
types full-employment equilibrium, and
under-employment equilibrium.
Clip 4.2
The Life of John Maynard Keynes
John Maynard Keynes (1883 1946) was the eldest son of
the British economist John Neville Keynes, who was the
Registrar of Cambridge University. Keynes graduated from
Cambridge University in 1905 with a mathematics tripos
and embarked upon a high-flying career which would see
him at various points of time as an Economist, Adviser to
the Government, Editor, and Professor of Economics.
For two years from 1906 to 1908 he served in the India Office
of the British Government. From 1909 to 1915 he was a
lecturer at Kings College, Cambridge during which period
he wrote Indian Currency and Finance in 1913. In 1912
he became the editor of the Economic Journal, a post he
held till 1945. From 1915 to 1919 he served the British treasury, and in 1919
he wrote The Economic Consequences of the Peace, where he criticised the
war reparations imposed on Germany as too high. His book A Treatise on Money
appeared in 1930.
In 1936 he wrote his revolutionary book, The General Theory of Employment,
Interest and Money. In 1944, he took a leading part in the discussions at Bretton
Woods, which led to the establishment of the IMF. In appreciation of his services
to his country, the British Government made him the first Baron of Tilton (Lord
Keynes of Tilton). He died on April 21, 1946.
AGGREGATE DEMAND
AND
AGGREGATE SUPPLY
IN
Full-employment Equilibrium
Full-employment equilibrium is an
equilibrium state where all resources
in the economy are fully utilised. The
Classical school of economics believed
that the full-employment equilibrium
would always prevail in the economy.
They recognized the possibility that
though the economy might briefly
depart from this equilibrium, it would
be restored due to the free play of the
market forces, i.e. interaction between
aggregate demand and aggregate
supply. The theoretical foundation of
this belief in full-employment
equilibrium was based upon the
assumptions of (a) Says law of
markets, and (b) wage-price flexibility.
The full-employment equilibrium is
The Y-axis measures the general
price level. The X-axis measures the
level of output. AD is the aggregate
demand curve and AS is the Classical
aggregate supply curve.
Price level
Peq
AS
E
AD
Q eq
Output
Fig 4.4: Full-employment equilibrium
MACROECONOMICS
47
Point E represents the fullemployment equilibrium. It is the point

of intersection of the aggregate supply
curve and the aggregate demand curve.
Corresponding to point E, the
equilibrium price level is Peq and the
equilibrium level of output is Qeq. Since
aggregate supply is always at the
full-employment level, the equilibrium
level of output Q eq is also the
full-employment level of output.
The equilibrium is therefore a
full-employment equilibrium. The
aggregate demand curve serves only to
determine the equilibrium price level.
Under-employment Equilibrium
Under-employment equilibrium is a
state of equilibrium where resources are
under-employed. The idea of underemployment equilibrium is explained
in the Keynesian approach. The
Keynesian approach was developed
against the background of the Great
Depression of the 1930s. When an
economy is gripped by the
phenomenon of depression, there is
decline in economic activity. This
results in under utilisation of resources,
as there is no active or effective demand
for output. The reason for under employment equilibrium is a condition
of deficiency of aggregate demand.
Keynes understood aggregate
supply to be perfectly elastic with
respect to price that is, the producers
were willing to supply any amount of
goods and services at a given price level.
As pointed out earlier, the theoretical
48
foundations of the perfectly elastic

aggregate supply curve were the
assumptions of (a) wage-price rigidity
and (b) constant marginal product of
labour.
With a perfectly elastic aggregate
supply curve, the determination of the
equilibrium level of output and
employment depends only on the level
of aggregate demand. When there is
deficient aggregate demand, that is, a
level of aggregate demand which is less
than the full employment level of output,
there will be an under-employment
equilibrium.
The under-employment equilibrium
is shown in Figure 4.5.
Price level
AS
AD
Peq
Qeq
Q*
Output
Fig. 4.5: Under-employment equilibrium
AD is the aggregate demand curve

and AS is the aggregate supply curve.
Peq is the equilibrium price level, Qeq is
the equilibrium level of output, and Q*
is the full-employment level of output.
Point E is an under-employment
equilibrium. It is the point of
intersection of the aggregate demand
curve and the aggregate supply curve.
It is an under-employment equilibrium
because the equilibrium level of output

Qeq is less than the full-employment level
of output Q*.
Given the perfectly elastic aggregate
supply curve, the equilibrium level of
output and employment is determined
solely by the level of aggregate demand.
The equilibrium price level is
determined by the height of the
aggregate supply curve above the
X-axis.
The Keynesian approach to moving
the economy out of the under employment equilibrium to fullemployment equilibrium was to
increase the aggregate demand by the
device of increasing the government
expenditure on goods and services.
The increase in aggregate demand
would automatically call forth an
equivalent increase in aggregate supply
without affecting the price level. The
economy could thus be moved to a fullemployment equilibrium by merely
increasing the level of aggregate demand
to that level required for the fullemployment level of output. The
process of altering aggregate demand
by the government, as against
aggregate supply, is called demand
management policy.
The Keynesian remedy for underemployment equilibrium places
emphasis on increasing the level of
aggregate demand for the attainment of
the full-employment equilibrium level.
We shall therefore look at the
components of aggregate demand, and
the determination of equilibrium output
and employment in the Keynesian
framework in the next two chapters.
AGGREGATE DEMAND
AND
AGGREGATE SUPPLY
IN
MACROECONOMICS
49
SUMMARY
l
Aggregate demand is the total demand for goods and services in the economy.
Aggregate supply is the total supply of goods and services in the economy.
The Classical aggregate supply curve is perfectly inelastic with respect to

prices. The aggregate supply is always at the full-employment level of output.
The theoretical basis of the Classical aggregate supply curve is (a) Says law
of markets, and (b) wage-price flexibility.
The Keynesian aggregate supply curve is perfectly elastic with respect to

prices until the full-employment level of output. This means that firms are
willing to supply any amount of output at the prevailing price level.
The theoretical basis of the Keynesian aggregate supply curve is (a) constant
marginal product of labour, and (b) wage-price flexibility.
Equilibrium between aggregate demand and aggregate supply occurs when

at a particular price level, aggregate demand equals aggregate supply.
Equilibrium may be of two types full-employment equilibrium and underemployment equilibrium.
Full-employment equilibrium is that equilibrium where all resources are

employed to their full limit.
Under-employment equilibrium is that equilibrium where resources are not

fully employed.
EXERCISES
1.
2.
3.
4.
5.
6.
What is aggregate demand?

What is aggregate supply?
How is the Classical concept of aggregate supply different from
the Keynesian concept of aggregate supply?
What is meant by equilibrium?
Differentiate between full-employment and under -employment
equilibrium.
Explain: (a) voluntary, and (b) involuntary unemployment.
APPENDIX 4.1: THE GREAT DEPRESSION
In the 1930s there was a world

depression. There was a serious
decline in economic activity, of
unprecedented length and severity. The
1920s saw a stock market boom in the
U.S. as the result of general optimism:
businessmen and economists believed
that the newly-born Federal Reserve
(the Central Bank of the United States
of America) would stabilize the
economy, and that the pace of
technological progress guaranteed
rapidly rising living standards and
expanding markets. The U.S. Federal
Reserves attempts in 1928 and 1929
to raise interest rates to discourage
speculation in the stock market
brought on an initial recession.
In the figure given below, the Y-axis

measures the index of product of G-7
countries, with 1929 as the base year
(see Fig A4.1).
Caught by surprise, firms cut back
their own plans for further purchase of
producer durable goods; firms making
producer durables cut back
production and those who feared they
might soon be out of work cut back
purchases of consumer durables, and
firms making consumer durables faced
falling demand as well.
Falls in pricesdeflationduring
the Depression set in motion
contractions in production, which
triggered additional falls in prices. With
prices falling at ten per cent per year,
Fig A4.1 : Index of production of G-7 Countries during Great Depression
AGGREGATE DEMAND
AND
AGGREGATE SUPPLY
IN
investors could calculate that they

would earn less profit investing now
than delaying investment until next
year when their dollars would stretch
ten per cent further. Banking sector
became panicky and the collapse of the
world monetary system cast doubt on
everyones credit, and reinforced the
belief that now was a time to watch and
wait. The slide into the Depression, with
increasing unemployment, falling
production, and falling prices,
continued.
In the United States, the
unemployment rate rose from 3.2% of
the labour force in 1929 to 25.2% of
the labour force in 1933, the highest
level during the course of the
depression. Unemployment remained
over 10% throughout the decade. Real
GNP fell by 30% and it could not reach
the 1929 level again till 1939.
Meanwhile, things were even worse
in Great Britain. The depression started
even earlier there. High unemployment
began in the early 1920s and
continued into and throughout the
MACROECONOMICS
51
1930s. In fact, unemployment in Great

Britain was above 10% by 1923, and
remained above 10% until 1936.
This was a state of affairs
significantly different from the classical
world of full employment, with only
temporary deviations from full
employment. This period of high and
prolonged unemployment was the
cause of great debate among
economists and policy-makers as to the
cause of the unemployment and the
correct remedy for the problem.
Among the debaters was one John
Maynard Keynes (later Lord). He
propounded a revolutionary theory of
macroeconomics, which blamed the
high unemployment on a deficiency in
aggregate demand. Aggregate demand
was too low because of inadequate
investment demand. Keynes theory
provided an economic policy to combat
unemployment stimulate aggregate
demand. Keynes was in favour of fiscal
measures such as government
spending on public works in order to
stimulate aggregate demand.
CHAPTER
AGGREGATE DEMAND AND

COMPONENTS
We have defined aggregate demand as
the total demand for goods and services
in the economy. In this chapter we will
look at the components of aggregate
demand, and what determines the
magnitudes of these components. Our
discussion in this connection will be
based upon a simple model of
Keynesian macroeconomics.
The components of aggregate
demand include goods and services
demanded for private consumption (C),
for investment (I), for government
expenditure (G) and for net exports
(X-M). Aggregate demand (AD) is
therefore given by
AD = C + I + G + (X-M)
We may now focus on the
determinants of the individual
components of aggregate demand.
Consumption demand and
consumption function
Consumption demand in microeconomics
is defined as the value of commodities
1
ITS
and of services that households are able

and willing to buy at a particular time.
This demand is influenced by many
variables such as price of the goods or
services, income, wealth, expected
income, tastes and preferences of
individuals and so on. Keynes
formulated
his
fundamental
Psychological Law of Consumption to
lay down a behavioural rule to the
process of consumption activity.
Keynes proposed that consumption
demand increases with the level of
income. His fundamental psychological
law, holds, that men are disposed, as
a rule and on the average, to increase
their consumption as their income
increases, but not by as much as the
increase in their income. 1 This
relationship between consumption and
income is called the consumption
function.
The consumption function may be
represented by the following equation.
This relationship between consumption and income holds good for the individual, the household,
as well as for the economy as a whole. In the context of this chapter, consumption and income
shall be understood as referring to aggregate consumption and income.
AGGREGATE DEMAND
AND ITS
COMPONENTS
C = C + bY C > 0, 0 < b < I.

Where,
C = Consumption
C = Autonomous Consumption
b = Marginal Propensity to Consume

Y = Level of income
The intercept C represents
autonomous consumption, that is, the
amount of consumption expenditure
when income is zero.2 C is assumed to
be positive, that is, there is
consumption even in the absence of any
income. Hence, it is not possible to
think of a situation where there is no
consumption at all.
The slope of the consumption
function is b. It measures the rate of
change in consumption per unit change
in income and is also known as the
Marginal Propensity to Consume
(MPC).3 For example, if b is 0.6, then a
rupee change in income causes a 0.60
rupee change in consumption. If b is
0.45, then a rupee change in income
will cause a 0.45 rupee change in
consumption.
By assumption, the MPC is positive,
and its value ranges between 0 and 1.
This means that consumption
increases with income, but a rupee
2
53
increase in income causes less than a

rupee increase (of b) in consumption.4
For example, if b is 0.90, a rupee
increase in income causes a 0.90 rupee
increase in consumption.
The consumption function may be
plotted in a graph, with the help of a
numerical example. Figure 5.1 shows
the graph of the hypothetical
consumption function.
Consider a consumption function
given by
C = 100 + 0.8 Y
Since this is an equation of a straight
line, the consumption function will have
a constant slope.
Table 5.1 shows the level of
consumption for various levels of
income.
Column (1) shows the consumption
expenditure at various levels of income.
The values in column (1) are obtained
from the consumption function.
Column (5) in table 5.1 shows how MPC
is calculated. As income increases from
Rs.600 to Rs.700 (an increase of 100
rupees), the consumption increases
from Rs.580 to Rs.660 (an increase of
80 rupees). The MPC is therefore 80/
100 = 0.8. The MPC at all levels of
income is the same because of the
The following two points must be kept in mind about the consumption function: (a) consumption
is actually a function of disposable income (that is, personal income minus personal taxes) per se.
However, since we have ignored the role of government, the disposable income is equal to income; (b) consumption is possible when the income is zero, a phenomenon also called as dissaving.
Marginal in economics means incremental or additional. Propensity to consume is the desire or
urge to consume. Marginal propensity to consume is thus the additional or extra consumption
that results from additional income.
The range of b may be deduced from the fundamental psychological law. Men are disposed, as
a rule and on the average, to increase their consumption as their income increases, this means
that b>0. but not by as much as the increase in their income; this means that b<1. Taken
together, 0<b<1.
54
Table 5.1: Consumption, Income and Marginal Propensity to Consume

Consumption
C
Change in
Consumption
C
Income
Y
Change in Income
Y
Marginal Propensity
to Consume (MPC)
= (2)/(4) = C/Y
(1)
(2)
(3)
(4)
(5)
100
180
80
100
100
(80/100) = 0.8
260
80
200
100
(80/100) = 0.8
340
80
300
100
(80/100) = 0.8
420
80
400
100
(80/100) = 0.8
500
80
500
100
(80/100) = 0.8
580
80
600
100
(80/100) = 0.8
660
80
700
100
(80/100) = 0.8
740
80
800
100
(80/100) = 0.8
820
80
900
100
(80/100) = 0.8
900
80
1000
100
(80/100) = 0.8
particular consumption function we

have used in our example. (Constant
slope and therefore constant MPC is a
feature of all straight line consumption
functions). The information given in the
Table 5.1 can be plotted in a graph, as
shown in Fig. 5.1.
Fig. 5.1 shows the graph of the
consumption function C = 100 + 0.8 Y.
To understand the figure, it is
helpful to look at the 45o line drawn
from the origin. Since the vertical and
horizontal axes have the same scale, the
45o line has the property that at any
point on it, the distance up from the
horizontal axis (which is consumption
expenditure) exactly equals the
distance across from the vertical axis
(which is income).
Thus, at any point on the 45o line,

consumption expenditure exactly
equals income. The 45o line therefore
immediately tells us whether
consumption spending (as per the
consumption function) is equal to,
greater than, or less than the level of
income.
The consumption function crosses
the 45o line at point B. This point is
known as the breakeven point. Here,
households are just breaking even,
because the consumption is exactly
equal to the income. In our example,
the income and consumption at the
breakeven point is Rs.500.
At any point other than B on the
consumption function, consumption is
not equal to income. At points to the
AGGREGATE DEMAND
AND ITS
COMPONENTS
55
C
1000
S= 80
900
Consumption
Function
800
700
= 80
600
500
y = 100
400
C=820
300
S= - 60
MPC
200
C 80

0.8
Y 100
C= 260
100
45
O
100
200
300 400
500
600 700 800
900
1000
Fig 5.1 : The Consumption Function C = 100 + 0.8 Y
left of B, the consumption function lies

above the 45 o line, therefore
consumption expenditure is greater
than income; for example, at an income
level of Rs 200, the consumption is
Rs.260. The household must find
funds to meet this consumption
expenditure. The shortage in income
will make them to sell the assets
acquired in the past, or to resort to
borrowing so that Rs.60 could be
raised for consumption. This act on the
part of the household to liquidate their
own assets or to go in for a loan is
referred to as the process of dissaving.
Dissaving is in order to help the
households to finance the consumption
over and above the level of income.5
5
At any point to the right of B, the

consumption function lies below the 45o
line; therefore consumption expenditure
is less than the level of income. The part
of income, which is not consumed, is
saved. This must be so, because income
is either consumed or saved, there is no
other use to which it can be put. Savings
can be measured in the graph as the
vertical distance between the
consumption function and the 45o line.
For example, at an income level of Rs.900,
consumption is Rs.820. Therefore, the
amount of savings is the difference
between the two, that is, Rs.80.
To sum up: when the consumption
function lies above the 45 o line,
consumption is greater than income at
Dissaving literally means the opposite of saving. That is an individual would reduce his prior
accumulated savings to compensate for the reduction in his income and thus maintain his consumption
level.
56
each level of income. This means that

there is dissaving. When the two lines
intersect, the level of consumption is
exactly equal to the level of income.
When the consumption function lies
below the 45 o line, the level of
consumption is less than the level of
income. This means that there is
positive saving. The amount of
dissaving or saving is always measured
by the vertical distance between the
consumption function and the 45o line.
Consumption and Savings
We shall now look into the relationship
between consumption and saving. We
may obtain the savings function from
this relationship.
The equation below says that
income that is not spent on
consumption is saved, that is
SYC
This equation tells us that by
definition, saving is equal to income
minus consumption.
The consumption function, along
with the above equation, implies a
savings function. The savings function
relates the level of saving to the level of
income. Substituting the consumption
function into the above equation we can
get the savings function.
S YC
= Y ( C + bY)(Since C = C + bY)
= Y C bY
S = C + (1 b)Y
This is the savings function. The
intercept term C is the amount of
savings made when there is zero level

of income. It is already shown that C is
always positive. Therefore C is negative.
Thus, there is negative savings C at zero
level of income. Since negative savings
is nothing but dissaving, this means
that at zero level of income, there is a
dissaving of amount C . Note that the
amount of autonomous consumption
is exactly equal to the amount of
dissaving at zero level of income. This
is because of the fact that Y C + S
(whether S is positive or negative).
The slope of the savings function is
(1 b). The slope of the savings function
gives the increase in savings per unit
increase in income. This is known as
the Marginal Propensity to Save (MPS).
Since b is less than one it follows that
(1 b) and therefore MPS is positive.
Therefore, savings is an increasing
function of income. Suppose the MPC,
that is, b is 0.8, then the MPS, that is,
(1 b) is 0.2. This means that for every
one rupee increase in income, savings
increase by 0.2 rupee.
Note that MPS = 1 b = 1 MPC.
This means that the part of the increase
in income, which is not consumed, is
saved. This is because income is either
consumed or saved. Therefore, it is
always the case that MPC + MPS = 1.
Using the numerical example of the
consumption function we had earlier,
we can derive the corresponding
savings function.
S = C + (1 b) Y
= 100 + (1 0.8)Y
S = 100 + 0.2Y
AGGREGATE DEMAND
AND ITS
COMPONENTS
57
Table 5.2: Consumption Saving Relationship

Change
in Y
Y
Change
in C
C
MPC
C/Y
Saving
S
(1)
(2)
(3)
(4)
(5)
(6)
Change in MPS
S
S/Y
S
(7)
(8)
100
0.8
-100
100
100
180
80
0.8
-80
20
200
100
260
80
0.8
-60
300
100
340
80
0.8
400
100
420
80
500
100
500
600
100
700
100
800
C+S MPC+MPS
(9)
(10)
0.2
100
20
0.2
200
-40
20
0.2
300
0.8
-20
20
0.2
400
80
0.8
20
0.2
500
580
80
0.8
20
20
0.2
600
660
80
0.8
40
20
0.2
700
100
740
80
0.8
60
20
0.2
800
900
100
820
80
0.8
80
20
0.2
900
1000
100
900
80
0.8
100
20
0.2
1000
Table 5.2 shows the levels of

consumption and savings for various
levels of income. Note that (a)
consumption plus saving everywhere
equals income, and (b) MPC + MPS = 1.
Columns (1) to (5) are repeated from
Table 5.1. Column (6) shows the level of
savings at different levels of income. The
values in this column are obtained from
the savings function. Column (8) in table
5.2 shows how MPS is calculated. As
income increases from Rs.600 to Rs.700
(an increase of Rs.100), the savings rises
from Rs.20 to Rs.40 (an increase of Rs.20).
The MPS is therefore (20/100) = 0.2.
The MPS is the same at all levels of
income because of the particular
savings function (a linear curve with
constant slope) we used in our example
(constant slope and therefore constant
MPS is a feature of all straight line

savings functions).
Column (9) of the table shows the
sum of consumption expenditure and
saving at every level of income. Note that
column (9) is identical to column (1). This
is because income is either consumed
or saved, there is no other use to which
it can be put. Thus, the sum of
consumption expenditure and saving
must be identical to income.
Column (10) of the table shows the
sum of the MPC and MPS. Note that the
sum of MPC and MPS is equal to one.
This means that the part of the increase
in income, which is not consumed, is
saved. This is because income is either
consumed or saved.
The information given in table 5.2 can
be plotted in a graph, as shown in Fig. 5.2.
58
C
Part - A
1000
S= 80
900
Consumption
function
800
700
600
B
500
400
C=820
300
S= - 60
200
100
C= 260
45o
O
100
200
300 400
500
600 700 800
900
1000
S
Part - B
Savings
function
100
100
S= - 60
300
400
B
500
S=80
600
700
800 900 1000
- 100
Fig 5.2: The Consumption Function and its associated Savings Function
Part A of Fig. 5.2 shows the

consumption function. Part B shows the
savings function. This is the counterpart
of the consumption shown in part A. In
part A, the amount of saving at any level
of income is the vertical distance,
between the consumption function and
the 45o line. The saving function shown
in part B can therefore be directly derived
from part A.
When income is 500, we see in part

A that consumption is 500 and saving
equals 0. This is depicted in part B by
the intersection of the savings function
with the horizontal axis at point B, which
corresponds to an income level of 500.
When income is 200, consumption is
260 and saving is -60 (dissaving is 60);
the savings function lies 60 below the
horizontal axis at an income level of 200.
AGGREGATE DEMAND
AND ITS
COMPONENTS
When income is 900, consumption is

820 and saving is 80; the saving
function lies 80 above the horizontal axis
at an income level of 900.
In general, to the left of point B in part
A, the consumption function lies above
the 45o line (consumption is more than
income). Hence to the left of point B in
part B, savings is negative and the savings
function lies below the horizontal axis.
To the right of point B in part A, the
consumption function lies below the 45o
line (consumption is less than income).
Hence to the right of point B in part B,
savings is positive and the savings
function lies above the horizontal axis.
Average Propensities to Consume
and Save
From the consumption function, we can
find out the value of the consumptionincome ratio C/Y, at every level of income.
At any particular level of income, the ratio
of consumption to income is called the
Average Propensity to Consume (APC).
The APC gives the average consumption
income relationship at different levels
of income.
Similarly, from the savings function,
we can find out the average savings
income ratio. At any particular level of
income, the Average Propensity to Save
(APS) is the ratio of savings to income.
We have
APC = C/Y and APS = S/Y
Now, the sum of the APC and APS
is always equal to one. This is because
income is either consumed and or
saved. The proof of this statement is as
follows: From the relationship between
income, consumption and saving,
59
we have
YC+S
Dividing both sides of the equation
by Y we have
Y/Y C/Y + S/Y
Thus, 1 APC + APS
Using the earlier examples of
consumption function and savings
function we can calculate the values of
APC and APS for every level of income.
This is done in Table 5.3.
Column (3) shows how APC is
calculated. At a particular income level,
the APC is the corresponding level of
consumption divided by that level of
income. Similarly; APS is calculated in
column (5). At a particular income level,
the APS is the corresponding level of
saving divided by that level of income.
Column (6) shows the sum of APC and
APS. As expected, at every level of
income, the sum of APC and APS is
equal to one. This is because income is
either consumed and or saved.
Therefore, the proportion of income that
is not consumed must be saved.
As we can see from the above table,
APC is continuously declining as
income increases; and APS is
continuously increasing as income
increases. This means that as income
increases, the proportion of income
saved increases and the proportion of
income consumed decreases.
Investment
The second component of aggregate
demand is investment which means
addition to the stock of capital goods,
in the nature of equipment, residential
60
Table 5.3 Average Propensities to Consume and Save

Y
APC
(2)/(1)
APS
(4)/(1)
APC+APS
(1)
(2)
(3)
(4)
(5)
(6)
100
-100
100
180
1.8
-80
-0.8
200
260
1.3
-60
-0.3
300
340
1.13
-40
-0.13
400
420
1.05
-20
-0.05
500
500
600
580
0.97
20
0.03
700
660
0.94
40
0.06
800
740
0.92
60
0.08
900
820
0.91
80
0.09
1000
900
0.90
100
0.10
Note: (a) means infinity

(b) Figures in table are rounded up to two decimal points
structures or inventory. Investment

plays two important roles in
macroeconomics. Firstly, due to the its
volatile nature, changes in investment
are the main cause of fluctuation in
aggregate demand. Secondly, since
investment
leads
to
capital
accumulation, it helps the economy to
produce higher levels of output.
Among the three categories of
investment purchases of residential
structures, additions to inventory, and
investment in fixed plant and
machinery, the last is usually the
largest. In this section, we will consider
the determinants of investment
demand, focusing on the last category
of investment.
In general, firms invest when
they expect their investment will be
profitable, i.e. it will earn them revenues

greater than the costs of the investment.
So, the three elements important in
understanding investment are
revenues, costs and expectations.
Revenues: An investment will bring a
firm additional revenue only if investing
allows a firm to sell more. So investment
decision depends upon the demand for
the output produced by the new
investment. For example, if the demand
for glucose biscuits is very high, then a
biscuit manufacturing firm can expect
an increase in its revenues by investing
more in new biscuit making machines.
Costs: A second important determinant
of the level of investment demand is the
costs of investing. One type of cost of
investment is the cost of the equipment
AGGREGATE DEMAND
AND ITS
COMPONENTS
and structures, and the costs incurred

in their maintenance and operation.
This is usually netted out from revenue
to get net revenue. The other type of cost
is that associated with the funding of
the investment, at the market rate of
interest.
Since the capital goods usually last
many years, firms tend to pay for
investments by borrowing funds. The
cost of borrowing is the interest rate on
borrowed funds. The interest rate is the
price paid for borrowing money for a
period of time.
Expectations: The third element in the
determination of investment is the
entrepreneurial expectations of the
future profit. (This is known as Marginal
Efficiency of Capital (MEC) or expected
rate of return from Capital). This is the
Keynerian framework. Expectation is an
individuals guess about what is likely
61
to happen in the future. Firms invest

when they expect their investment will
be profitable, that is it will earn them
revenues greater than the costs of the
investment. An investment can then be
compared to a bet, that present and
future revenues will be greater than
present and future costs. In other words,
it is a bet that the investment will be
profitable. However, the future is
unknown and unpredictable. The firms
will thus have to make guesses and form
expectations about the future in order
to invest. Since investment depends on
expectations about unpredictable
future events it is very volatile.
The Investment Demand Curve
Of all the variables that affect investment
demand, the most important one is the
rate of interest. The relationship between
investment demand and the rate of
Table 5.4: Interest Rates and Investment

Project
Total size
of Project
(Rs. in Lakhs)
Annual net
revenue per
Rs.100
invested
Cost per Rs.100

of project at annual
interest rate of
(10%)
(5%)
Annual net
Profit per Rs.100
invested, at
annual interest
rate of
(10%)
(5%)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
150
10
140
145
22
10
12
17
10
16
10
11
10
13
10
11
10
15
10
10
10
20
10
62
interest is given by the investment

demand function. There is a negative
relationship between the rate of interest
and investment demand; that is, the
higher the rate of interest, the lower will
be the level of investment demand. The
following example will make the
inverse relationship between the two
variables clear.
Consider a simple economy where
firms have numerous investment
projects: project A, B, C, D, and so on
up to H. For simplicity, assume that,
(a) the projects yield a constant annual
stream of net revenues, (b) all
investments are financed purely by
borrowing at the market interest rate
and (c) the projects are so long lived that
there is no need for replacements. Table
5.4 shows the financial data for each of
the investment projects.
The eight investment projects shown
in the table are ranked in order of
return. Column (2) shows the total size
of the projects. Column (3) calculates
the annual net return each year per
Rs.100 invested. Columns (4) and (5)
show the cost of the investment per Rs.
100 of the project. These are assumed
to be two alternative market rates of
interest 10% and 5% per year. At 10%
annual interest rate, the cost of
borrowing Rs. 100 is Rs.10 per year.
At a 5% annual interest rate the cost of
borrowing Rs. 100 is Rs. 5 per year.
The last two columns show the
annual net profit (revenue cost) from
the investment. Now, the firms will
compare the annual revenues from an
investment with the annual cost of
capital, where the cost of capital
depends on the interest rate. The

difference between annual revenue and
annual cost is the annual net profit.
When annual net profit is positive, the
investment makes money. When the
annual net profit is negative, the
investment loses money. Therefore,
firms will undertake only those
investment projects which have positive
annual net profits.
Look at the last column of the Table
5.4. This gives the annual net profit
corresponding to a 5% interest rate. At
this interest rate, projects A to G will be
profitable. So profit-maximizing firms
will invest in all seven projects. From
column (2) we see that this totals up to
Rs.55 lakhs of investment demand.
Now suppose that the market rate
of interest increases to 10%. The cost
of financing the projects would then
double. From column (6) we see that
investment projects F and G become
unprofitable at an interest rate of 10%.
The firms would therefore reject these
two projects. Then the investment
demand will fall to Rs. 30 lakhs.
We see from this example that a rise
in the interest rate has reduced the
investment demand. This is because, at
higher interest rates, the costs of all
projects increase while the revenues of
all projects remain the same. Thus,
fewer projects remain profitable in the
face of the higher interest rate. Since
firms invest only in profitable projects,
the investment demand decreases as the
interest rate increases.
Government Expenditure
Government
expenditure
or
governments demand for goods and
AGGREGATE DEMAND
AND ITS
COMPONENTS
63
services is the third component of

aggregate demand. The level of
government expenditure is determined
by government policy. As we will see in
the next chapter, varying government
expenditure is an important tool for
demand management.
Net Exports
The fourth component of aggregate
demand is net exports. Net exports is
the difference between exports and
imports. It shows the effect of domestic
spending on foreign goods and services
(imports) and foreign spending on
domestic goods services (exports), on
the level of aggregate demand. When
foreigners purchase domestic goods
and services, it adds to the demand for

domestic goods and services and is
hence a part of aggregate demand.
Correspondingly, our spending on
foreign goods and services has to be
subtracted from the demand for
domestic goods and services in order
to get the correct figure for aggregate
demand.
The determination of income and
output in the Keynesian framework
depends mainly on the level of
aggregate demand. Having seen the
various components of aggregate
demand and their determinants, we are
now in a position to look at the
determination of income and output in
the Keynesian framework.
SUMMARY
l
l
l
l
l
l
l
l
l
l
l
l
The components of aggregate demand are consumption, investment,

government expenditure and net exports.
The relationship between consumption and income is called the consumption
function.
The slope of the consumption function, which measures the change in
consumption per unit change in income, is known as the marginal propensity
to consume.
That part of income, which is not consumed, is saved.
The relationship between savings and income is called the savings function.
The slope of the savings function, which measures the change in savings per
unit change in income, is known as the marginal propensity to save.
Investment means addition to the stock of capital goods in the nature of
structures, equipment or inventory.
Three elements important in understanding investment are revenues, costs
and expectations.
The relationship between investment demand and the rate of interest is known
as the investment demand function.
There is an inverse relationship between investment demand and the rate of
interest.
The governments expenditure on goods and services constitutes government
expenditure.
Net exports is the difference between exports and imports.
64
EXERCISES
1.
2.
3.
4.
5.
6.
7.
List the components of aggregate demand.

What is the consumption function?
What is the savings function?
Define the marginal propensity to consume.
Define the marginal propensity to save.
Which are the elements important in understanding investment?
What is the investment demand function?
APPENDIX 5.1: INVERSE
RELATIONSHIP BETWEEN THE INTEREST RATE
AND INVESTMENT DEMAND
As we know, investment causes an

addition to the capital stock, which
increases the productive capacity of the
economy. We assume that the state of
technology and employment are
constant.
An investment will be made only if
it is profitable. In other words, the
discounted value of the income which
the capital good will yield over its life
must be greater than the purchase price
of that capital good.
Suppose the proposed investment
is in a laddoo-making machine. The cost
of the machine is Rs.4329.40. The
machine is expected to produce a net
income (after deducting the operating
costs) of Rs.1000 per year over its life
span of five years. We can calculate the
Marginal Efficiency of Capital (MEC) as
follows:
For an income stream over n years the
formula is
C=
R3
R1
R2
R4
+
+
+
+
(1 + r ) (1 + r )2 (1 + r )3 (1 + r )4
R5
(1 + r )5
+ ..........
Rn
(1 + r )n
Where,
C = purchase price or cost of the
capital good
R1 = net income from the capital good
in the ith year.
r=
marginal efficiency of capital

The MEC is thus the rate of return
that equates the present value of the
returns from the capital good with its
cost. We may calculate the MEC of any
proposed investment given the
purchase price of the capital good and
the expected stream of net income over
the life of the capital good.
In our example, we get the MEC as
4329.40 =C
=
1000 1000
1000
+
+
+
(1 + r ) (1 + r )2 (1 + r )3
1000
(1 + r )
1000
(1 + r )5
Solving either through trial and

error method or with the help of
discounting tables we get the following
result,
r
= 0.05
= 5%
Thus, the marginal efficiency of
capital in our above example is 5%.
By comparing the MEC with the
market rate of interest, we can
determine whether the investment is
profitable or not. If MEC is greater than
the market rate of interest, then the
investment is profitable. If MEC is less
than the market rate of interest, than
the investment is unprofitable. The
market rate of interest is used as a
yardstick on two accounts:
66
l
If the firm has to use borrowed

money to finance the investment,
then the investment should yield a
return greater than the cost of the
borrowed funds (which is nothing
but the market rate of interest) in
order to be profitable.
If the firm is financing the
investment out of its own funds,
then it would be better off by lending
the amount at the market rate of
interest to someone else if the MEC
of the proposed investment is less
than the market rate of interest. Here
the market rate of interest is the
opportunity cost of the investment.
The return from the investment
must be greater than its
opportunity cost in order for it to
be profitable.
Marginal Efficiency Schedule

The relationship between investment
demand and the MEC is called the
marginal efficiency schedule (MEC
schedule) 1. The marginal efficiency
schedule for the economy as a whole
may be derived by aggregating the
marginal efficiency schedules of the
individual firms. Figure A5.1 shows the
marginal efficiency schedule for a
hypothetical firm. Suppose the most
profitable investment opportunity for a
firm is the purchase of a machine
costing Rs.1000, with an MEC of 10%.
The next most profitable investment
opportunity is the purchase of a new
small machine costing Rs.500, with an
MEC of 8%. The next most profitable
1
MEC in %
10
8
M
A
C
H
I
N
E
1000
SMALL MACHINE
PLANT
3000
Investment
expenditure
Fig A5.1: Marginal Efficiency Schedule

of a Firm
investment opportunity is the

expansion of the firms plant at a cost
of Rs.1500, with an MEC of 3%. These
projects are arranged in order
of decreasing profitability in
Figure A5.1.
The bold line in the diagram is the
firms marginal efficiency schedule. If
the MEC schedules for all firms are
added horizontally, we will get the
aggregate MEC schedule for the
economy. This will be a continuous
smooth curve because of the
aggregation.
The MEC schedule for a single firm
is based on the assumption that the
prices of capital goods are given.
However, when the individual MEC
schedules are added, then the capital
costs of the various investment projects
will not remain constant - it will go up.
The aggregate MEC schedule that takes
into account the increased costs of
capital goods will lie below the curve
This section draws on material from Principles of Macroeconomics By C. Rangarajan and B.H.
Dholakia, Tata McGraw-Hill Publishing Company, 2002.
AGGREGATE DEMAND
AND ITS
COMPONENTS
MEI in %
67
Investment Demand Schedule

The MEI schedule does not tell us how
much investment will be made. The
quantum of investment depends on the
rate of interest. Investment will be
pushed up to a level where the marginal
efficiency of investment will be equal to
the interest rate. Only this much, and
no more investment will be profitable.
Thus, by substituting the MEI by
the rate of interest we will have the
investment demand schedule. Figure
A5.3 shows the investment demand
Investment
schedule.
Fig A5.2 : The Marginal Efficiency of

Investment Schedule
which simply aggregates the individual

firms MEC schedules.
Such an aggregate schedule, that
takes into account the increased costs
of capital goods, is called the Marginal
Efficiency of Investment schedule (MEI
schedule). The concept of MEI for
investment for the economy as a whole
is analogous to the concept of MEC for
one firms investment project. The MEI
schedule will be downward sloping.
This means that the marginal efficiency
of investment falls as investment
increases. This is because with
increased investment, the diminishing
marginal productivity of capital will
reduce the prospective returns from
each successive unit of investment.
Figure A5.2 shows the marginal
efficiency of investment schedule.
The X-axis measures investment in
the economy as a whole and the Y-axis
measures the marginal efficiency of
investment.
Rate of
interest
Investment demand
Fig A5.3 :
The Investment Demand

Schedule
The X-axis shows the investment

demand in the economy, and the Y-axis
shows the rate of interest. If, at Rs.200
crores of investment, the MEI is 15%,
then at an interest rate of 15%, there
will be Rs.200 crores of investment. The
shape of the investment demand
schedule is thus the same as that of the
MEI schedule. Since the MEI schedule
is downward sloping, the investment
demand schedule is also downward
sloping. This shows the inverse
and the investment demand.
CHAPTER
DETERMINATION OF INCOME,
EMPLOYMENT AND OUTPUT
In the previous chapter we saw the
components of aggregate demand. In
the Keynesian framework, the
equilibrium level of output is
determined solely by the level of
aggregate demand. The first section of
this chapter will show the
determination of the equilibrium level
of output in the Keynesian framework.
Then, the concept and working of the
multiplier will be introduced. The
second section will deal with the
problems of excess and deficient
demand, followed by the measures to
correct these problems.
Determination of Equilibrium Level
of Output
We shall confine our analysis of the
determination of the equilibrium level
of output to an economy with only two
sectors, households and firms. Hence,
the only components of aggregate
demand will be consumption demand
and investment demand. The absence
of the government sector and the
foreign sector means that income
equals output, which is equal to Gross
National Product.
Output Determination by
Consumption plus Investment
Approach
We may show output determination
using the consumption plus investment
(C+I) approach. This is illustrated in Fig.
6.1, which shows total spending or
aggregate demand plotted against
output or income. The line CC is the
consumption function, showing the
desired level of consumption
corresponding to each level of income.
We now add desired investment (which
is at fixed level Io to the consumption
function. This gives the level of total
desired spending or aggregate demand,
represented by the C + Io curve. At every
point, the (C + Io) curve lies above the CC
curve by an amount equal to Io.
The 45 o line will enable us to
identify the equilibrium. At any
point on the 45o line, the aggregate
demand (measured vertically) equals
the total level of output (measured
horizontally).
The economy is in equilibrium
when aggregate demand, represented
by the C + I0 curve is equal to the
total output.
DETERMINATION
OF
INCOME, EMPLOYMENT
AND
OUTPUT
69
C&I
C+ Io
C
E
C + Io
Io
Io
C
45o
M
Q*
Output
Fig. 6.1: Output Determination by Consumption plus Investment approach
The aggregate demand (C + I0) curve

shows the desired level of expenditure
by consumers and firms corresponding
to each level of output. The economy is
in equilibrium at the point where the
C + I0 curve intersects the 45o line - point
E in Fig. 6.1. At point E, the economy is
in equilibrium because the level of
desired spending on consumption and
investment exactly equal the level of total
output. The level of output
corresponding to point E, is the level of
output 0M. Thus, 0M is the equilibrium
level of output.
The Adjustment Mechanism
Equilibrium occurs when planned
spending equals planned output. When
planned spending is not equal to
planned output, then output will tend
to increases or decreases until the two
are equal again.
Consider the case when the economy

is at a level of output greater than the
equilibrium level M in Figure 6.1. At any
such greater level of output, the C + Io
line lies below the 45o line, that is,
planned spending is less than planned
output. This means that consumers and
firms together would be buying less
goods than firms were producing. This
would lead to an unplanned, undesired
increase in inventories of unsold goods
(representing goods neither sold to
households for consumption nor
bought by firms for investment). Firms
would then respond to this unplanned
inventory increase by decreasing
employment and hence output. This
process of decrease in output will
continue until the economy is back at
output level M, where again aggregate
demand equals planned output and
there is no further tendency to change.
70
Consider another case when the

economy is at a level of output less
than the equilibrium level 0M. At any
such lower level of output, the C + Io
line lies above the 45o line, that is,
planned spending is more than
planned output. This means that
consumers and firms together would
be buying more goods than firms were
producing. This would lead to an

unplanned, undesired decrease in
inventories. Firms would then
respond to this unplanned inventory
decrease by increasing employment
and hence output. This process of
increase in output will continue until
the economy is back at output level
0
M, where again aggregate demand
Consumption
(C)
Consumption
Function
B
45
Q*
Savings
Function
Savings
(S)
Output
Q*
Output
Fig 6.2: The Consumption Function and the corresponding Savings Function
DETERMINATION
OF
INCOME, EMPLOYMENT
AND
OUTPUT
equals planned output and there is

no further tendency to change.
Output Determination Using the
Savings Functions and the
Investment Schedule
Savings Function
Figure 6.2 shows the consumption
function and the corresponding savings
function. Is it not similar to Fig. 5.2?
Recall that each point on the
consumption function shows desired or
planned consumption at that level of
income. Each point on the savings
function shows the desired or planned
saving at that income level.
The two functions are closely related,
since
income
always
equals
consumption plus saving. Therefore,
these can be called complementary
curves. The level of output 0Q* is the
full-employment level of output.
Investment schedule
We have seen in the previous chapter
that the level of investment demand
71
depends mainly upon the interest rate.

Here, however, for simplicity, we shall
assume that firms plan to invest exactly
the same amount every year, regardless
of the level of output.
If we plot on a graph the level of
investment demand at every level of
output (and therefore income), we will
have the investment schedule. Figure 6.3
shows the investment schedule.
Since firms plan to invest the same
amount Io regardless of the level of
output, the investment schedule will be
a horizontal line. This is because every
point on the investment schedule lies at
the same height above the horizontal
axis. That is, the level of investment
demand is the same at every level
of output.
Equilibrium Output
By examining the interaction of savings
and investment, we can find the
equilibrium level of output. Fig. 6.4
combines the savings function of Fig. 6.2
and the investment schedule of Figure 6.3.
Investment
(I)
Investment
o
Q*
Fig 6.3: The Investment Schedule
Output
72
We see that the savings function and

the investment schedule intersect at
point E. This point corresponds to a level
of output M, which is the equilibrium
level of output.
This intersection of the savings
function and the investment schedule
gives the equilibrium towards which,
output will gravitate.
Meaning of the Equilibrium
Point E is the point of intersection of the
savings function and the investment
schedule. Thus, only at point E will
planned savings of households equal
planned investment of firms. When
planned savings and planned
investment are not equal, output will
tend to adjust up or down till they are
equal again.
The savings function and the
investment schedule of Fig. 6.4
represent planned levels of savings and
investment respectively. Thus, at output
level 0M, firms plan to invest an amount
equal to ME. Also, households plan to
save an amount equal to ME. However,

in general, there is no necessity for actual
saving (or investment) to be equal to
planned saving (or investment). This
may be due to mistakes, incorrect
forecasting of events, or for a variety of
other reasons. In any case, actual
savings or investment might be different
from planned savings or investment.
We will look at the mechanism of
how output adjusts until planned
savings and planned investment are
equal, under three separate cases.
The first case is where the economy is
at a level of output equal to 0M. At this level
of output, planned savings of households
equals planned investment of firms. Since
the plans of households and firms are
satisfied, they will be content to continue
doing exactly what they had been doing
till then. Thus, output, employment and
income will remain the same. In this case,
it is rightly called an equilibrium.
The second case is where the
economy is at a level of output greater
than 0M. At the corresponding level of
Savings,
Investment (S,I)
Savings
function
E
Io
O
Output
Fig 6.4: Intersection of the Savings Function and the Investment Schedule
DETERMINATION
OF
INCOME, EMPLOYMENT
AND
OUTPUT
income, the savings function lies above

the investment schedule. Therefore, at
this level of income households are
saving more, that is, they are refraining
from consuming by an amount greater
than firms are investing. The effect of this
will be to cause an undesired,
unplanned build-up of inventories of
unsold goods. The effect of an undesired,
unplanned inventory build-up is to
increase the actual level of investment
to a level greater than the planned level
of investment.1 Since firms plans have
not materialized, they will act in order
to correct the situation. In order to
reduce the unsold inventories to the
desired level firms will cut back
production and reduce employment.
The effect of this will be to reduce output
until the economy returns to
equilibrium at output level 0M, where
planned savings equals planned
investment, equals actual investment,
and there is therefore no further
tendency to change.
The third case is where the economy
is at a level of output less than 0M. At the
corresponding level of income, the
savings function lies below the
investment schedule. Therefore, at this
level of income households are saving an
amount less than firms plan to invest.
Households are thus, refraining from
consuming by an amount less than firms
plan to invest. The effect of this will be to
cause an unplanned, undesired
reduction in inventories of unsold goods.
Thus, the actual level of investment will
be less than the planned level of
1
73
investment. Again, since firms plans have

not materialised, they will act in order to
correct the situation. In order to increase
inventories to the desired, planned level,
firms will increase production and
increase employment. The effect of this
will be to increase output till the economy
returns to output level 0M, where planned
savings equal planned investment,
planned investment equals actual
investment, and there is thus no further
tendency to change.
All three cases lead to the same
inference. The only equilibrium level of
output is M, where planned saving
equals planned investment. At any other
level of output, the discrepancy between
planned saving and planned investment
will cause firms to change their
production and employment levels,
thereby returning the economy to the
equilibrium output and employment.
Planned versus Actual Amounts
Till now we have repeatedly used the
words planned or desired and actual
amounts of consumption, investment,
output, etc. There is a difference between
(a) the amount of planned or desired
consumption or investment, given by the
consumption function or by the
investment demand function, and (b) the
actual amounts of consumption or
investment that is measured after the
accurrence.
The distinction between the two
emphasises the fact that output is at
equilibrium only when firms and
consumers are actually on their
schedules of desired spending and
Actual investment equals planned investment plus unplanned investment. The unplanned investment
changes due to unplanned inventory increase or decrease.
74
investment. As measured by the National

Income Accounts, savings will always be
identically equal to investment in a twosector economy. This is because
C+SYC+I
YC+I
and
Y C + S,
C +S C + I
Therefore, S I.
However, actual investment will differ
from planned investment when actual
sales are unequal to planned sales and
firms thus face an unplanned build-up
or reduction in inventories. Only when
the level of output is such that aggregate
demand equals planned output will
there be no tendency for output, income
and employment to change.
A Numerical Example
A numerical example will show why the
equilibrium level of output occurs
when planned spending and planned
output are equal. Table 6.1 shows an
example using a consumption function

and the associated savings function.
The consumption function is
C = 1000 + 0.67Y
The associated savings function is
S = -1000 + 0.33Y
Column (2) represents the level of
planned consumption at various levels
of income. The values in column (2) are
derived from the consumption function
used above. Column (3) represents the
levels of planned saving at various levels
of income. The values in column (3) are
derived from the savings function used
above. Column (5) is a reproduction of
column (1). Column (6) shows the level
of aggregate demand at various levels of
income it is the sum of consumption
demand in column (2) and investment
demand in column (4). It shows what
firms actually manage to sell.
The level of income at which
consumption is exactly equal to income
(that is, all income is consumed), and
Table 6.1: Determination of Output (All Figures in Rs. Crores)

Output and
Income
Planned
consumption
Planned
Saving
(3)=(1)(2)
Planned Output and

InvestIncome
ment
(5) = (1)
Aggregate
Tendency
Demand of Output to
(6)=(2)+(4)
(1)
(2)
(3)
(4)
(5)
(6)
4200
3800
400
200
4200>
4000
Decrease
3900
3600
300
200
3900>
3800
Decrease
3600
3400
200
200
3600=
3600
Equilibrium
3300
3200
100
200
3300<
3400
Increase
3000
3000
200
3000<
3200
Increase
2700
2800
-100
200
2700<
3000
Increase
(7)
DETERMINATION
OF
INCOME, EMPLOYMENT
AND
OUTPUT
therefore, savings is exactly equal to zero

is known as the break-even level of
income. In our example, the breakeven
level of income is Rs.3600 crores.
Now, each change of income of
Rs.300 crores causes a change of Rs.100
crores in saving, and a change of Rs.200
crores in consumption. Thus, MPS is a
constant and is equal to 1/3 and MPC is
a constant and is equal to 2/3.
Investment is assumed to be
exogenous. Firms plan to invest a
constant amount of Rs.200 crores as
shown in column (4). That is, at each
level of income, firms plan to purchase
Rs.200 crores of investment goods.
Consider the top row of the Table 6.1.
If firms are producing Rs.4200 crores of
output, then the planned spending or
aggregate demand is only Rs.4000
crores. In this situation, there will be an
unplanned accumulation of inventories
to the tune of Rs.4200 crores Rs.4000
crores = Rs.200 crores. Firms will respond
to this unplanned inventory build-up by
sealing down their operations and thus
output will decrease.
The opposite case is represented by
the bottom row of Table 6.1. Here, firms
are producing Rs.2700 crores of output
but aggregate demand is Rs.3000
crores. In this situation, there will be
an unplanned decrease in inventories
to the tune of Rs.3000 crores Rs.2700
crores = Rs.300 crores. Firms will
respond to this unplanned inventory
decrease by expanding their operations,
thus causing an increase in output.
Thus, when firms as a whole are
temporarily producing more than they
can sell, they will contract their
75
operations, causing output to fall.

When they are temporarily selling more
than their current production, they will
expand their operations, causing
output to rise.
Only when the level of output in
column (5) is equal to aggregate
demand in column (6) will output be in
equilibrium. Firms sales will be just
enough to justify continuing their
current level of aggregate output. Thus,
aggregate output will neither expand
nor contract, and will be in equilibrium.
The equilibrium level of output in our
example is Rs.3600 crores.
The Multiplier
A change in the investment spending
will affect output and therefore
employment. It is logical that an
increase in fixed investment will increase
the level of output and employment
through increase in productive
capacity. Conversely, a decrease in
investment will decrease the level of
output and employment.
The operation of the multiplier
ensures that a change in investment
causes a change in output by an
amplified amount, which is a multiple
of the change in investment.
The multiplier is the number by
which the change in investment must
be multiplied in order to determine the
resulting change in output.
For example, if an increase in
investment of Rs.100 crores causes an
increase in output of Rs.300 crores,
then the multiplier is 3. If, instead the
resulting increase in output is Rs.400
crores, then the multiplier is 4.
76
We may derive an expression for the

multiplier as follows:
At equilibrium, we have
Y=C+I
i.e., income equals the sum of
consumption plus investment.
We can use the consumption
function to substitute C with the
expression C +bY, to give
Y
= C + bY + I
so Y bY = C + I
or, Y (1b) = C + I
or, Y =
1
( + I)
(1 b) C
Since b is nothing but the MPC, we

have
Y=
1
( + I)
(1 MPC) C
To find out the effect of a change in

investment on income, we differentiate
the equation to obtain
1
I
(1 MPC)
So, (Change in Income) = (Multiplier)
(Change in Investment)
The multiplier is equal to 1/(1MPC).
It is the number by which the change in
investment must be multiplied in order
to determine the resulting change
in output.
As we can see, the size of the
multiplier depends on value of the MPC.
Since 0 < MPC < 1, the multiplier
will be greater than 1. Hence, a change
in investment will cause a multiple
change in output.
Y =
The actual size of the multiplier

depends on the value of MPC. For
example, if MPC is 2/3, then the
multiplier is 3. If MPC be at 4/5, the
multiplier is 5.
A numerical example will enable us
to see the operation of the multiplier.
Let the MPC be at 4/5. Suppose there
is an increase in investment of Rs.1000,
which results in the construction of a
new building. Then, the builder, the
architect and the labourers together will
get an increase in income of Rs.1000.
Since the MPC is 4/5, they will together
spend 800 (4/5 of Rs.1000) on new
consumption goods. The producers of
those consumption goods will thus have
an increase of Rs.800 in their incomes.
Since their MPC is also 4/5, they will in
turn spend Rs.640 (4/5 of Rs.800, or
4/5 of 4/5 of Rs.1000). This will cause
an increase in income of other people
by Rs.640. This process will go on, with
each new round of spending (and
therefore increase in income) being 4/5
of the previous round.
Thus, an endless chain of secondary
consumption spending is set in motion
by the primary investment of Rs.1000.
However, not only is the chain of
secondary consumption spending
endless, it is also ever-diminishing.
Eventually, the sum of the secondary
consumption expenditures will be a
finite amount.
We can calculate the total increase
in consumption plus investment
spending and therefore the total
increase in income as follows:
Rs. 1000
= 1 Rs.1000
+
+
Rs.800
4/5 Rs.1000
DETERMINATION
OF
INCOME, EMPLOYMENT
AND
OUTPUT
+
Rs. 640
+
Rs. 512
+
Rs. 409.6
+
..
.
Rs. 5000
+
(4/5)2 Rs. 1000
+
(4/5)3 Rs. 1000
+
(4/5)4 Rs. 1000
+
..
.
[1/{1-(4/5)}] Rs. 1000
Multiplier
We have said that the chain of
secondary consumption spending is an
endless ever-diminishing chain, whose
sum is a finite amount.
We may find the sum of the total
increase in spending by using the
formula for the sum of an infinite
geometric progression.
The sum of the total increase in
spending and the total increase in
income is:
Y=
1 Rs.1000 + (4/5) Rs.1000

+ (4/5)2 Rs.1000 + (4/5)3
Rs.1000 +
Y=
Rs.1000 + [ 1 + (4/5) + (4/5)2 +

(4/5)3 +...}
The term in square brackets is of the

form of the sum of an infinite geometric
progression, whose first term is 1 and
where constant multiplier r is 4/5.
The formula for the sum of such
an infinite geometric progression is
1/(1r). In our case,
r = 4/5, therefore the sum of the
geometric progression is
1/[1 (4/5)] = 5
Replacing the term in the square
brackets by 5, we have
Y = Rs. 1000 x 5
77
Y = Rs. 5000
We can see that with an MPC of 4/5,
the multiplier is 5.
We may also express multiplier in
terms of the marginal propensity to
save, that is MPS.
Multiplier =
1
1 MPC
Since MPS= 1 MPC, we have

Multiplier =
1
MPS
i.e., if MPS were 1/x, then the

multiplier would be x.
In our example, the MPS is 1/5. Let
the investment expenditure increase by
Rs.1000 crores. Planned saving will have
to rise till it equals the new and higher
level of investment, in order to bring
output to a new equilibrium. The only
way that saving can rise is for income to
rise. With an MPS of 1/5 and an increase
in investment of Rs.1000 crores, income
must rise by Rs.5000 crores to bring to
forth Rs.1000 crores of additional saving
to match the new investment. Hence, at
equilibrium, Rs.1000 crores of
additional investment induces Rs.5000
crores of additional income, in line with
our multiplier arithmetic.
Problems of Excess and Deficient
Demand and Measures to Correct
Them
Thus far, we have studied the
determination of output, income and
employment in the Keynesian
framework. The equilibrium level of
output, income and employment were
determined solely by the level of
78
rise to a deflationary gap, which causes

the economys income, output and
employment to decline, thus pushing
the economy into an under employment equilibrium. Figure 6.5
depicts the situation of deficient
demand.
The Y-axis measures consumption
demand, investment demand, and their
sum the aggregate demand. The X-axis
measures the level of output and
income. OQ* is the full employment level
of output and income. (C+I)o and (C+I)1,
are two parallel aggregate demand
curves, differing only by the amount of
investment expenditure.
For the economy to be at a fullemployment equilibrium, the aggregate
demand should be for a level of output
equal to the full-employment level of
output OQ*. In other words, aggregate
aggregate demand. The economy will

be in full-employment equilibrium if the
aggregate demand is for an amount of
output that is equal to the fullemployment level of output. If the
aggregate demand is for an amount of
output less than the full employment
level of output, then it is known as
deficient demand. If the aggregate
demand is for a level of output more
than full-employment level of output,
then it is known as excess demand. We
will take up the problems of and
remedies for excess and deficient
demand individually.
Problem of Deficient Demand
If aggregate demand is for a level of
output less than the full-employment
level, then a situation of deficient
demand exists. Deficient demand gives
Aggregate
Demand
(C + I)1
F
(C + I)o
G
E
Deflationary
Gap
45o
M
Q*
Fig 6.5: Deficient Demand
Output & Income
DETERMINATION
OF
INCOME, EMPLOYMENT
AND
OUTPUT
demand should be equal to Q*F. The

economy will then be in a full
employment equilibrium, corresponding
to the point F on the aggregate demand
curve (C+I)1, and the economy
will produce full-employment level of
output OQ*.
Suppose, however, that the
aggregate demand is for a level of
output Q*G. Q*G is less than Q*F. Then
aggregate demand is for a level of
output which is less than the fullemployment level. This level of
aggregate demand corresponds to point
G on the aggregate demand curve (C+Io ).
This results in a situation of deficient
demand. The resulting deflationary gap
created due to deficient demand is
represented in Figure 6.5 by FG.
The deflationary gap is the difference
between the actual level of aggregate
demand, and the level of aggregate
demand required to establish the fullemployment
equilibrium.
The
deflationary gap is a measure of the
79
amount of deficiency of aggregate

demand.
The deflationary gap will set in
motion forces that will cause a decline
in the economys output, income and
employment. At point G, the aggregate
demand curve (C+Io) lies below the 45o
line. As a result, the aggregate demand
Q*G is less than the level of output OQ*.
Firms will experience an unplanned
build-up of inventories of unsold goods.
They will respond by reducing
employment and cutting back
production. This will reduce the
economys output, income and
employment, until a new equilibrium
is reached at point E. This is an
equilibrium, because the aggregate
demand EM is equal to output OM
(since point E lies on the 45o line).
It will be noted that point E is an
under-employment equilibrium. The
equilibrium levels of output, income
and employment corresponding to
point E are less than the full
Aggregate
Demand
Inflationary Gap
E
(C + I)1
(C + I)0
45o
Q*
Fig 6.6: Excess Demand
Output & income
80
employment levels of output, income

and employment corresponding to
point F. Thus, the deficient demand
caused deflationary gap has pushed the
economy into an under-employment
equilibrium.
Problem of Excess Demand
If aggregate demand is for a level of
output more than the full employment
level, then a situation of excess demand
exists. Excess demand gives rise to an
inflationary gap, which causes a rise
in the price level or inflation. Figure 6.6
depicts the situation of excess demand.
The X-axis measures the level of
output and income. The Y-axis measures
consumption demand, investment
demand, and their sum, the aggregate
demand. 0Q* is the full employment level
of output and income. (C+I)o and (C+I)1,
are two parallel aggregate demand
curves, differing only by the amount of
investment expenditure.
The economy will be in a fullemployment equilibrium at point F on
the aggregate demand curve (C+I) o, and

the economy will produce fullemployment level of output OQ*.
While analysing the output-cumincome axis, one important point must
be kept in mind. The axis measures
nominal output and income. Due to the
peculiar shape of the Keynesian,
aggregate supply curve (reproduced in
Figure 6.7) prices are rigid till the fullemployment level of output. Thereafter,
the aggregate supply curve becomes
perfectly inelastic with respect to prices.
This
has
the
following
repercussions on the analysis of the
output-cum-income axis of Figure 6.6.
Uptil point Q*, increases in nominal
income and output correspond to
increases in real income and output
(since prices are constant). Beyond
point Q*, increases in nominal income
and output do not correspond to any
change in real income and output. This
is because real income and output
cannot increase beyond the full
employment level, as all resources are
Price
Level
Q* is the full employment
level of output.
Output
Fig 6.7: Keynesian Aggregate Supply Curve
DETERMINATION
OF
INCOME, EMPLOYMENT
AND
OUTPUT
already fully employed. The increases

in nominal income and output are
merely due to increases in the price level.
Suppose that the aggregate
demand is for a level of output Q*G,
which is greater than the fullemployment level of output. This level
of aggregate demand corresponds to
point G on the aggregate demand curve
(C+I)o. This is a situation of excess
demand. The resulting inflationary gap,
created due to the excess demand is
represented in Figure 6.6 by FG.
The inflationary gap is the amount
by which the actual aggregate demand
exceeds the level of aggregate demand
required to establish the full-employment
equilibrium. The inflationary gap is a
measure of the amount of the excess of
aggregate demand.
The inflationary gap is so called
because it sets in motion forces that will
cause inflation or a rise in the price level.
At point G, the aggregate demand curve
(C+I)o lies above the 45o line. As a result,
the aggregate demand Q*G is greater
than the level of output OQ*. The effect
of this will be to create demand pull
inflation (an aggregate demand induced
rise in the price level). The rise in price
level, given the constant real output, will
cause an increase in the nominal
output until a new equilibrium is
reached at point E. This is an
equilibrium because the aggregate
demand ME is equal to the output OM
(since point E lies on the 45o line).
It will be noted that the real output
and real income are the same at the new
2
3
81
equilibrium E. Correspondingly, the

equilibrium level of employment also is
the same. All that has happened is that
nominal output and income have
increased due to an increase in the price
level. Thus, the excess demand caused
an inflationary gap, which caused
inflation, and therefore, the price level to
rise. In other words, the economy remains
at a full-employment equilibrium,
although at a higher price level.
The Government Sector
Before entering into a study of the
measures to correct the problems of
excess and deficient demand, it will be
necessary to include the government
sector in the economy. Then the
economy under consideration becomes
a three-sector economy; the three
sectors being households, firms and
government. It is well known that fiscal
policy (Government expenditure and
tax programmes) has a major impact
on economic activity, specifically on
output, employment and prices. In fact,
it is this knowledge that led to the
Keynesian policy of demand
management through fiscal policy in
order to correct excess of or deficiency
of aggregate demand.
To simplify the analysis, we may
focus on the effects of government
expenditure with the total taxes collected
held constant.2 In the face of taxes,
consumption is no longer a function of
income Rather, consumption is a
function of disposable income.3 However,
under simplifying assumptions
Taxes that do not change with income or other economic variables are called lump sum taxes.
Disposable income equals income minus taxes.
82
Aggregate
Demand
Inflationary Gap
(C + I)1
(C + I)0
F
45o
Q*
Output, income
Fig 6.8: Effect of Constant Tax on Consumption Function
(absence of foreign trade, transfers,

depreciation, etc.) we have output equals
disposable income plus taxes. Since tax
revenues are held constant, output and
disposable income will always differ by
the same amount. Thus, after taking into
account such taxes, we can still plot the
consumption function against output,
rather than against disposable income.
We may plot the new consumption
function as a parallel downward shift of
the old consumption function. The
justification of this is as follows. In the
face of constant taxes, at every income
level the disposable income will be less
than the income level by the constant
amount of the tax. The effect of this
uniformly lower disposable income
level is to cause a uniformly lower level
of consumption. The decrease in
consumption at every income level will
be an amount MPC times the reduction
in income. This is because MPC is the
change in consumption for a given
change in income. If income is reduced
by the amount of tax, then consumption
will be reduced by an amount equal to

MPC times the tax.
Algebraically, the new consumption
function is
C1 = C + b (Yd)
Where Yd is disposable income
C1 = C + b (YT)
where T is constant taxes
C1 = C + bY - bT
C1 = C bT
where C is the old consumption function
i.e. C = C + bY,
Finally, we get C - C1 = bT
This equation may be interpreted as
follows:
The new consumption function is
uniformly less than the old
consumption function by an amount
equal to the MPC times the decrease in
income (i.e., the constant tax T). Since
b and T are constants, we have the term
bT being a constant. Therefore, we can
DETERMINATION
OF
INCOME, EMPLOYMENT
AND
OUTPUT
depict the new consumption function

as a parallel downward shift of the old
consumption function. The amount of
the downward shift will be bT. The new
consumption function is depicted
in Fig. 6.8.
C is the old consumption function.
C1 is the new consumption function
in the face of taxes.
This is as regards the effect of taxes
on consumption demand. We may now
turn to the effect of government
expenditure G on aggregate demand.
Recall that in a three-sector economy,
where the three sectors are households,
firms and government; aggregate
demand is equal to the sum of
consumption, investment and
government expenditure. Figure 6.9
shows the effect of G on aggregate
demand. For simplicity, we consider
government expenditure to be a
83
constant amount. The new aggregate

demand curve C+I+G lies parallel above
the old aggregate demand curve C+I.
This is because, at every level of output
the vertical distance between the C+I
curve and the C+I+G curve is the
constant amount of government
expenditure.
Thus, the inclusion of government
expenditure in aggregate demand
causes a parallel upward shift by an
amount G, in the aggregate demand
curve.
We are now in a position to return
to the measures that can be taken to
remedy the problems of excess and
deficient demand. In the following
discussion, aggregate demand will be
taken to mean the sum of
consumption, investment and
government expenditure, since we are
now considering a three-sector
Aggregate
demand
C+I+G
G
C+I
45o
Output
Fig 6.9: The Effect of Government Expenditure on Aggregate Demand
84
Aggregate
Demand
F
C+I+G
E
Deflationary Gap
45o
M
Output
Fig 6.10: Deficient Demand in a Three-sector Economy
economy. This modification to the

definition of aggregate demand does
not however change the nature of or
definition of excess and deficient
demand.
We will first consider the remedy to
the problem of deficient demand.
Remedy for Deficient Demand
As we have seen earlier, if aggregate
demand is for a level of output less than
the full employment level of output, then
a situation of deficient demand exists.
Figure 6.10 depicts the situation of
deficient demand in the context of the
three-sector economy.
In order to remedy the problem of
deficient demand, the aggregate
demand has to be increased by an
amount equal to the deflationary gap.
This will move the economy to the full
employment equilibrium at point F.
The aggregate demand may be

increased by taking recourse to fiscal
policy, monetary policy or both.
Fiscal Policy Measures
We shall first consider the fiscal policy
measures to increase aggregate demand.
This may be done by either increasing
the level of government expenditure, or
by reducing the amount of taxes. If the
government expenditure is increased by
an amount equal to the deflationary gap,
it will restore the economy to the fullemployment equilibrium. This increase
in government expenditure is shown in
Figure 6.11.
The new level of aggregate demand
is C+I+G1 corresponding to a higher
level of government expenditure G1.
This level of aggregate demand is
sufficient to keep the economy at the
full employment equilibrium, thus
DETERMINATION
OF
INCOME, EMPLOYMENT
AND
OUTPUT
85
may be increased, thus combating the

problem of deficient demand.
eliminating the problem of deficient

demand. Thus,increase in government
expenditure by an amount FG will
eliminate the problem of deficient
demand.
The other fiscal policy measure that
will increase aggregate demand is the
reduction in the level of taxes. A
reduction in the level of taxes will
increase the disposable income by the
amount of the reduction in taxes. As a
result, consumption demand will
increase by an amount of MPC times
the increase in disposable income. The
increase in consumption demand will
increase the aggregate demand by an
equal amount. Thus, by lowering the
taxes, the aggregate demand may be
increased.
This way, by a mix of fiscal policy
measures of increasing government
expenditure and decreasing the level of
taxes, the level of aggregate demand
Monetary Policy Measures

The problem of deficient demand can
also be solved by taking resort to
monetary policy measures. The aim of
the monetary policy measure is to cause
an increase in the investment
expenditure by firms. This may be done
in a two step manner. The first step is
to increase the availability of credit. This
may be done by reducing the reserve
ratios, thus giving commercial banks
greater ability to create credit. The next
step is to lower the interest rate by
increasing the supply of money. The
purpose of this step is to ensure the off
take of the increased credit by firms.
Recall that there is an inverse
and the level of investment demand. If
the economys Central Bank4 lower the
Aggregate
demand
C+I+G1
F
C+I+Go
45o
M
Output
Fig 6.11: Increase in Government Expenditure

4
Reserve Bank of India (RBI) is the Central Bank for the Indian Economy.
86
C+I+G
Aggregate
Demand
E
G
C+I+G
Aggregate
Demand
E
G
C1+I+G
Inflationary Gap
45o
M
Q*
Output
C1+I+G
Inflationary Gap
45o
M
Q*
Output
Fig 6.12 Excess Demand in the Context of the Three-sector Economy
interest rate, then there would be an

increase in investment demand.
This increase in investment demand
would cause an increase in aggregate
demand. Thus, by sufficiently lowering
the interest rate, the Central Bank may
increase investment demand and
therefore aggregate demand, until the
economy is restored to a fullemployment equilibrium.
Remedy for Excess Demand
As we have seen earlier, if aggregate
demand is for a level of output greater
than the full employment level of output,
then a situation of excess demand
exists. Figure 6.12 depicts the situation
of excess demand in the context of the
three-sector economy.
In order to remedy the problem of
excess demand, the aggregate demand
has to be reduced by an amount equal
to the inflationary gap. This will keep
the economy at full employment

equilibrium but will lower the price level
and thus combat the inflation. The
aggregate demand may be reduced by
taking recourse to fiscal policy or to
monetary policy.
Fiscal Policy Measures
The fiscal policy measures to reduce
aggregate demand are (a) reducing the
government expenditure, and (b)
increasing the amount of taxes. For
example, where tax was uniformly
Rs.300 crores at every level of income,
it may be increased to say Rs.400
crores at every level of income. If the tax
rate is increased it will uniformly
reduce the disposable income, thus
causing a parallel downward shift of the
consumption function. Consequently,
the level of aggregate demand will fall.
If the amount of taxes is increased
sufficiently so that aggregate demand
DETERMINATION
OF
INCOME, EMPLOYMENT
AND
OUTPUT
falls enough to eliminate the inflationary

gap, then the economy will come back
to the full employment equilibrium,
without inflation.
In Figure 6.12, if taxes are raised
such that aggregate demand falls from
C+I+G to C1+I+G, then the price level
falls and inflation is successfully
combated.
Thus, reduction of aggregate demand
by an amount GF through the mechanism
of increasing the taxes eliminates the
problem of excess demand.
Alternatively, the level of aggregate
demand may be reduced by reducing
the amount of government expenditure.
A mix of fiscal policy measures of
reducing government expenditure and
increasing the taxes are employed to
combat excess demand.
Monetary Policy Measures
Contrary to keynesian emphasis on
87
fiscal measures for correcting encess/

deficient demand, the monetary policy
measure to combat the problem of
excess demand will operate through a
reduction in the investment demand by
firms. Recall that there is an inverse
and the level of investment demand. If
the economys Central Bank were to
increase the interest rate, then there
would be a decrease in investment
demand.
This decrease in investment
demand would cause a decrease in
aggregate demand. Thus, by
sufficiently raising the interest rate, the
Central Bank may decrease
investment demand and therefore,
aggregate demand, until the
inflationary gap is eliminated, and the
price level reduced.
SUMMARY
l
l
l
l
The equilibrium level of income is that level of income where the aggregate
demand equals the level of output, and the level of planned savings equals
planned investment.
A situation of deficient demand arises if the aggregate demand is for a level of
output that is less than the full-employment level of output. This gives rise to
a deflationary gap.
A situation of excess demand arises if the aggregate demand is for a level of
output that is more than the full-employment level of output. This gives rise
to an inflationary gap.
The introduction of government sector means that aggregate demand is now
equal to the sum of consumption, investment and government expenditure.
The government sector impacts the level of aggregate demand through both
government expenditure and taxes.
Excess and deficient demand may be corrected through fiscal policy and
monetary policy measures.
88
EXERCISES
1.
2.
3.
4.
5.
6.
7.
What is equilibrium income?

What is the difference between planned and actual investment?
What is multiplier?
What is deficient demand?
What is excess demand?
How does the introduction of the government sector affect the
economy?
How can the problems of excess and deficient demand be combated?
UNIT-IV
MONEY
AND
BANKING
CHAPTER
MONEY
AND
Money plays an important role in the

economic system we see the use of
money at every step of life indeed it
would be hard to imagine life without
money! The main function of money in
an economic system is to facilitate the
exchange of goods and services, i.e. to
lessen the time and effort required to
carry on trade.
Imagine Robinson Crusoe living
alone on an island. He produces all the
goods and services he requires for his
consumption. Of what use is money to
him? He cannot eat it, wear it or use it
to exchange goods and services with
others remember he is alone on the
island.
Now suppose that he is joined on
the island by ten of his friends. All eleven
of them would be engaged in the
production of the goods and services
they require for their consumption. It
is likely that each one of them would
be proficient in the production of one
particular good and only average in the
production of the others. It would be
advantageous to the group as a whole
if each one specialised in the production
of the good or service in which he or
BANKING
she was most proficient. This

specialisation would result in a supply
of goods and services of the best
possible
quality
under
the
circumstances.
The need would then arise for each
one to exchange his or her good or
service for the goods and services of the
others. How would they exchange the
goods and services? The simplest
possible method would be to directly
exchange one commodity for another.
This exchange of goods for goods is
called barter exchange. In the above
limited context of exchange between
only eleven people, barter exchange
could take place with minimum loss of
time and effort. Let us call this economy
the C-C economy, i.e. commodity for
commodity exchange economy.
As the group becomes larger and
larger, problems begin to emerge with
this direct exchange of goods for goods.
The larger the group, the greater will
be the trading costs of barter exchange.
Trading costs are nothing but the cost
of engaging in trade. There are two
components of trading costs. One is the
search cost the physical cost of
MONEY
AND
BANKING
searching for a person willing and

prepared for the exchange of goods (it
can be thought of as the opportunity
cost of not producing more goods in the
time spent searching, or it may be
thought of as the cost of the
deterioration in the good and its adverse
effect on its desirability during the time
spent searching). The second
component is the disutility of waiting
as perceived by the individual during
the search period. More time and effort
will have to be spent in searching for
the person who both needs the good
you have more than anything else and
has the good that you need more than
anything else, simply because there are
now more people to canvass. The longer
you spend searching for such a person,
the greater will be the search cost.
A possible solution to this problem
would be to use a commonly accepted
good as the medium of exchange. The
medium of exchange has to be
commonly accepted in order to facilitate
exchange. This will reduce the trading
cost substantially by removing the
necessity of simultaneously finding the
preferred buyer with the preferred
commodity. This simultaneous
fulfilment of mutual wants by buyers
and sellers is known as double
coincidence of wants. It is the difficulty
of coming across double coincidence of
wants that makes direct barter (direct
exchange of goods for goods) inefficient
in large groups. In the past many
communities have used articles such
1
91
as seashells, pearls, precious stones,

livestock, etc. as medium of exchange.
However, even this system will not
reduce to the maximum possible extent
the difficulties and costs of commodity
exchange. This is because barter has
certain inherent deficiencies as will be
discussed later in this chapter.
The main purpose of money is then
to enable trade to be carried on as
cheaply as possible in order to enable
the maximum degree of specialisation
and therefore, the maximum amount
of productivity. Modern economies
are highly specialised in their respective
field. There is specialisation of firms, of
businesses, of regions, of types of
capital, etc. Such specialisation allows
the utilisation of each person to the best
of his or her ability and skill, each
region to the maximum advantage, and
the use of large amounts of specialised
capital to reap economies of scale. The
fruits of this are high standards of living
and productivity. All this specialisation
will not be possible without an equally
highly developed system of exchange
and trade, i.e. the use of money.
Barter Exchange
Prior to the introduction of money as
it is known today, trade was carried
out by barter, i.e. exchange of goods
for goods1. Due to the wasteful nature
of barter, the amount of trade that
could be carried out by this method
of exchange was limited. The utility
gained from trade would be
outweighed by the utility lost in the
The following three sections draw on materials from The Economics of Money and Banking by
Stephen M. Goldfeld and Lester V. Chandler, Harper and Row, 8th Edition, New York, 1981.
92
process of making the trade. The

following will explain the difficulties
involved in barter exchange.
The first main drawback of barter
is the absence of a common unit in
terms of which can be measured the
values of goods and services. The value
of a good or service means the amount
of other goods and services with which
it can be exchanged for in the market.
The lack of a common unit meant that
no proper accounting system was
possible. The value of each good and
service would have to be expressed not
just as one quantity but in as many
quantities as there are kinds and
qualities of other goods and services in
the market. If there were 1000 goods
and services in the market, then the
value of each would have to be
expressed in terms of 999 others.
Secondly, under barter there was
the lack of double coincidence of wants.
It would be a rare occasion when the
owner of some goods or services could
find someone else who both wanted the
formers good or service more than
anything else and possessed that good
or service that our trader wanted more
than anything else. Consider a situation
where a person desires to exchange his
cow for a bullock cart. His problem is
that he has to find a provider of a
bullock cart either new or pre-existing
that matches the required
specifications, who wants exactly the
kind of cow that the person is offering.
This type of chance, discovery of a
bullock cart provider would be a rare
occurrence. The person would most
likely have to make some intermediate

transactions cow for horse, horse for
boat, boat for sheep and finally sheep
for the desired bullock cart; or he would
have to accept something less desirable
than the bullock cart.
Thirdly, the barter system lacks any
satisfactory unit to engage in contracts
involving future payments. Contracts
requiring future payments are
commonplace in any exchange
economy we enter into agreements
regarding wages, salaries, interests,
rents etc. and other prices extending
over a period of time. In a barter
economy future payments would have
to be stated in terms of specific goods
or services. This leads to the following
problems:
l
There could be disagreement
regarding the quality of the goods
or services to be repaid.
l
There could be disagreement
regarding which specific commodity
would be used for repayment.
l
The risk exists that the commodity
to be repaid could increase or
decrease markedly in value over the
duration of the contract, thus
benefiting the creditor or the debtor
respectively.
Fourthly, the barter system does
not provide for any method of storing
generalised purchasing power. People
can store purchasing power for future
use by holding stocks of certain
commodities to be exchanged for other
commodities later. This holding of
stocks of certain commodities is subject
to certain problems such as costly
storage, deterioration or appreciation in
MONEY
AND
BANKING
the value of the stored commodity, or

difficulty in quickly disposing of the
commodity without loss if the owner
wants to buy something else.
Due to the above four disadvantages
of the barter system, the exchange
process tends to be highly inefficient. It
was to overcome these difficulties that
money, as we understand it today, was
invented by society. This was
necessitated by the increasing scale of
industrialisation and commercialisation,
which warranted the monetisation
of transactions.
Functions of Money
Money performs four specific functions,
each of which overcomes the difficulties
of barter. The functions of money are to
serve as: (1) a unit of value, (2) a
medium of exchange, (3) a standard of
deferred payments and (4) a store of
value.
Money as a Unit of Value
The first function of money is to be a
unit of value or a unit of account. The
monetary unit is the unit in terms of
which the value of all goods and services
is measured and expressed. The value
of each good or service is expressed as
a price, which is the number of
monetary units for which the good or
service can be exchanged. If the price
of a pen is Rs.10 then a pen can be had
in exchange for ten monetary units
(where the monetary unit in this case is
the rupee).
Measuring values in monetary units
helps in measuring the exchange values
of commodities. If a pen is worth Rs.10
and a notebook is worth Rs.20 then a
93
notebook is worth two pens. Further,

accounting is simplified, as all items will
be recorded in terms of monetary units
that can be added and subtracted.
Money is a useful measuring rod of
value only if the value of money itself
remains constant. This is similar to
saying that a scale is a useful measure
of length only if the length of the scale
itself is constant. The value of money is
linked to its purchasing power.
Purchasing power is the inverse of the
average or general level of prices as
measured by the consumer price index
etc. As the general price level increases,
a unit of money can purchase a lesser
amount of goods and services so the
value or purchasing power of money
declines. So, money will be a useful unit
of value only as long as its own value
or purchasing power remains constant.
Money as a Medium of Exchange
Money also acts as a medium of
exchange or as a medium of payments.
This function of money is served by
anything that is generally accepted by
people in exchange for goods and
services. Anything has been quite a
variety of things across places and times.
Some of the things that have served as
money are clay, cowry shells, tortoise
shells, cattle, pigs, horses, sheep, tea,
tobacco, wool, salt, wine, boats, iron,
copper, brass, silver, gold, bronze,
nickel, paper, leather, playing cards,
debts of individuals, debts of banks,
debts of governments, etc.
Money will then reduce the time and
energy spent in barter. The person who
owned a cow can now simply sell it to
94
the person who offers the most money

for it and then buy the bullock cart from
another person who offers him the best
bargain. Ultimately, all trade may be
considered barter one good or service
is traded for another good or service
either directly, or indirectly with money
acting as the intermediary. However, by
acting as an intermediary, money
increases the ease of trade.
Money is also called a bearer of
options or generalised purchasing
power. This indicates the freedom of
choice that the use of money offers. The
owner of the cow need not procure
goods and services from those to whom
he sold his cow. He can use the money
to buy the things he wants most, from
those who offer him the best bargain
(not necessarily those who bought his
cow), at the time he considers most
advantageous (not necessarily
immediately). Again, this function can
only be performed properly if the value
of money remains constant.
Money as a Standard of Deferred
Payments
If money performs the previous two
functions then it may also perform the
function of being the unit in terms of
which deferred or future payments are
stated. Examples of situations where
future payments are to be made are
pensions, principal and interest on
debt, salaries etc. As long as money
maintains a constant value through
time, it will overcome the problems
associated with making future
payments with specific commodities.
Money as a Store of Value

If money becomes a unit of value and a
means of payment then it may also
perform the function of serving as a
store of value. The holders of money are
holders of generalised purchasing
power that can be spent through time.
They know that it will be accepted at
any time for any good or service and is
thus a store of value. This function will
be performed well as long as money
retains a constant purchasing power.
It may be noted that any asset other
than money may also perform the
function of store of value, for example,
bonds, land, houses, etc. These assets
have the advantage that, unlike money,
they yield income and may appreciate
in value over time. However, they are
subject to the following: (1) they may
involve storage costs, (2) they may not
be liquid in the sense that they could
not be quickly converted into money
without loss of value, and (3) they may
depreciate in value. A person may
choose to store value in any form
depending on considerations of income,
safety and liquidity.
Definitions of Money
After considering the functions of
money, we must now decide what
things are to be considered as money,
i.e. we must define what money is. The
various types of definitions of money are
as follows:
Legal Definitions of Money
The statement that money is what the
law says it is would sum up such a
definition. A thing will have general
MONEY
AND
BANKING
acceptability if the law proclaims it as

money. It may be further endowed
with legal tender power, i.e. it has the
legal power to discharge debts, and a
creditor who refuses, it is not legally
entitled to receive anything else in
payment of an existing debt.
Currency, being legal tender, is also
called fiat money because it serves as
money on the fiat (order) of the
government. This is not true of deposit
money. Demand deposits of banks are
fiduciary money because they are
accepted as money on the basis of the
trust that their issuer commands. A
person can however legally refuse to
take payment through cheques
because there is no guarantee that a
cheque will be honoured by the issuers
bank. A cheque is an instrument that
instructs the bank to transfer funds
from the cheque issuers account to the
cheque receiver.
However, legal definitions of money
are not the only determinants of what
things serve as money. For example,
people may not prefer legal tender in
payment and refuse to sell goods and
services to those offering it. On the
contrary, things that are not legally
defined as money for example, cheques
may be generally acceptable as a means
of payment. Today, credit cards can
also be placed in this category.
Functional Definitions of Money
By functional definition, money will
include all things that perform the four
functions that money does. Two of the
functions of money, i.e. a unit of value
and standard of deferred payment will
95
not help narrow down the list of things

that are included in money. For
example, houses could be a unit of
value and a standard of deferred
payment, but are houses money? They
are not, because they are not generally
acceptable in payment of debt and for
goods and services.
It is commonly accepted that
anything that is generally acceptable in
payment of debt and as payment for
goods and services should be included
in the money supply. If a good is in fact
generally acceptable in payment and
generally used as a medium of
payment, it is money, no matter what
its legal status may be. In India, the
money supply includes coins and
paper money, which are together
known as currency, and deposit money.
Currency is generally acceptable and
is endowed with legal tender status.
Deposits are moneys accepted by
various agencies from others to be held
under stipulated terms and conditions.
The deposits accepted by banks and
post offices only are considered as
constituents of alternative measures of
money supply.
Narrow vs. Broad Definitions of Money
The narrow definition of money is based
upon its medium of payments function.
The broad definition of money tried to
extend the money category to include
some other things that have a high
degree of moneyness and are widely
used as a store of value. Thus, also
included in broad money would be time
and savings deposits at banks and post
offices. These financial assets have a
96
high degree of moneyness or liquidity

but are not generally acceptable in
payment. We shall see some examples
of narrow and broad definitions of
money later in the chapter.
Classifications of Money
Money can be classified based on the
relationship between the face value of
money and the value of money as a
commodity (or intrinsic value). The
classifications are as follows:
Full-bodied Money: Full-bodied
money is money whose value as a
commodity for non-monetary purposes
is as great as its face value as money.
Most of the earlier commodity moneys
for e.g. gold, silver, cattle etc. were as
valuable for non-monetary purposes as
they were for monetary uses. The main
full bodied monies in modern economies
have been the coins of the standard
metal when the economy was on a
metallic standard: gold coins in a gold
standard, silver coins in a silver
standard and gold as well as silver coins
when the country was on a bimetallic
standard.
Representative Full-bodied Money:
This type of money is usually made of
paper. It is equivalent to a circulating
warehouse receipt for full-bodied coins
or their equivalent in bullion. The paper
money itself has no value as a
commodity, it is after all just a piece of
paper, but it represents in circulation
an amount of money with a commodity
value equal to the value of the money.
The advantage of this type of money is
that it is convenient to engage in trade
which requires large sums of money
(imagine carrying huge sacks of gold
coins in the case of full-bodied money!).

Credit Money: This refers to money,
whose value as money is greater than
the commodity value of the material
from in which the money is made. How
can it maintain a higher value as money
than its commodity value? This is done
by limiting the quantity of money by
preventing the free and unlimited
transformation of the commodity into
money. The government will fix the
quantity of the particular type of money
to be issued and buy only as much of
the money material as needed for the
purpose. The remainder of the supply
of that commodity is left for nonmonetary purposes. This remaining
supply may be so large relative to the
demands for non-monetary uses that
the market value of the commodity will
fall below the value of the money.
Credit money is of various forms:
1. Token coins: All our coins (Rs.5, Rs.2,
Re.1, 50p, 25p, 20p, 10p, and 5p)
are token coins in the sense that their
value as money is far above the value
of the metal contained in them. If you
melt a five rupee coin and sell the
metal in the market place you would
be extremely lucky to get Rs.5 for it!
2. Representative Token Money: This is
usually of the form of paper, which is
in effect a circulating warehouse
receipt for token coins or an equivalent
amount of bullion that is backing it.
The coin or bullion backing the
representative token money is worth
less as a commodity than as money,
thus making it credit money. For
example, if Rs.10000 worth of
MONEY
AND
BANKING
representative token money is

circulated as paper money in the
economy, then Rs.10000 worth of
token coins will back it. However, the
commodity value of the token coins
will be less than Rs.10000, and so will
be the value of the bullion if instead of
token coins, bullion was backing the
representative token money.
3. Circulating promissory Currency
(notes) issued by Central Banks:
This is the greatest part of modern
currency, and includes all currency
notes in India issued by the Reserve
Bank of India. If you look at any
note you will see a legend I
promise to pay the bearer the sum
of Rs. X signed by the Governor
of the RBI. This is nothing but a
circulating promissory note issued
by the RBI.
4. Deposits at Banks: These deposits
in banks e.g. savings deposits, are
claims of creditors against banks
which can be transferred from one
person to another by means of
cheques. Since the bank does not
back all the chequable deposits it
has with an equivalent amount of
financial assets or money, these
chequable deposits are credit
money. We will study how banks
may keep less than 100% reserves
backing their chequable deposits
later in the chapter.
Indian Monetary System
India is at present on the paper
currency standard. This standard is
also referred to as the managed
currency standard.
97
The term monetary standard refers

to the type of standard money used in
the economy. The standard money is
that legal money in which the
government of the country discharges
its obligations. The monetary standard
is thus synonymous with the standard
money adopted by the countrys
monetary authority. Since Indias
monetary authority, the Reserve Bank
of India (RBI) has adopted a standard
currency made of paper, India is on a
paper currency standard.
Paper currency is the main
currency of the country. It has an
unlimited legal tender, i.e. it can be used
to settle debts and make payments up
to an unlimited amount. For making
smaller payments, coins made of cheap
and light metals are used. These coins
are limited legal tender since they can
be used to make payments and settle
debts only up to a limited amount. It
would be inconvenient to settle a debt
of Rs.1000 with 50p. coins!
RBI has the sole right to issue
currency notes, other than the one
rupee note in the country. The
Government of India under the Indian
Coinage Act issues the one rupee note
and all coins. Though the Government
issues the one rupee note and coins,
the responsibility for putting them in
circulation rests with the RBI.
The system governing note issue in
India is the Minimum Reserve System.
Paper currency is not convertible into
the precious metal (gold) that is backing
it; hence the currency is said to be
inconvertible.
98
Money Supply
Having defined money we may now list
out the things that serve as money.2
Then, the money supply, i.e. the total
stock of moneys of various kinds at any
particular point of time can be
computed. By repeated measurements
at different points of time we may get a
time series of the total stock of money.
By analysing this time series in
conjunction with time series of other
economic variables such as incomes,
wages, prices, employment, etc. we can
hope to understand the effect of money
on the other variables in the economy.
It is important to note two things
regarding any measure of money
supply. First, the supply of money is a
stock variable, i.e. it does not have any
time dimension it refers to the total
amount of money at any particular
point of time. It is not a flow variable in
the sense of income, which refers to a
rate per unit time, i.e. so many rupees
per year.
Second, the stock of money always
refers to the stock of money held by the
public. This is always smaller than the
total stock of money in existence. The
term public includes all economic units
households, firms, etc. except the
producers of money, i.e. the government
and the banking system. The banking
system includes the Reserve Bank of
India and all the banks that accept
demand deposits. The reason for such a
distinction is to separate the producers
or suppliers of money from the holders
2
or demanders of it. This separation is

required for monetary analysis.
Measurement of Money Supply
This is an empirical matter. It involves
defining various measures of money
supply and computing their values. The
Reserve Bank of India has been
publishing data on four alternative
measures of money supply namely,
M1, M2, M3 and M4. These are defined
as follows:
M1 = C + DD + OD
C is currency held by the public. It

consists of paper currency as well as
coins. DD is the demand deposits in
banks. Only the net demand deposits
of banks are included in money supply
because the part of demand deposits
that represents inter-bank deposits
held by one bank with another does not
constitute demand deposits held by the
public. Since money supply is defined
as money held by the public, we must
net out the inter-bank deposits to arrive
at net demand deposits in banks.
OD is other deposits with the RBI.
These are the deposits held by the RBI
of all economic units except the
government and banks. OD includes
demand deposits of Public Financial
Institutions (like IDBI, etc.), foreign
central banks and governments, the
IMF, the World Bank, etc.
M2 = M1 + savings deposits with post
office savings banks
M3 = M1 + net time deposits of banks
M4 = M3 + total deposits with post office
savings organisation (excluding
National Savings Certificates)
The following sections draw on material from Monetary Economics : Institutions, Theory and
Policy, by Suraj B. Gupta, 1982.
MONEY
AND
BANKING
M1 and M2 are measures of narrow

money. M3 and M4 are measures of
broad money. M3 is most widely used
measure of money supply. It is also
called aggregate monetary resources of
the society.
The RBI views the four measures of
money stock as representing different
degrees of liquidity, with M1 being the
most liquid and M4 being the least
liquid. Liquidity means the ability to
convert an asset into money quickly
and without loss of value.
Having defined the measures of
money supply, we shall investigate
what determines the actual amount of
money stock at any point of time, and
changes in the money stock over time.
Money supply will change if the
magnitude of any of its constituents
changes. Changes in C, DD and net time
deposits of banks cause changes in
money stock as measured by M3. We
will go into money supply and changes
in money supply after looking at the
commercial banking system and the
Central Bank, as these two are key
players in determining the changes in
the quantum of money supply.
BANKING
Commercial Banks
Banking is defined as the accepting, for
the purpose of lending, or investment
of deposits, money from the public,
repayable on demand or otherwise and
withdrawable by cheque, draft, order
or otherwise.
Thus the two essential functions
that make banks as Financial
Institutions (FIs) are accepting
chequable deposits from the public
and lending.
99
Acceptance of chequable deposits is

a necessary, but not sufficient condition
for FI to be a bank. For example, post
office savings banks are not banks in
this sense of the term even though they
accept deposits from the public. This is
because they do not perform the other
essential function of lending.
Similarly, lending alone does not
make FI a bank. For example, many FIs
like LIC, UTI, and IDBI, etc. lend to others
but they are not banks in this sense of
the term, as they do not accept
chequable deposits.
The main functions that commercial
banks perform are:
1. Acceptance of deposits
The bank accepts three types of
deposits from the public.
l
Current Account Deposits: Deposits
in current accounts are payable on
demand. They can be drawn upon
by cheque without any restriction.
These accounts are usually
maintained by businesses and are
used for making business payments.
No interest is paid on these deposits.
However, the banks offer various
services to the account holders for a
nominal charge, the most important
being the cheque facility. Only when
the ownership of these deposits has
been so transferred, the medium of
exchange or means of payment
function of these deposits gets
completed. Banks keep regular
accounts of all transactions made in
a particular account and submit
statements of the same to the
account-holder at regular intervals.
100
Fixed/Term Deposits: These are

deposits for a fixed term (period of
time) varying from a few days to a
few years. They are not payable on
demand and do not enjoy chequing
facilities. The moneys deposited in
such accounts become payable only
on the maturity of the fixed period
for which the deposit was initially
made. Interest is paid on these
deposits and the rate of interest
rises with the term of the deposits.
A variant of fixed deposits are
recurring deposits. In these
accounts, a depositor makes a
regular deposit of an agreed sum
over an agreed period e.g. Rs.100
per month for 5 years. Interest is
paid on the deposits in these
accounts.
l
Savings Account Deposits: These
deposits combine the features of
both current account deposits and
fixed deposits. They are payable on
demand and also withdrawable by
cheque, but with certain restrictions
on the number of cheques issued
in a period of time. Interest is paid
on the deposits in these accounts
but the interest paid on savings
account deposits is less than that
of the fixed deposits.
In monetary analysis deposits are
classified into two types: demand
deposits and time deposits. Demand
deposits are payable on demand either
through cheque or otherwise. Only
demand deposits may serve as a
medium of exchange, because their
ownership can be transferred from
person to person through cheques. All
l
other deposits that are not payable on

demand are called time deposits.
All current account deposits are
demand deposits and all term deposits
are time deposits. The classification of
savings deposits is not as
straightforward because they combine
features of both demand and time
deposits. The Reserve Bank of India
distinguishes between the demand
liability portion of savings deposits
(which are included under demand
deposits) and the time liability portion
of savings deposits (that are included
under time deposits). The rule to decide
which part of the savings deposits
comes under which category is: the
average of the monthly minimum
balances in the savings accounts on
which interest is being paid shall be
regarded as a time liability and the
excess over the said amount shall be
regarded as a demand liability.
2. Giving Loans
The deposits received by the bank are
not allowed to lie idle by the bank. After
keeping a certain portion of the
deposits as reserves, the bank gives the
balance to borrowers in the form of
loans and advances. The different types
of loans and advances made by banks
are as follows:
l
Cash Credit In this arrangement,
an eligible borrower is first
sanctioned a credit limit upto which
he may borrow from the bank. This
credit limit is determined by the
banks estimation of the borrowers
creditworthiness. However, actual
utilisation of credit by the customer
MONEY
AND
BANKING
depends upon his withdrawing

power. The withdrawing power
depends on the value of the
borrowers current assets, which
comprise mainly stocks of goods
raw materials, semi-manufactured
or finished goods, and bills
receivable (dues) from others. The
borrower has to submit a stock
statement of his assets to the bank
showing evidence of on-going trade
and production activity; and acting
as a legal document in possession
of the bank, to be used in case of
default. The borrower has to pay
interest on the drawn or utilised
portion of the credit only.
Demand Loans - A demand loan is
one that can be recalled on demand.
It has no stated maturity. The entire
loan amount is paid in lump sum
by crediting it to the loan account of
the borrower. Thus, the entire loan
amount becomes chargeable to
interest. Security brokers and others
whose credit needs fluctuate day to
day usually take these loans. The
security against these loans may be
personal, financial assets or goods.
Short-term Loans Short-term
loans may be given as personal
loans, loans to finance working
capital or as priority sector
advances. These loans are secured
loans, i.e. they are loans made
against some security. The whole
amount of the term loan sanctioned
is paid in lump sum by crediting it
to the loan account of the borrower.
Thus, the entire loan amount
becomes chargeable to interest. The
101
repayment is made as scheduled,

either in one instalment at the end
of the loan, or in a number
of instalments over the period of
the loan.
In addition, commercial banks
extend the following facilities when they
are requested by their customers.
3. Overdrafts
An overdraft is an advance given by
allowing a customer to overdraw his
current account upto an agreed limit.
The security for overdrafts is usually
financial assets of the account holder
such as shares, debentures, life
insurance policies etc. Overdraft is a
temporary facility and the rate of
interest charged on the amount of credit
used is lower than that on cash credit
because the risk involved and service
cost of such credit is less it is easier to
liquify financial assets than
physical assets.
4. Discounting Bills of Exchange
A bill of exchange is a document
acknowledging an amount of money
owed in consideration for goods
received. For example, if A buys goods
from B, he may not pay B immediately.
He may give B a bill of exchange, stating
the amount of money owed and the time
when the debt has to be settled. If B
wants the money immediately, he will
present the bill of exchange to the bank
for discounting. The bank will deduct a
commission and pay the present value
of the bill to B. Upon maturity of the bill;
the bank will secure payment from A.
102
5. Investment of funds
The banks invest their surplus funds
in three types of securities
Government securities, other approved
securities, and other securities.
Government securities are
securities of both the Central and State
governments such as treasury bills,
national savings certificates etc.
Other approved securities are
securities approved under the
provisions of the Banking Regulation
Act, 1949. These include securities of
State sponsored bodies like electricity
boards, housing boards, debentures of
Land Development Banks, units of UTI,
shares of Regional Rural Banks etc.
Part of the banks investment in
government securities and other
approved securities are mandatory
under the provisions of the Statutory
Liquidity Ratio requirement of the RBI.
However, banks hold excess investments
in these securities because banks can
borrow against these securities from
RBI and others, or sell these securities
in the open market to meet their need
for cash. Banks hold them even though
the return from them is lower than that
on loans and advances because they
are more liquid.
6. Agency Functions of the Bank
The bank performs certain agency
functions for its customers in return for
a commission. The agency services
provided by the banks are:
(i) Transfer of funds the bank
provides facility for cheap and
easy remittance of funds from
place to place via instruments
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)
such as the demand drafts, mail

transfers, telegraphic transfers,
etc.
Collection of funds the bank
undertakes to collect funds on
behalf of its customers through
instruments such as cheques,
demand drafts, bills, hundis, etc.
Purchase and sale of shares and
securities on behalf of customers.
Collection of dividends and
interest on shares and
debentures on behalf of
customers.
Payment of bills and insurance
premia as per customers
directions.
Acting as executors and trustees
of wills.
Provision of income tax
consultancy and acceptance of
income tax payments of
customers.
Acting as correspondent, agent or
representative of customers as
well as securing documentation
for air and sea passage.
7. Miscellaneous Functions
(i) Purchase and sale of foreign
exchange.
(ii) Issuance of travellers cheques
and gift cheques.
(iii) Safe custody of valuable goods in
lockers.
(iv) Underwriting activities (agreeing
to partly or fully purchase the
whole or the unsold portion
respectively of new issue of
securities) and private placement
of securities (selling securities not
through the open market, but
privately to selected entities).
MONEY
AND
BANKING
103
Commercial banks
Scheduled
commercial banks
Public sector banks
SBI and its Subsidiaries
Non-scheduled
commercial banks
Private sector banks
Foreign banks
Other nationalized banks
Fig. 7.1: Schematic Classification of Commercial Banks
As is evident from the above list,

banks provide a wide range of services
to their customers.
Under the present economic
liberalisation, commercial banks are
urged to assume certain roles which are
usually outside the purview of typical
commercial banking such as
development banking, insurance in
addition to commercial banking
practices.
Figure 7.1 gives a schematic
classification of commercial banks.
The Central Bank
The central bank is the apex institution
of a countrys monetary system. The
design and the control of the countrys
monetary policy is its main responsibility.
As pointed out earlier, Indias central
bank is the Reserve Bank of India.
The Central Bank performs the
following functions:
1. Currency Authority
The Central Bank is the sole authority
for the issue of currency in the country.
All the currency issued by the Central
Bank is its monetary liability. This
means that the Central Bank is obliged
to back the currency with assets of
equal value. These assets usually
consist of gold coin, gold bullion,
foreign securities, and the domestic
governments local currency securities.
The countrys Central Government
is usually authorized to borrow money
from the Central Bank. The government
does this, by selling local currency
securities to the Central Bank. The effect
of this is to increase the supply of money
in the economy. When the Central Bank
acquires these securities, it issues
currency. This authority of the
government gives it flexibility to monetize
its debt. Monetizing the governments
104
debt (called public debt) is the process

of converting its debt (whether existing
or new), which is a non-monetary
liability, into Central Bank currency,
which is a monetary liability.
Putting and withdrawing currency
into and from circulation are also the job
of its banking department. For example,
when the government incurs a deficit in
its budget, it borrows from the Central
Bank. This is done by selling treasury
bills to the Central Bank, the latter paying
for the bills by drawing down its stock of
currency or printing currency against
equal transfer of the said securities. The
government spends the new currency
and puts it into circulation.
2. Banker to the Government
The Central Bank acts as a banker to
the government both Central as well
as State governments. It carries out all
the banking business of the
government, and the government keeps
its cash balances on current account
with the Central Bank.
As the banker to the government,
the Central Bank accepts receipts and
makes payments for the government,
and carries out exchange, remittance
and other banking operations. The
Central Bank also provides short-term
credit to the government, so that the
government can meet any shortfalls in
receipts over disbursements. The
government borrows money by selling
treasury bills to the Central Bank. The
government carries on short term
borrowing by selling ad-hoc treasury
bills to the Central Bank.
As the governments banker,

the Central Bank also has the
responsibility of managing the public
debt. This means that the Central Bank
has to manage all new issues of
government loans (by advising the
government on the quantum, timing
and terms of such loans), services the
public debt outstanding (by making
sure that interest is paid on time and
maturing bills are retired by repaying
the principal) and nurtures the market
for government securities (by ensuring
that the market functions smoothly,
with adequate supply of all maturities
of existing bills and has enough
liquidity to pick up the new issues
of bills).
The Central Bank also advises the
government on banking and financial
matters.
3. Bankers Bank and Supervisor
(Lender of the last report) As the
banker to banks, the Central Bank
holds a part of the cash reserves of
banks, lends them short-term funds
and provides them with centralised
clearing and remittance facilities. The
banks are required to deposit a
stipulated ratio of their net total
liabilities (the CRR) with the Central
Bank. The purpose of this stipulation
is to use these reserves as an
instrument of monetary and credit
control. In addition to this, the bank
holds excess reserves with the Central
Bank to meet any clearing drains due
to settlement with other banks or net
withdrawals by their account holders.
The pool of funds with the Central
Bank serves as a source from which it
MONEY
AND
BANKING
can make advances to banks

temporarily in need of funds, acting in
its capacity as lender of last resort.
However, the banks in temporary need
of funds are supposed to approach
other sources first like the call money
market and then only approach the
Central Bank.
The Central Bank supervises,
regulates and controls the commercial
banks. The regulation of banks may be
related to their licensing, branch
expansion, liquidity of assets,
management, amalgamation (merging
of banks) and liquidation (the winding
up of banks). The control is exercised
by periodic inspection of banks and the
returns filed by them.
4. Controller of Money Supply and
Credit
The Central Bank controls the money
supply and credit in the best interests
of the economy. The bank does this by
taking recourse to various instruments.
Generally they are categorised as
quantitative
and
qualitative
instruments. Let us first deal with the
instruments of quantitative control, i.e.
those that affect only the quantity of the
particular variable:
1. Bank Rate Policy: The bank rate is
the rate at which the central bank
lends funds as a lender of last
resort to banks, against approved
securities or eligible bills of
exchange. The effect of a change in
the bank rate is to change the cost
of securing funds from the central
bank. An increase in the bank rate
increases the costs of securing
105
funds and of borrowing reserves

from the central bank. This will
reduce the ability of banks to create
credit and thus to increase the
money supply. A rise in the bank
rate will then cause the banks to
increase the rates at which they
lend. This will then discourage
businessmen and others from
taking loans, thus reducing the
volume of credit. A decrease in the
bank rate will have the opposite
effect. In actual practise however,
the effectiveness of bank rate policy
will depend on (a) the degree of
banks dependence on borrowed
reserves (positive relationship),
(b) the sensitivity of banks demand
for borrowed funds to the differential
between the banks lending rate and
their borrowing rate (positive
relationship), (c) the extent to which
other rates of interest in the
market change and (d) the state of
supply of and demand for funds
from other sources.
2. Open Market Operations: OMO is
the buying and selling of
government securities by the
Central Bank from/to the public
and banks on its own account. It
does not matter whether the
securities are bought from or sold
to the public or banks because
ultimately the amounts will be
deposited in or transferred from
some bank. The sale of government
securities to banks will have the
effect of reducing their reserves.
When the bank gives the Central
Bank a cheque for the securities, the
106
Central Bank collects the amount

by reducing the banks reserves by
the particular amount. This directly
reduces the banks ability to give
credit and therefore decrease the
money supply in the economy.
When the Central Bank buys
securities from the banks it gives the
banks a cheque drawn on itself in
payment for the securities. When
the cheque clears, the Central Bank
increases the reserves of the bank
by the particular amount. This
directly increases the banks ability
to give credit and thus increase the
money supply. Successful conduct
of OMO as a tool of monetary policy
requires first that a well functioning
securities market exists. If banks
regularly and routinely resort to
keeping excess reserves then the
utility of such a policy will be
doubtful. In developed countries
like the US, banks are not affected
by the OMO because they buy
securities with excess reserves and
when they sell securities, the
amount realised is added to the
excess reserves. In such a situation,
OMO becomes a ineffective tool.
3. Varying Reserve Requirements:
Banks are obliged to maintain
reserves with the Central Bank on
two accounts. One is the Cash
Reserve Ratio or CRR and the other
is the SLR or Statutory Liquidity
Ratio. Under CRR the banks are
required to deposit with the Central
Bank a percentage of their net
demand and time liabilities. Varying
the CRR is a tool of monetary and
credit control. An increase in the

CRR has the effect of reducing the
banks excess reserves and thus
curtails their ability to give credit.
Reducing the CRR has the effect of
increasing the banks excess
reserves, which increases its power
to give credit.
The SLR requires the banks to
maintain a specified percentage of their
net total demand and time liabilities in
the form of designated liquid assets
which may be (a) excess reserves
(b) 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
(c) current account balances with other
banks. Varying the SLR affects the
freedom of banks to sell government
securities or borrow against them from
the Central Bank. This affects their
freedom to increase the quantum of
credit and therefore the money supply.
Increasing the SLR reduces the ability
of banks to give credit and vice versa.
We now deal with instruments of
qualitative credit control, which deal
with the allocation of credit between
alternative uses.
1. Imposing margin requirement on
secured loans: A margin is the
difference between the amount of
the loan and market value of the
security offered by the borrower
against the loan. If the margin
imposed by the Central Bank is
40%, then the bank is allowed to
give a loan only up to 60% of the
value of the security. By altering the
MONEY
AND
BANKING
margin requirements, the Central

Bank can alter the amount of loans
made against securities by the
banks. The advantages of this
instrument are manifold. High
margin requirements discourage
speculative activities with bank
credit and therefore divert resources
from unproductive speculative
activities to productive investments.
By reducing speculative activities,
there is reduction in the fluctuation
of prices in the market price of
securities.
2. Moral Suasion: This is a combination
of persuasion and pressure that the
Central Bank applies on the other
banks in order to get them to fall in
line with its policy. This is exercised
through discussions, letters,
speeches and hints to banks. The
Central Bank frequently announces
its policy position and urges the
banks to fall in line. Moral suasion
can be used both for quantitative
as well as qualitative credit control.
3. Selective Credit Controls (SCCs):
These can be applied in both a
positive as well as a negative
manner. Application in a positive
manner would mean using
measures to channel credit to
particular sectors, usually the
priority sectors. Application in a
negative manner would mean using
measures to restrict the flow of
credit to particular sectors.
Banks and Monetary Policy: A
Recent Scenario
In the present Indian macroeconomic
scenario, structural adjustment
107
programme of the economy has had

implications on the monetary policy of
the government. One important
component of such policy has been the
gradual downward adjustment of the
structure of interest rates in favour of
a lower interest rate regime. The
apparent reason is that the interest
rates in India are too high, and given
the low inflation rate recently, the real
interest rates are therefore too high. The
effect of this is to dampen investment.
One suspects that the real reason for
the governments decision to lower
interest rates is the fact that the interest
and repayment obligations on
government debt are fast reaching
unsustainable levels. The government
is reaching a stage where it has to
borrow not for productive activities or
to finance developmental works, but
rather to pay off old debts. Where it has
to borrow to repay past principal is not
that dangerous a state of affairs. Where
it has to borrow to meet interest
obligations on past debt is a
calamitous state of public finances.
The effect of lower interest rates is
beneficial to the state of public finances.
The government can retire costly old
debt and replace with cheaper new
debt, and it can reduce the interest
burden of its debt. The added
advantage of low interest rate regime
is that it boosts investment.
The Government has also gone in for
reform of the Banking System in a big
way, in line with the structural
adjustment programme. The main
thrust of the reforms as per the
108
recommendations of the Narasimhan

Committee Reports, 1991 and 1998 was
to reduce the excessively high CRR and
SLR (to increase the banks capability to
create credit), reduce and ultimately
deregulate the interest rates, give more
autonomy to the operational functioning
of the banks to increase their efficiency,

allow foreign private banks to set up
branches or subsidiaries in India and
reduce the directed, subsidized credit
to priority sectors (to allow banks to
allocate credit on commercial rather than
developmental criteria).
SUMMARY
l
l
l
l
l
l
l
l
l
l
l
The main function of money in an economic system is to facilitate the

exchange of goods and services, that is, to lessen the time and effort required
to carry on trade.
The exchange of goods for goods is called barter exchange.
Barter becomes unwieldy as groups become larger. A possible solution is
the use of a commonly accepted good as a medium of exchange.
Barter suffers from four main drawbacks, each of which is overcome by a
specific function of money.
Money may be defined using legal definitions or functional definitions.
Money may be classified based on the relationship between the value of the
money as money, and the value of money as a commodity.
India follows a managed paper currency standard with a minimum reserve
system of note issue.
Money supply is the total stock of moneys of various kinds at any particular
point of time.
Banking is defined as the accepting, for the purpose of lending, or investment
of deposits, money from the public, repayable on demand or otherwise and
withdrawable by cheque, draft, order or otherwise.
Two essential functions of a bank are accepting deposits and giving loans.
The Central Bank is the apex institution of a countrys monetary system.
The design and control of the countrys monetary policy is its main
responsibility.
EXERCISES
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
What is the main function of money in an economic system?

What is barter?
What are the drawbacks of barter?
How does the use of money overcome the drawbacks of barter?
How can money be defined?
How can money be classified?
What monetary system does India follow?
What is money supply?
What are the various money stock measures?
What is banking?
What are the functions of commercial banks?
What are the functions of central banks?
APPENDIX 7.1: THEORY
In this chapter, we have studied only

the supply of money. We may round off
the discussion on money by
introducing the theory of demand for
money, from the Keynesian perspective.
The Keynesian theory of the demand for
money (liquidity preference) is as
follows. Keynes believed that people
demand money for three reasons or
motives.
1. Transactions Motive
The reason for transactions demand is
as follows. Money is needed to carry
out ordinary day-to-day transactions.
This is the medium of exchange
function of money. The need to hold
monetary balances arises because
people in general do not have
synchronized
receipts
and
expenditures patterns. In other words,
the amount of money individuals
receive at any point of time may not be
equal to the amount of payments that
have to be made at that point of time.
For example, an individual may receive
a monthly salary but have to pay the
milkman every week. As a result he will
have to hold cash balances in order to
pay the milkman every week. If the
amount that a person receives at every
point of time equalled the amount that
he paid out at each point of time then
there would be no need to hold money
balances for transactions.
OF
LIQUIDITY PREFERENCE
The amount of transaction balances

a person must hold increases
proportionately with the money volume
of transactions. Among all the
transactions made, only some of them
will be in final goods and services. If we
assume that the ratio of GNP to the
volume of all transactions as some
constant, then we have the amount of
money balances that the public as a
whole wishes to hold for transactions
purposes depending on the level of
income.
Further, the amount of transactions
balances required varies proportionately
with the price level P at which the output
is sold. Twice as much money is
required to purchase a commodity that
costs Rs.100 as was required to
purchase the same commodity when its
price is Rs.50. The same is true for the
economy wide total of purchases PY,
where Y is real GNP.
The transactions demand may be
expressed in equation form as
Mt = k(PY)
Where,
Mt = transactions demand for money
k = constant of proportionality
P = price level
Y = real GNP
110
If we assume that a change in the

price level causes a proportionate
change in the quantity of transactions
balances required, we may rewrite the
equation as:
Mt = Pk(Y)
To convert the demand for nominal
balances into real balances we divide
throughout by P to get
Mt
= k (Y )
P
where
Mt
is the demand for real
P
balances for transactions purposes.

2. Precautionary Motive
The precautionary demand for money
arises because of uncertainty regarding
future receipts and expenditures.
Precautionary balances enable people
to meet unanticipated increases in
expenditures or unanticipated
reductions or delays in receipts.
Demand for precautionary balances
varies directly with income. An
individual can and will need to
keep aside more money for this purpose
as his income increases. Since
both transactions demand and
precautionary demand are functions of
income, they may be combined so that
the equation
Mt
= k (Y ) can be used to
P
denote the demand for both (real)

transactions and precautionary
balances.
3. Speculative Motive
The speculative demand for money
arises from the speculative motive for
holding money. In the Keynesian world,

a person who buys bonds is
speculating that the interest rate will not
rise appreciably during the period in
which he intends to hold the bond. The
uncertainty regarding the future
interest rate causes people to hold
money for speculative purposes. There
is a negative relationship between the
interest rate and the market price of
a bond, or for that matter any
debt security.
People who buy bonds expect the
interest rate to fall and the prices of
bonds to rise. In other words, they
regard the present interest rate as high
and the present bond prices as low.
Those who switch from bonds to money
have opposite expectations.
Now, people who view the current
interest rate as too high or too low
obviously have some notion in their
minds of the normal rate of interest,
with which they compare the current
rate of interest. Given this notion of the
normal rate of interest, at any point of
time people will decide that the current
rate of interest is higher than, lower
than or equal to the normal rate of
interest.
If people view the current rate of
interest as too high, they will expect the
rate to drop as it returns to the normal
rate. At the current high rate, people
will therefore, hold bonds instead of
money. They will therefore, not only
currently enjoy the high rate of return
provided by the bonds, but will also
expect capital gains as the bond prices
rise and the interest rate falls to normal.
MONEY
AND
BANKING
111
On the other hand if people view the

current interest rate as low, then they
will expect it to rise and bond prices to
fall, as the interest rate returns to the
normal rate. They will therefore hold
money rather than bonds. The interest
lost as a result of holding money will
be small in comparison to the
prospective capital losses if the interest
rate does indeed rise. Thus, holding idle
money is the safer policy.
Thus, we can conclude that the
demand for speculative balances varies
inversely with the interest rate. We may
write the equation for speculative
demand for money as:
Msp = P.h(r)
Where,
Msp = demand for nominal speculative
balances
P = price level
h(r) = function of r (Msp is an inverse
function of r)
Dividing throughout by P we get the
demand for real speculative balances:
msp =
M sp
P
= h(r)
We may show the relationship

between msp and r in diagrammatically
in Fig. A7.1.
The higher the market interest rate,
the lower will be the amount of real
balances that people will maintain for
speculative purposes. At some high
interest rate r0, the curve shows that
people will hold no money in speculative
balances. This is because all people
believe that the interest rate is so high
that it can only fall. At this interest rate,
r0
r1
msp
msp
Fig A7.1: Relationship between Interest

Rate and Real Balances
no one prefers money to bonds.

At the other end of the curve,
speculative demand becomes perfectly
elastic with respect to interest rate (the
curve becomes parallel to the X-axis),
i.e. a small proportional change in the
interest rate causes an infinitely
larger change (in the opposite direction)
in the quantum of speculative
balances demanded.
This is because all people believe
that the interest rate is so low that it
cannot go any lower it can only rise.
To hold bonds at this interest rate is to
take the almost certain risk of a capital
loss as the interest rates rise and the
bond prices fall. Thus, all people hold
money, and no bonds at this interest
rate. This section of the curve (where it
becomes perfectly interest elastic) is
called the liquidity trap. It is in this
section of the curve that increases in
money supply, since it goes entirely into
speculative balances, cannot affect the
interest rate.
112
The Total Demand for Money

(liquidity preference)
The total demand for money expressed
in real terms is the sum of the
transactions demand, the precautionary
demand and the speculative demand. It
may be written as:
md = k(Y) + h(r)
For any given price level, we know
from k what mt will be for every level of
Y; and we know from h what msp will be
for every level of r.
From k and h we know what the
total demand for money will be for every
combination of Y and r. This may
be represented diagrammatically
in Fig A7.2.
The curve m d is the liquidity
preference curve. It shows the demand
r0
md
mt m sp m d
Fig A7.2 : Liquidity Preference Curve.
for money at different rates of interest.

At the rate of interest r0 the demand for
transactions and precautionary
balances is mt and the demand for
speculative balances is msp.
APPENDIX 7.2 : MONETARY EQUILIBRIUM

The equilibrium interest rate is
determined by the interaction of the
curves representing the supply of
money and the demand for money.
Assume the supply of money, i.e. the
money stock to be some given constant
amount. Given the money supply and
the income level, there will be some
interest rate at which the sum of the
transactions, precautionary and
speculative demands for money will be
just equal to the supply of money. The
interest rate that equates the supply of
money with the demand for money is
called the equilibrium interest rate. At
that rate, there will be monetary
AND THE
INTEREST RATE
equilibrium with the supply of money

(ms) being equal to the demand for
money. This may be represented
diagrammatically in Fig A7.3 below :
r
re
md
md ms
md , ms
Fig A7.3 : Equilibrium Rate of Interest
MONEY
AND
BANKING
113
ms
ms1
The supply of money curve is a r
vertical straight line because it is a
constant, and is independent of the rate
of interest. The money market is in
equilibrium at interest rate re because r0
the supply of money equals the demand r1
for money.
md
Altering the money supply will affect
the interest rate. Consider the effect of
an increase in the money supply from
md,ms
ms to ms1. We can portray the effect of
Fig A7.4 : Rate of Interest and Changes in
this diagrammatically in fig A7.4. The
Money Supply
effect of an increase in the money supply
is to cause a decrease in the interest rates
from r0 to r1. However this will occur only supply increase is trapped in the
if the money supply increase takes place speculative balances and does not affect
the region of the demand for money interest rate.
curve that does not correspond to the
Decreasing the money supply
liquidity trap. If money supply increases will have the opposite effect of
over the section of the curve where the increasing the rate of interest. This can
liquidity trap operates, then all the happen when the economy is not in the
additional liquidity created by the money liquidity trap as well.
APPENDIX 7.3 : BALANCE SHEET

Commercial banks are financial
intermediaries. They deal in financial
assets and money. A look at the
consolidated balance sheet for all
commercial banks reflects their heavy
involvement in dealing with financial
assets.
A glance at the table shows that
banks raise the bulk of their funds by
selling deposits, and their assets
comprise mainly of: (a) bank credit
consisting of loans, advances, and bills
discounted and purchased, (b)
investments and (c) cash. A brief
OF
COMMERCIAL BANKS
explanation of the assets and liabilities

of banks follows:
Liabilities
1. Capital and Reserves: Capital and
reserves constitute the owned funds of
the banks. Paid up capital is the amount
of share capital contributed by the
owners, i.e. the shareholders of
the banks. Reserves are the retained
earnings or undistributed profits of the
banks. The purpose of accumulating
reserves is to improve the banks capital
position so as to better meet unforeseen
114
Table A.7.1 Consolidated Balance Sheet of Indian Commercial

Banks as on March 31, 2002
Item
Amount
(Rs. in Crores)
% to Total
1. Capital
21497.18
1.40
2. Reserves and surplus
62648.94
4.08
1202767.43
78.33
4. Borrowings
107178.82
6.98
5. Other liabilities
141420.76
9.21
Total Liabilities
1535513.13
100.00
86760.51
5.65
2. Balances with banks and

money at call and short notice
117518.25
7.65
3. Investments
588058.29
38.30
4. Loans and advances
645743.04
42.05
5. Fixed assets
20083.30
1.31
6. Other assets
77349.74
5.04
1535513.13
100.00
Liabilities
3. Deposits
Assets
1. Cash and balances with RBI
Total Assets
liabilities and unexpected losses. The

owned funds of banks usually
constitute a small source of their funds.
This is because their business is in
other peoples money!
2. Borrowings: Banks as a whole
borrow from the RBI, IDBI, NABARD
and from other Non-Banking Financial
Institutions like UTI, GIC and its
subsidiaries, and the ICICI, which are
allowed to lend in the inter bank call
money market. Individual banks borrow
from each other, from the call money

market and from other sources also.
Assets
1. Cash: This item includes cash in hand
and balances with other banks including
the RBI. Banks hold balances with the
RBI under the cash reserve ratio, which
is a mandatory requirement. Such
reserves are called statutory reserves.
Besides these, banks voluntarily hold
extra reserves to meet daily withdrawals
of cash by their account holders.
MONEY
AND
BANKING
2. Money at call at short notice: This

consists of money lent to other banks,
stock brokers and other financial
institutions for short periods of time
varying from 1 day to 14 days. Banks
lend their surplus cash in such a
manner in order to earn interest without
putting undue strain on their liquidity
position.
3. Bills: These may be inland or foreign,
depending upon where the party is,
from whom the bank has to collect
payment. In business, it is customary
to make payments through a bill,
which is nothing but a document
acknowledging that payment has to be
made of a certain amount at a certain
115
time for goods received. The person who

issues the bill is the debtor and the
person who accepts the bill is the
creditor. If the creditor wants the
amount immediately he may get the bill
discounted by a bank, i.e. the bank
deducts a commission and pays the
creditor the amount. Thereafter the
bank collects the amount from the
debtor. Thus, during the pendency of
the bill, it is an asset of the bank.
The table illustrates the nature of
business turned out by the scheduled
commercial banks and this will make
us understand the relative positions of
liabilities and assets in banking
business.
APPENDIX 7.4 : C REDIT C REATION

OF DEPOSITS
We are now in a position to look at
increases in the supply of money as a
result of the increase in one of the
components of money, namely, deposits
with the bank. Increases in deposits
with the bank, i.e. DD happens through
the process of credit creation and
multiple expansion of deposits.
To analyse the basic economics of
credit creation, we may make some
simplifying assumptions. This will help
in understanding the process without
getting too mired in detail. The key
simplifying assumptions are as follows:
1. Banks accept targeting the demand
deposits.
2. All banks face the same cash reserve
requirement of nearly 10%.
3. Banks have no desire to hold excess
reserves.
AND
M ULTIPLE E XPANSION
4. The public do not alter its currency

holdings, i.e. there is no extranormal cash drain from the
banking system due to net
withdrawals by account holders.
These four assumptions would
explain the link between the quantity
of bank deposits and the quantity of
reserves. As we will see, the volume of
deposits can change only if the volume
of reserves held by banks change.
The RBI determines the quantity of
reserves, specifically by two policies.
The first policy is for RBI to lend
reserves to the banks. These reserves
are called borrowed reserves or
borrowings. When the RBI increases
its loans to banks then reserves
116
increase, and when RBI reduces the

loans, reserves decrease.
The second way the RBI can alter
the quantity of reserves is through open
market operations. Open market
operations is the buying and selling of
securities by the RBI in the open
market. When RBI purchases securities
it does so by writing a cheque on itself.
The seller of the security deposits the
cheque with a bank and the bank
passes along with the cheque to the RBI
for payment. Payment is made by
adding the amount to the banks reserve
account at the RBI. In other words, by
purchasing securities the RBI simply
create reserves. The RBI can reduce
reserves by simply selling securities. The
RBI, as the seller of the securities
receives a cheque drawn on some bank.
When it clears the cheque it reduces the
reserve account of the bank by the
cheque amount, thus reducing total
reserves.
Consider now that the RBI
purchases securities from an individual
worth Rs.1000 and the individual
deposits the cheque with bank A. We
will now trace the effects of this action.
Deposit Expansion at the First Bank
As a result of RBIs security purchase,
bank A finds itself with an additional
Rs.1000 of demand deposits.
Furthermore, after it has presented the
cheque drawn on the RBI to the RBI,

bank A will be credited with Rs.1000
of reserves. This will cause an alteration
of the T-account (an account showing
changes in the balance sheet) as below:
The bank has to keep 10% of
Rs.1000, i.e. Rs.100 as reserves under
cash reserve requirement. The
remaining Rs.900 is excess reserves,
which the bank does not want by
assumption. The bank would like to
convert these excess reserves into an
earning asset. It may do this by
purchasing securities or by making a
loan. Let us suppose that the bank
chooses to make a loan. When the bank
makes a loan, it opens an account in
the name of the borrower for the amount
of the loan. Thus, when the bank lends,
it creates a demand deposit. Since
demand deposits are included in the
definition of money, the bank is creating
money.
The amount of money the bank can
safely lend is the amount of its excess
reserves. This means that bank A can
lend Rs.900 and create an equivalent
amount of deposits. The recipient of the
loan will most likely spend it and the
funds will ultimately get deposited in
another bank. This will affect its Taccount as follows.
Thus, bank A has adjusted to its
original Rs.1000 deposit by adding
Rs.100 to reserves and Rs.900 to
Bank A
Change in Assets
Cash reserves
Required reserves
Excess reserves
+Rs.1000
+Rs.100
+Rs.900
Change in Liabilities
Demand deposits
+Rs.1000
MONEY
AND
BANKING
117
earning assets in the form of loans. The

banks excess reserves have been
eliminated and the bank is satisfied.
Have all the effects of the initial
deposit worked themselves out?
Definitely not! There is still the matter
of the Rs.900 deposited in another bank
by the borrower. We have to trace the
effects of this deposit. Following exactly
the same steps and same logic as before,
we have:
The loans made by bank B were

made to someone, and that someone
spent the amount and it ultimately got
deposited in a demand deposit account
in another bank. That bank would then
have a deposit of Rs.810, required
reserves of Rs.81 (being 10% of Rs.810)
and excess reserves of Rs.729. This
Rs.729 can be used to acquire
earning assets simply continuing this
Bank A
Change in Assets
Cash reserves
Loans
Required reserves
Excess reserves
+Rs.100
+Rs.900
+Rs.100
Rs.0
Assume that he borrower deposited

the Rs.900 in bank B. then bank Bs
T-account will alter as follows.
Bank B will want to make profitable
use of its excess reserves and decides
Demand deposits
+Rs.1000
sequence.
The pattern of the sequence is as
follows. At each step the bank sets aside
10% of the newly acquired deposits in
the form of required reserves and uses
Bank B
Change in Assets
Cash reserves
Required reserves
Excess reserves
+Rs.900
Demand deposits
+Rs.900
+Rs.90
+ Rs.810
to make loans worth Rs.810. After it

makes the loan, it will have converted
Rs.810 of excess reserves into earning
assets. The T-account will now be as
follows.
the remaining 90%, its excess reserves

to acquire earning assets. As the
number of such cycles increases, the
total quantity of assets and demand
deposit accounts in the banking system
Bank B
Change in assets
Cash reserves
Loans
Required reserves
Excess reserves
+Rs.90
+Rs.810
+Rs.90
Rs.0
Demand deposits
+Rs.900
118
increase, although it is evident that at

each succeeding cycle, the increase is
10% smaller than in the previous one.
The need to set aside 10% of each
addition to deposits in the form of
required reserves ultimately limits the
size of the expansion.
The deposit expansion process can
is summarised in Table A7.2.
The cycles cease when all excess
reserves have been converted into
required reserves. At that point, as per
the table, demand deposits (and
therefore money) have increased by
Rs.10000, required reserves have
increased by Rs.1000 and loans (credit
created) has increased by Rs.9000.
Note that the total increase in
demand deposits is the sum of the
increases in each of the individual
cycles. That is, we have to add 1000 +

900 + 810 + where each term is 0.9
times the preceding term. This amounts
to finding the sum of a geometric series
of the form a + ar+ ar2 + ar3 + where
in our example, a = 1000 and r = 0.9.
The formula for the sum of a geometric
progression is a/(1r). Computing
the value for our example we get
1000/(1 0.9) = 10000, as shown in
the table.
As we can see, demand deposits
have increased by a tenfold multiple of
the initial increase in reserves.
The transfer of funds between
banks that goes on in each cycle helps
explain why banks try to attract
deposits away from other banks. The
bank that succeeds in drawing reserves
away from other banks can increase
Table A7.2 : The process of Credit Creation and Deposit Expansion
(All figures are in rupees)

Bank name
Additional
deposits (Rs.)
Additional
loans (Rs.)
(money increase)
(credit increase)
1000.00
900.00
100.00
900.00
810.00
90.00
810.00
729.00
81.00
729.00
656.10
72.90
656.10
590.49
65.61
590.49
531.44
59.05
531.44
478.30
53.14
and so on
10000.00
9000.00
1000.00
Total
Additional required
reserves (Rs.)
MONEY
AND
BANKING
its own lending power. An important

point to be noted is that the terms
multiple deposit expansion and
credit creation refer to the banking
system as a whole and not to an
individual bank. For an individual
bank, after setting aside the required
119
reserves, it may create deposits and

loans only with the remaining amount,
which is a sub multiple of the initial
deposit. In other words, all the banks
taken together are able to create
demand deposits and credit several
times larger than the initial deposit.
UNIT-V
GOVERNMENT BUDGET
AND THE ECONOMY
CHAPTER
GOVERNMENT BUDGET
ECONOMY
The purpose of this chapter is to
understand what a government budget
is and how the government budget
interacts with and affects the economy.
The budget is the most important
information document of the
government. One part of the budget is
similar to a companys annual report.
This part presents the overall picture
of the financial performance of the
government during the period since its
last budget. The second part of the
budget presents the governments
financial plans for the period up to its
next budget, in order to inform the
country, and seek legislative approval.
As a consequence of Keynesian
economics, budgetary policies are
considered significant in the
stabilisation of the economy.
Budget and its Objectives
The budget is an annual statement of
the estimated receipts and expenditures
of the government over the fiscal year,
which runs from April 1 to March 31.
The government has several policies it
wishes to implement in the overall
task of performing its functions.
AND THE
Implementation of these policies

requires expenditure by the
government, and some source of
funding for that expenditure. The
budget, is thereby a fiscal tool for the
government to implement its various
policies.
The objectives that are pursued by
the government through the budget are
as follows:
1. Activities to secure a reallocation of
resources: The government has to
reallocate resources in line with
social and economic considerations
in case the market fails to do so, or
does so inefficiently.
2. Redistributive Activities: The
government redistributes income
and wealth to reduce inequalities,
by expenditures on social security,
subsidies, public works etc.
3. Stabilising
Activities:
The
government tries to prevent
business fluctuations and maintain
economic stability through
expanding public expenditure
during recession and contracting
the former during inflation.
(Keynesian economics).
122
4. Management of Public Enterprises:

Government undertakes commercial
activities that are of the nature
of natural monopolies, heavy
manufacturing, etc. through its
public enterprises. A natural
monopoly is a situation where there
are economies of scale over a large
range of output; then one firm can
produce at a lower average cost
than could more than one firm.
Industries which are potential
natural monopolies are railways,
electricity etc. These usually come
under state regulation because if left
unregulated, there will be a
tendency of the monopolist to
curtail output in pursuit of profit
maximising behaviour, thereby
lowering social welfare.
There are three levels at which the
budget impacts the economy. First, is
aggregate fiscal discipline. This means
having control over expenditures, given
the quantum of revenues. This is
necessary for proper macroeconomic
performance. The second is the allocation
of resources based on social priorities and
the third is the effective and efficient
provision of programmes and delivery of
services. Effectiveness measures the
extent to which goods and services the
government provides achieves its goals,
or attains its targets or achieves its
mission. Efficiency refers to the cost per
unit of goods or services provided.
Components of the Budget
Governments at every level have their
own constitutional processes to prepare,
1
present and execute their budgets. We

shall however, focus only on the budget
of the Central Government.1 The budget
is divided into the revenue budget and
the capital budget. The Revenue Budget
consists of the revenue receipts of the
government and the expenditure met
from such revenues. The Capital Budget
consists of capital receipts and
payments. We will now undertake a
classification of receipts and
expenditure in order to understand how
they are reflected in the Revenue and
the Capital Budgets.
Budget Receipts
Receipts may be classified as revenue
receipts and capital receipts.
Revenue Receipts
Revenue receipts may be divided into
tax revenue and non-tax revenue. Tax
revenues consist of the proceeds of taxes
and other duties levied by the Union
Government (Central Government). The
proposals of government for levy of new
taxes, modification of the existing tax
rates or continuance of the existing tax
rates are contained the budget. Taxes
are of two types direct taxes and
indirect taxes. Direct taxes are those
taxes levied immediately on the
property and income of persons, and
those that are paid directly by the
persons to the state. Income tax, interest
tax, wealth tax, corporation tax are all
examples of direct taxes. Indirect taxes
are those that affect the income and
property of persons through their
consumption expenditures. Customs
duties, excise duties, sales tax, service
Similar to Central Government, states also prepare budgets.
GOVERNMENT BUDGENT
AND THE
ECONOMY
tax are all examples of indirect taxes.

Indirect taxes are levied on the goods
and services which people consume,
and are hence indirectly taxing income,
at the time when the income is spent.
While direct taxes are compulsory
and cannot be escaped, a person can
avoid paying indirect tax by refraining
from entering into the particular
transaction that leads to the tax being
levied e.g. a person can avoid excise
duty on biscuits by merely avoiding the
purchase of biscuits.
Non-tax revenue consists of all
other revenue receipts. They may be of
the following types. Commercial revenue
is revenue received by the government
in the form of prices paid for
government-supplied commodities and
services. This includes payments for
postage, tolls, interest on funds
borrowed from government credit
corporations, electricity, railway
services etc. Another source of
revenue is interest and dividends on
investments made by the government.
Administrative revenue is revenue that
arises on account of the administrative
function of the government. The
following are some examples of different
sources of administrative revenue.
Fees are defined as a payment to
defray the cost of each recurring service
undertaken by the government,
primarily in the public interest, but
conferring a measurable special
advantage on the fee payer, e.g. college
fees in government colleges. License
fees are paid in those instances in
which the government authority is
invoked simply to confer a permission
or privilege rather than to perform a
123
service of a more tangible and definite

sort, e.g. registration fee for an
automobile, firearm, etc. Fines and
penalties are levied for an infringement
of a law. Forfeitures of basic surety or
bonds are penalties imposed by courts
for non-compliance with orders or nonfulfilment of contract etc. Escheat refers
to the claim of the government on the
property of a person who dies without
having any legal heirs or without
leaving a will.
Table 8.1 shows the revenue
receipts of the Government of India as
per budget estimates for 2002-03.
Table 8.1: Revenue receipts of the Union
Government as per 2002-03
budget estimates
Item
Tax revenue
Non-tax revenue
Total revenue receipts
Amount
(Rs. in crores)
172965
72140
245105
Source : Economic Survey, 2002-03,

Government of India.
Capital Receipts
The main items of capital receipts are
loans raised by the government from the
public (these are called Market Loans),
borrowings by the government from the
Reserve Bank of India and other parties
through the sale of treasury bills, loans
received from foreign governments and
bodies (e.g. World Bank, Asian
Development Bank, etc.), recoveries of
loans granted to state and union
territory governments and other parties,
small savings and deposits in the public
provident fund (PPF), etc.
124
Table 8.2 shows the capital receipts

of the Government of India as per
budget estimates for 2002-03.
Table 8.2: Capital receipts of the Union
Government as per 2002-03
budget estimates
Item
Amount
(Rs. in crores)
Recovery of loans
17680
Other receipts (mainly

PSU disinvestment)
12000
Borrowings and
other liabilities
135524
Total Capital receipts
165204
Source : Economic Survey 2002-03, Government

of India.
Expenditure
Expenditure may be classified in the
following three ways:
1. Revenue expenditure and capital
expenditure
Revenue
expenditure
is
the
expenditure incurred for the normal
running of government departments
and provision of various services,
interest charges on debt incurred by the
government, subsidies etc. In general,
any expenditure that does not result in
the creation of assets is treated as
revenue expenditure. However, all
grants given to state governments are
treated as revenue expenditure even
though some of the grants may be for
creation of assets.
Capital expenditure consists mainly
of expenditure on acquisition of assets like
land, buildings, machinery, equipment;
investments in shares, etc., and loans and
advances granted by the central
government to state and union territory

governments, government companies,
corporations and other parties.
2. Plan expenditure and Non-Plan
expenditure:
Plan expenditure is that public
expenditure which represents current
development and investment outlays that
arise due to plan proposals. Non-plan
expenditure is all other expenditure,
generally of recurring nature.
Table 8.3 shows the break up of
expenditure into revenue and capital,
plan and non-plan, as per the budget
estimates for 2002-03.
Table 8.3: Break ups of expenditure as
per budget estimates for
2002-03
Sl.
Item
Amount
No
(Rs. in crores)
1 Interest payments
1,17,390
2 Major subsidies
38,923
3 Defence expenditure
43,589
4 Revenue expenditure
3,40,482
5 Capital expenditure
69,827
6 Plan expenditure
1,13,500
7 Non-plan expenditure 2,96,809
8 Total Expenditure
4,10,309
(6+7) or (4+5)
Source : Economic Survey 2002-03, Government
of India.
3. Developmental and Nondevelopmental expenditure

Developmental expenditure includes
plan expenditure of Railways, Posts
and Telecommunications and nondepartmental commercial undertakings
which are financed out of their internal and
extra budgetary resources, including
market borrowings and term loans from
GOVERNMENT BUDGENT
AND THE
ECONOMY
Table 8.4 : Break-ups of expenditure

of
Central,
State
and
Union Territory Governments,
2001-02.
Sl.
Item
No
1 Developmental
expenditure
2 Defence (net)
3 Interest payments
4 Tax collection charges
5 Police
6 Others
7 Non-developmental
expenditure
(2+3+4+5+6)
8
Total expenditure
(1+7)
Amount
(Rs. in crores)
369266
62000
144588
8533
24383
121045
360549
125
plans) into developmental and nondevelopmental expenditure, as per

2001-02 budget estimates.
Balanced, Surplus and Deficit
Budgets
We have defined the budget as an
annual statement of the estimated
receipts and expenditures of the
government over the fiscal year. A
budget may be in surplus, in deficit or
balanced, subject to the following
conditions:
Relative Sizes
of estimates
729815
Source : Economic Survey, 2002-03, Government

of India.
financial institutions to State Government

public enterprises. It also includes
developmental loans given by the Central
and State Governments to nondepartmental undertakings, local bodies
and other parties.
Non-developmental expenditures
include expenditures on defence,
interest payments, tax collection, police,
and other expenditures. Other
expenditures include that on general
administration, pensions, ex-gratia
payments to former rulers, famine relief,
subsidies on food and controlled cloth,
grants and loans to foreign countries
and loans for non-development purpose
to other parties etc.
Table 8.4 shows the break up of
expenditure of Central, State and Union
Territory Governments (including
internal and extra-budgetary resources
of public sector undertakings for their
Type of
Budget
Revenue < Expenditure
Deficit
Revenue = Expenditure
Balanced
Revenue > Expenditure
Surplus
Let us first consider the case of a

surplus budget. A surplus budget is
one where the estimated revenues are
greater
than
the
estimated
expenditures. To simplify the analysis,
let us assume a situation where the only
source of revenue is a lump sum tax.
Now, as we saw from chapter VI, the
effect of a tax is to lower the
consumption and therefore, aggregate
demand by an amount equal to the
marginal propensity to consume (MPC)
times the amount of the tax. The effect
of government expenditure is to
increase the aggregate demand by the
amount of the expenditure. Now, if tax
(and therefore revenue) is sufficiently
higher than the government
expenditure, then we will have MPC
times tax is greater than expenditure.
Then, the reduction in aggregate
demand (due to the tax) is greater than
126
the increase in aggregate demand (due

to expenditure). The net effect of this is
to lower aggregate demand. Thus, a
surplus budget will lower aggregate
demand.
Lowering aggregate demand is a
good way to combat inflation that arises
out of the presence of excess demand.
However, a surplus budget is a poor
strategy in the case of a deflation and
recession, as it will lower the already
deficient demand, thus worsening the
situation.
A balanced budget is one where the
estimated revenue equals the estimated
expenditure. Again, suppose that the
only source of revenue is a lump sum
tax. A balanced budget will then mean
that the amount of tax equals the
amount of expenditure. The decrease
in aggregate demand (due to the tax) is
equal to MPC times the tax. Since tax is
equal to expenditure, the decrease in
aggregate demand is also equal to MPC
times the expenditure. Now, the
increase in aggregate demand due to
the expenditure is equal to the amount
of the expenditure. Then, the increase
in aggregate demand (due to
expenditure) is greater than the
decrease in aggregate demand (due to
the tax). The net effect is to increase
aggregate demand by an amount equal
to the expenditure multiplied by
1 MPC. Thus, a balanced budget will
slightly increase the aggregate demand.
A balanced budget is therefore a policy
instrument to bring the economy which
is at near full-employment to a fullemployment equilibrium.
A deficit budget is one where the

estimated revenue is less than the
estimated expenditure. This means that
the tax is less than the expenditure. The
reduction in aggregate demand (due to
the tax) is equal to MPC times the tax.
The increase in aggregate demand (due
to expenditure) is by an amount equal
to the expenditure. Now, if tax is
sufficiently less than the expenditure
then the reduction in aggregate demand
will be less than the increase in aggregate
demand. The effect of this will be to
increase aggregate demand. The deficit
budget is therefore a policy instrument
to combat recession, where the economy
is in an under-employment equilibrium
due to deficient demand.
Types of Deficit
There are four different concepts of
budget deficit. They are budget deficit,
fiscal deficit, primary deficit and the
revenue deficit. We shall analyse them
individually.
Budget Deficit
The budget deficit is the difference
between the total expenditure on one
hand, and current revenue and net
internal and external capital receipts of
the government on the other. It has to
be financed by net internal and external
capital receipts. The calculation of the
budget deficit is shown in Table 8.6.
Fiscal Deficit
The fiscal deficit is the difference
between the total expenditure of the
government (by way of revenue
expenditure, capital expenditure and
loans net of repayments) on one hand,
GOVERNMENT BUDGENT
AND THE
ECONOMY
and on the other hand, the revenue

receipts plus those capital receipts
which are not in the nature of
borrowing, but which finally accrue to
the government.
The extent of the fiscal deficit is an
indication of how far the exchequer is
living beyond its means. The fiscal
deficit indicates the amount of
borrowing the government has to do. A
large fiscal deficit implies a large
amount of borrowings. This creates a
correspondingly large burden of
interest payments in the future. In the
present, a large fiscal deficit may also
fuel inflationary pressures.
Primary Deficit
The primary deficit is the fiscal deficit
minus interest payments. It therefore
indicates, how much government
borrowing is going to meet expenses
other than interest payments. It reflects
the extent to which current government
policy is adding to future burdens
stemming from past policy. It is often
used as a basic measure of fiscal
irresponsibility. In other words, it is a
measure of how much the government
is borrowing in continuance of its
profligate ways. A low or zero primary
deficit means that while its interest
commitments on earlier loans have
compelled the government to borrow,
it is aware of the need to tighten its belt.
Revenue Deficit
The revenue deficit is the excess of
governments revenue expenditures
over revenue receipts. It gives
information on what the government is
borrowing for. In the analogy of the
127
household, the revenue deficit tells the

amount the householder is borrowing
to pay the grocer, rather than add a roof
to the house. Given the same level of
fiscal deficit, a higher revenue deficit is
worse than a lower one. The revenue
deficit implies a repayment burden in
the future, not matched by any benefits
via investment.
Table 8.5 shows the various deficits
as per 2002-03 Indian budget
estimates.
Table 8.5: Types of deficits as per
2002-03 budgetary estimates
No. Item
Amount
(Rs. in Crores)
1. Revenue receipts
245105
(i) Tax revenue
172965
(ii) Non-tax revenue
72140
2. Capital receipts
165204
(i) Recovery of loans 17680
(ii) Other receipts
12000
(mainly PSU
disinvestments)
(iii) Borrowings and
135564
other liabilities
3. Revenue expenditure
340482
(i) Interest payments 117390
(ii) Major subsidies
38923
(iii) Defence expenditure43589
4. Capital expenditure
69827
5. Total expenditure
(i) Plan expenditure
(ii) Non-plan
expenditure
6. Fiscal deficit
[5 1 2(i) 2(ii)]
7. Revenue deficit
[3 1]
8. Primary deficit
[6 3(i)]
410309
113500
296809
135524
95377
18134
Source : Economic Survey, 2002-03, Government

of India.
128
The overall budgetary deficit of

Central, State and Union Territory
Governments is estimated using the
table of budgetary transactions
(Table 8.6)
Table 8.6: Overall budgetary deficit of
Central, State and Union
Territory Governments as
per 2001-02 budgetary
estimates.
No.
Item
Amount
(Rs. in Crores)
1. Total Outlay
729815
A.Development
369266
B. Non-Development
360549
(i) Defence (net)
62000
(ii) Interest payments 144588
(iii) Tax collection
charges
8533
(iv) Police
24383
(v) Others
121045
2. Current Revenue
A. Tax Revenue
(i) Income and
corporation tax
(ii) Customs
(iii) Union excise duties
(iv) Sales tax
(v) Others
476031
371355
84801
54822
81720
81579
68433
B.Non-Tax Revenue
104676
(Internal resources of
public sector undertaking
for the plan)
(45100)
3. Gap (1 2)
Financed by:
253784
4. Net Capital Receipts (A+B)

A. Internal (net)
248124
245561
(i) Net market loans

84410
(ii) Net small savings 11938
(iii) Net State and PPFs 31525
(iv) Special deposits on 10500
non-government PFs
(v) Net miscellaneous
capital receipts
107188
B. External
(i) Net loans
1165
(a) Gross
10763
(b) Less repayments 9598
(ii) Grants
698
(iii) Revolving fund
700
5. Overall Budgetary
Deficit (3 4)
2563
5660
Source:Economic Survey, 2002-03, Government

of India.
We have now seen the four concepts

of deficits. The deficit in a budget has
to be financed in one of two ways by
monetary expansion or by borrowing.
Monetary expansion amounts to
printing money to the extent of the
deficit. The process of monetary
expansion involves the government
borrowing from the Central Bank
through the issue of treasury bills to
the Central Bank. The Central bank
purchases the treasury bills in return
for cash, which the government uses
to fund the deficit. Alternatively, the
deficit may be funded by borrowing
from the public through market loans
etc. The safe level of fiscal deficit is
considered to be 5% of Gross
Domestic Product.
GOVERNMENT BUDGENT
AND THE
ECONOMY
129
SUMMARY
l
l
l
l
l
l
l
l
The budget is an annual statement of the estimated receipts and

expenditures of the government over the fiscal year, which runs from April
1 to March 31.
The government implements its policies through the budget.
The budget impacts the economy through aggregate fiscal discipline,
resource allocation and provision of programmes and delivery of services.
The budget is divided into revenue budget and capital budget.
Revenue may be divided into revenue receipts and capital receipts.
Expenditure may be classified in three ways revenue vs. capital, plan
vs. non-plan, and developmental vs. non-developmental.
Budgets are of three types surplus, balanced and deficit.
The three concepts of deficit are fiscal deficit, revenue deficit and primary
deficit.
EXERCISES
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
What is a budget?
What are the objectives of a budget?
What are the revenue items?
Define tax and non-tax revenue.
What is the difference between Revenue Budget and Capital
Budget?
Classify public expenditure.
Differentiate between developmental and non-developmental
expenditure.
What is non-plan expenditure?
Define:
(a) Fiscal deficit
(b) Budget deficit
(c) Revenue deficit
(d) Primary deficit
How may a deficit be financed?
U N I T - VI
BALANCE
OF
PAYMENTS
CHAPTER
FOREIGN EXCHANGE RATE:

MEANING AND DETERMINATION
A countrys economic stability is indicated,
among other things, by the stability in its
exchange rate. The strength of domestic
currency of a country is seen against that
of currencies of other countries in the
world. Earnings from exports and
payments for imports would directly be
affected by the exchange rate. Therefore,
it is important to know the forces that
operate upon the determination of foreign
exchange rate and the implications of
changes in it for the country concerned.
In this chapter we shall explain foreign
exchange rate determination.
Meaning
Foreign exchange rate is the price of one
currency in terms of another. It is the
rate at which exports and imports of a
nation are valued at a given point in
time. The foreign exchange rates, by
linking the currencies of different
countries, make the comparisons of
international costs and prices. They also
govern and are governed by the flow
and direction of foreign trade.
Foreign Exchange Market
The foreign exchange market is the
market where the national currencies
are traded for one another. Foreign

exchange market performs, mainly,
three functions viz., to transfer the
purchasing power between countries
(transfer function), to provide credit
channels for foreign trade (credit
function), and to protect against foreign
exchange risks (also known as hedging
function).
In view of the above three functions,
demand for foreign exchange is the
demand for foreign currencies by the
residents of a country. When people
wish to operate in the foreign exchange
market they intend to buy or sell foreign
exchange depending on their demand
for and supply of foreign exchange.
T ransactions in the foreign
exchange market are reflected in the
balance of payments account. The
value of Indian residents expenditure
abroad represents a supply of rupees
to the foreign exchange market. This is
because if an Indian buys a Japanese
radio from abroad, he will pay for it in
rupees. Now this total expenditure also
represents the demand for foreign
exchange that is Japanese Yen, since
the Japanese dealer will expect
132
payment in Yen. So rupees have to be

exchanged for Yen in the foreign
exchange market.
Similarly, the foreign earnings of
Indian residents reflect equal earnings
of foreign exchange. For example,
Indian exporters will expect to be paid
in rupees. So in order to buy our goods,
foreigners have to sell their currency and
buy rupees in return. Hence, there is
inflow of foreign exchange into India.
(c) foreign currencies flow into the

economy due to currency dealers
and speculators.
Hence the foreign exchange markets
are influenced by the above mentioned
underlying factors. The dominance of
demand or supply side is linked with
the nature of business fluctuations in
a given time period.
Demand and Supply Side
Foreign exchange market like any other

market is characterised by a downward
sloping demand curve and an upward
sloping supply curve. The price on the
vertical axis is stated in terms of
domestic currency (that is, how many
rupees for one US dollar, for instance).
The horizontal axis measures the
quantity demanded or supplied. The
intersection of the supply and demand
curves determines the equilibrium
exchange rate (Req) and the equilibrium
quantity (Qeq) of foreign currency, that
US ($). This is shown in Figure 9.1.
We have already pointed out that

peoples intention to transact in the
foreign exchange market depends upon
their demand and supply position with
respect to foreign exchange. The causal
factors behind the demand and supply
sides are mentioned below:
Demand Side
People desire to have or acquire foreign
exchange for the following reasons:
(a) to purchase goods and services
from other countries;
(b) to send a gift abroad;
(c) to purchase financial assets in a
particular country; and
(d) to speculate on the value of foreign
currencies.
Supply Side
Foreign currencies, flow into the
domestic economy due to the following:
(a) foreigners purchasing home
countrys goods and services
through exports.
(b) foreign investment in home country
through joint ventures or through
financial market operations; and
Equilibrium in the Foreign Exchange

Market
Price
Rs/$
S$
R'
S'$
Req
R"
D'$
D$
Qeq
Q" Q'
Demand and Supply of

US $
Fig. 9.1 : Equilibrium in the Foreign

Exchange Market
FOREIGN EXCHANGE RATE : MEANING
AND
DETERMINATION
Now, it is necessary to understand

the slopes of demand and supply curves.
In this figure the demand curve (D$) is
downward sloping. This means that less
foreign exchange is demanded as the
exchange rate increases. This is due to
the fact that the rise in the price of foreign
exchange will increase the rupee cost of
foreign goods, which makes them more
expensive. As a result, imports will
decline. Thus, the demand for foreign
exchange will also decrease.
The supply curve (S$) is upward
sloping which means that supply of
foreign exchange increases as the
exchange rate increases. This makes
home countrys goods become cheaper
to foreigner since the rupee is
depreciating in value. The demand for
our exports should therefore increase
as the exchange rate increases. 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.
Having shown the equilibrium in
the foreign exchange market, let us now
analyse disequilibrium conditions.
An increase in the demand for US
dollars in India will cause the demand
curve to shift to D$ and the exchange
raise rises. Note that the 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. Currency depreciation
takes place when there is an increase
in the domestic currency price of the
foreign currency. The domestic
currency is thus relatively less valuable.
133
Similarly, an increase in the supply

of US dollars will cause the supply curve
shift to S$ and exchange rate falls to
R. In this case rupee cost of US dollar
is decreasing and the Indian rupee is
said to be appreciating. Currency
appreciation takes place when there is
a decrease in the domestic currency
price of the foreign currency. In this case
domestic currency is more valuable.
Types of Exchange Rate Regimes
The determination of foreign exchange
depends on specific international
arrangement of procedure to determine
the exchange rate of one country
vis--vis others. Exchange rate regimes
have evolved over time in response to
global economic events. We shall
present below major international
monetary systems that India has
implemented so far.
Fixed Exchange Rate Systems
Under this system, exchange rate is
officially declared and it is fixed. Only a
very small deviation from this fixed
value is possible. A typical fixed
exchange rate system was associated
with the Gold Standard Systems of
1880-1914. Under the Gold Standard
systems each currency value was
defined in terms of gold and hence, the
exchange rate was fixed according to
the gold value of currencies that have
to be exchanged. This was referred to
as mint par value of exchange. For
example, if one Indian Rupee is
exchangeable for 125 grams of fine gold
and the US dollar ($) for 25 grams. Then
one rupee is equal to 125/25 = 5 US
dollars. So, the price is fixed at Re.1=$5.
134
Adjustable Peg System

The gold standard was abandoned in
the 1920s as it failed to automatically
correct the disequilibrium in countries
balance of payments. An alternate
system of fixed exchange rate called the
Bretton Woods system was established
in 1944. Under this arrangement, the
US dollar was made directly convertible
into gold at a fixed price. Member
countries fixed their rates of exchange
as against the US dollar. The Bretton
Woods system was an adjustable peg
system. The member countries were
required to fix the parity of their
currencies with gold. A change in the
parity was possible only through a
direction from the IMF. This system was
slightly modified from the fixed
exchange rate system but the role of gold
as ultimate unit of parity was preeminent.
Fixed exchange rate system was
supported due to its advantages as
given below:
(a) Fixed exchange rates ensure that
major economic disturbances
which will weaken the economic
policies of member countries, do not
occur.
(b) Fixed exchange rates contribute to
the coordination of macro policies
of countries in an interdependent
world economy.
(c) Fixed exchange rates are more
conducive to expansion of world
trade as they prevent risk and
uncertainty in transactions.
But the critics of fixed exchange
rates have identified several drawbacks
of this system. Hence, they suggest a

system of flexible exchange rates.
Flexible Exchange Rate System
Flexible exchange rates point to an
extreme situation where there is no
intervention by Central Banks. The
foreign exchange market is busy at all
times with changes in the exchange rates.
Following are the advantages
associated with flexible exchange rates.
(a) Flexible exchange rates eliminate
the need for central banks to hold
international reserves.
(b) Flexible exchange rates are helpful
to do away with barrier to trade and
capital movements.
(c) Flexible exchange rate enhances the
efficiency in the economy by
achieving optimum resources
allocation.
We have not provided a detailed
critique of both fixed and flexible rate
of exchange as it is beyond the scope of
our study here. But it must be borne
in mind that these are two extreme
positions and hence the debate on their
desirability is a continuing one.
Therefore, there have been numbers
of alternative systems suggested as
hybrid systems combining advantages
of fixed and flexible exchange rates. We
shall briefly describe their salient
features.
Wider Bands
This proposal considers the point that
Bretton Woods system allowed only 1
per cent variation on either side of the
parity values. The proposal for wider
bands states that the permissible
AND
DETERMINATION
variations around parity should be set

at 10 per cent, for all member countries to carry on balance of
payment adjustment easily. For
example, if a country has a balance of
payments deficit, the currency could be
depreciated up to 10 per cent from its
parity value to correct the
disequilibrium in the balance of
payments.
Crawling Peg
This is also a compromise between fixed
and flexible rates. According to crawling
peg scheme, a country specifies a parity
value for its currency and permits a
small variation around that parity
(such as 1 per cent from parity).
However, the parity rate is adjusted
regularly by small amounts as
warranted by the position of
international reserves held by a
country, changes in money supply or
prices, or recent variations in the
135
exchange rate around the parity. In the

crawling peg concept there is ceiling
and floor limits so that it can provide
for some discipline on the part of
monetary authorities. Figure 9.2 shows
the working of crawling peg.
In this crawling peg example, the
exchange rate fluctuates within its narrow band until point A is reached. The
loss of reserves from A to B and any
other indicators of currency weakness
trigger a small devaluation in the parity value. When difficulties again occur
from point C to point D, another small
official devaluation takes place. This
new parity value continues until a reserve buildup occurs from point F to
point G, whereupon the parity value of
the home currency is raised.
Managed Floating
The final hybrid in management of
exchange rates is the managed floating.
This is characterised by some
e
(Units of home
currency per
unit of foreign
currency)
C
A
Time
Fig. 9.2 : A Crawling Peg
136
hindrances with exchange rate

movements but the intervention is
discretionary on the part of monetary
authorities.
In other words, there is official
declaration of rules or guidelines for
intervention, no prefixed parity values,
and no announced times for variations.
Authority take a decision to intervene
if a particular situation in their
judgement requires it. Sometimes, this
intervention may be coordinated with
other countries as well.
Managed floating, in the absence of
rules and guidelines, could be
vulnerable to abuse of intervention. A
particular country could manipulate its
managed float to the detriment of other
countries. This behaviour is called dirty
floating.
This section has so far
summarized the two major systems
of exchange rates, namely, fixed and
flexible rates of exchange. Since the
arguments in favour of and against
these two systems are inconclusive,
attempts have been made to devise
hybrid systems such as wider bands,
crawling peg and managed floating.
The main object in providing these
details is to highlight the point that
determination of exchange rate is a
complex process in the international
monetary system.
Operation of Foreign Exchange
Market
Foreign exchange markets could be
studied in terms of period of transaction
carried out. If the operation is of daily
nature, it is called current market or
the spot market. On the other hand

market for foreign exchange for future
delivery is known as the forward
market.
Spot Market for Foreign Exchange
Spot rate of foreign exchange is
certainly
useful
for
current
transactions. But we should find what
the spot rate is. Besides, it is also
important to find the strength of the
domestic currency with respect to that
of the home countrys trading partners.
The measure of average relative
strength of a given currency is called
the Effective Exchange Rate (EER). As
we do not eliminate the effect of price
changes, this may also be called as
Nominal Effective Exchange Rate
(NEER).
If the domestic country (India) has
n trading partners then
n
NEER = ( R iindex ) (Wi )

i =1
Where, for the ith trading partner

(say the USA)
R i = exchange rate in Rupees/$

i
R a = exchange rate in year a
i
R b = exchange rate in base year b

i
i
R index = R a for the year b
i
Rb
Wi = ratio of trade volume with ith

partner to total trade volume of
domestic country
=
X i + Mi
X total + M total
AND
DETERMINATION
Where, X i = Exports to ith partner

Mi = Imports from ith partner
Xtotal = Total experts of domestic
country
Mtotal = Total imports of domestic
country
Secondly, we must have a measure
that could eliminate the effect of price
changes that is, an exchange rate that
would be based upon constant prices.
For this purpose we find out Real
Exchange Rate (RER).
In the year a for the partner i
RER index = R a
Price index in country ' i' in

year ' a' with base year as ' b'
Price index in India in year

' a' with base year as ' b'
Thirdly, the Real Effective Exchange

Rates (REER) calculates an effective
exchange rate based on real exchange
rates instead of nominal rates.
For n trading partners,
n
REER = (RER iindex (Wi )

i=1
Findings about exchange rate

appreciation or depreciation should be
made with reference to REER and not
solely upon NEER.
Fourth measure of the spot rate is
related to the equilibrium rate that
would make the current account being
in balance. This is based on the
argument that it is the relative prices of
goods and services between countries
that drive the exchange rates. This
argument is also referred to as
Purchasing Power Parity (PPP)
argument. There are two versions of it.
137
The absolute purchasing power parity

argument holds that commodities tend
to have the same price world wide when
measured in the same currency. There
is no empirical support to this line of
argument. The relative purchasing
power parity argument relates the
change in the exchange rate to the rates
of inflation in the two countries.
Forward Market for Foreign
Exchange
Unlike the spot market, the forward
market for foreign exchange covers
transactions which occur at a future
date. It is common to see that most of
the international transactions do not
occur on the same day. Usually they
materialise much later; that is beyond
the value date when the transaction is
signed. Since transactions contracted
at one point of time are completed only
at a later date, we should pay attention
to the forward exchange rate. It helps
both the parties involved to hedge
against risk in exchange rate at a future
date.
The forward market consists of
parties that demand or supply a given
currency at some future point in time.
A forward contract is entered into for
two reasons: one is to minimize risk of
loss due to adverse change in exchange
rate or to make a profit. First is called
hedging and the second is called
speculation.
We have thus far explained the
meaning and determination of foreign
exchange rates. For an economy, the
exchange rate stability is an important
objective of its macroeconomic policies.
138
Today, we find that any problem with

the exchange rate could create
enormous difficulties not only for the
country concerned but to others as
well. Recently, in the mid-1990s we
witnessed the East Asian currency
crisis mainly triggered by fluctuation

and instability of the currencies in East
Asia. Those interested could study
similar disturbances that have
occurred in other parts of the world
as well.
SUMMARY
l
l
l
l
l
l
Foreign exchange rate has become an important variable that engages the
attention of all those who are concerned with foreign trade.
Foreign exchange market plays many roles to transfer purchasing power, to
provide credit and help in hedging operations.
Equilibrium in the freely fluctuating foreign exchange market is brought about
by the intersection demand for and supply of foreign exchange.
Apart from two extremes of fixed exchange and flexible exchange rates, some
hybrid systems such as wider bands, crawling peg and managed floating are
also followed by some countries.
Distinction between spot and forward markets help understand the complex
operation in the foreign exchange market.
Instability in the exchange rate could give rise to currency crises.
EXERCISES
1.
2.
3.
4.
5.
6.
7.
8.
What is a foreign exchange rate?

Define foreign exchange market.
Describe the equilibrium in the foreign exchange market.
What are: (a) spot, and (b) forward markets in foreign exchange?
Define: (a) NEER (b) REER and (c) RER.
Differentiate between fixed and flexible exchange rates.
What is a parity value?
Explain the meaning of crawling peg and managed float.
CHAPTER
10
BALANCE OF PAYMENTS:
MEANING AND COMPONENTS
The Balance of Payment (BOP)
Accounts are an important aspect of the
study of macro economy. In our four
sector circular flow diagram given in
Chapter 2, it has been shown that the
external sector influences the working
of an open economy. Macroeconomic
phenomena cannot be confined with a
particular economy. On the other hand,
open economies react sharply to events
that are occurring in the rest of world
sector. In order to record the overseas
transactions of a country, the BOP
accounts are maintained and they
constitute an important part of the
national income accounts.
The BOP accounts are a summary
of international transaction of a country
for a given period, that is a financial
year. The balance of payments of a
country is a systematic record of all
economic transactions between the
residents of the reporting country and
the residents of foreign countries during
a given period of time1.
Here, are two questions that need
to be answered. They are: who is a
1
2
resident? What is a economic

transaction?
Resident of a country ordinarily
includes individuals, business units,
government and their agencies. An
economic transaction is an exchange of
value: a process in which there is
transfer of title to an economic good, the
rendering of an economic service from
residents of one country to residents of
other countries.2
Relation between National Income
and Balance of Payments
Economic activity usually generates two
types of transactions that give rise to
international payments and receipts.
Firstly, activities arising from production
and sale of current output and secondly,
those arising from the purchase and sale
of existing assets, both real and financial.
Let us consider the first, which is
production and sale of current output.
In an open economy, the expenditure of
consumers, investors and government
in addition to the expenditure of
foreigners on the countrys exports
International Economics, Charles P. Kindleberger Homeward, Illinois, Irwin, p. 457.

ibid
140
generates the nations production of

goods and services. The income
generated by this can be shown in the
following expression:
Y=C+I+G+X
This income is disposed off in the
purchase of consumer goods and
services (C), savings (S) and taxes (T). Add
the goods and services purchased from
abroad by the domestic sectors, that is
imports (M). Following expression gives
the way income is disposed off:
Y=C+S+T+M
According to national income
accounting, income generated must be
equal to income disposed off. Therefore,
C+I+G+X=C+S+T+M
Simplifying this we obtain
I+X+G=S+T+M
Here I, G and X are injections into
the income stream and S, T and M are
leakages there from. So, in equilibrium
planned injections must be equal to
total planned leakages.
Balance of Trade and Balance of
Payments
Balance of Trade takes into account only
those transactions arising out of the exports
and imports of goods (the visible items). It
does not consider the exchange of services
rendered such as shipping, insurance and
banking, payment of interest and dividend
or expenditure by tourists which are also
known as invisible items.
3
Balance of Payments takes into

account the exchange of both visible
and invisible items. Hence, the balance
of payments represents a better picture
of a countrys economic transactions
with the rest of the world than the
Balance of Trade.
Structure of Balance of Payment
Accounting
The transactions are recorded in the
balance of payments accounts in
double-entry book keeping. 3 Each
international transaction undertaken
by the country will result in a credit
entry and debit entry of equal size. As
international transactions are recorded
in double-entry accounting, the BOP
accounting must always balance: that
is, total amount of debits must equal
total amount of credits. Of course, the
balancing item Errors and Omissions
must be included to balance the BOP
accounts. By convention, debit items
and credit items are entered with a
minus sign and plus sign respectively.
Transactions in BOP are classified
into five major categories as given below:
1. Goods and services account
2. Unilateral transfer account
3. Long-term capital account
4. Short-term private capital account
5. 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
Table 10.1.4
Double-entry book keeping is an accounting principle requiring funds that come in to be entered in
an account that shows where they came from and also in an account that shows where they are put.
Funds that go out are entered in an account that shows what they are spent on and also in an
account that shows where they came from.
Dennis R. Appleyard and J. Field Homeward, International Economics, Illinois, Irwin 1992, p. 471.
BALANCE
OF
PAYMENTS: MEANING
AND
COMPONENTS
141
Table 10.1: Classification on System of Debits and Credits in the Balance of

Payments Accounts
Debits (-)
Credits (+)
CATEGORY - I
A. Imports of Goods
A. Exports of Goods
B. Imports of Services
B. Exports of Services
CATEGORY - II
Unilateral Transfers (Gifts) made
Unilateral transfers (Gifts) received
CATEGORY - III
A. Increase in long-term foreign assets
owned by home country private
citizens and government.
B. Decrease in long-term home country
assets owned by foreign private
citizens and governments.
A. Decrease in long-term foreign assets

owned by home country citizens and
government.
B. Increase in long-term home country
citizens and governments.
CATEGORY - IV
A. Increase in short-term foreign assets
citizens.
B. Decrease in short-term home country
citizens.
A. Decrease in short-term foreign assets

citizens.
B. Increase in short-term home country
citizens.
CATEGORY - V
A. Increase in short-term foreign assets
owned by home country government
(official monetary authorities).
B. Decrease in short-terms home country
asset owned by foreign governments
A. Decrease in short-term foreign assets

owned by home country government
B. Increase in short-term home country
asset owned by foreign governments,
Since there are two major categories

of accounts in the BOP accounts
statement, that is, current and capital
accounts, an explanation of current
and capital account is in order at this
stage to understand their components.
Current Account
The Current Account records imports
and exports of goods and services and
unilateral transfers. Exports, whether
of goods (steel, machinery, rice, etc.) or
services (banking services, insurance
142
services, tourism services to foreign

tourists in India, etc.) are entered as
positive items in the account. This is
because exports cause an inflow of
foreign exchange into the country.
Imports are recorded as negative items
in the account because imports cause
an outflow of foreign exchange from the
country.
1. BOP accounts differentiate between
trade in goods and trade in services.
The balance of exports and imports
of goods is called the balance of
visible trade, and the balance of
exports and imports of services is
called the balance of invisible trade.
The terms are used because goods
are visible to the eye but services are
invisible to the eye.
2. Unilateral transfers or unrequited
transfers are receipts which
residents of a country receive, or
payments that the residents of a
country make without getting
anything in return, i.e. receipts or
payments for which there is no quid
pro quo. Receipts from abroad are
entered as positive items and
payments abroad are entered as
negative items.
Private unrequited transfers are
gifts that domestic residents receive
from or make to foreign residents. An
example of this would be Indians in
Gulf countries sending back money to
their relatives in India. Official
unrequited transfers is the receipt of or
giving of foreign aid, from developed
countries or to developing countries.
The net value of balances of visible
trade and of invisible trade and of
unilateral transfers is the balance on

current account.
Capital Account
The Capital Account records all
international transactions that involve
a resident of the domestic country
changing his assets with a foreign
resident or his liabilities to a foreign
resident. The various forms of capital
account transactions are given below.
1. Private transactions: These are
transactions that are affecting
assets or liabilities by individuals,
businesses, etc. and other nongovernment entities. The bulk of
foreign investment is private.
2. Official transactions: Transactions
affecting assets and liabilities by the
government and its agencies.
3. Direct investment: It is the act of
purchasing an asset and at the same
time acquiring control of it (other
than the ability to re-sell it). An
example of such an investment is
the acquisition of a firm in one
country by a firm in another
country. The transfer of funds from
the parent company abroad to the
subsidiary company in the domestic
country so that the subsidiary can
acquire assets in the domestic
country is another type of direct
investment. Such business
transactions form the major part of
private direct investment overseas.
Similar transactions by individuals
could be the purchase of a house
abroad, etc.
4. Portfolio investment: It is the
acquisition of an asset that does not
BALANCE
OF
PAYMENTS: MEANING
AND
COMPONENTS
give the purchaser control over the

asset. An example of such
investment is the purchase of shares
in a foreign company or of bonds
issued by a foreign government, or
loans made to foreign firms or
governments.
By convention, the purchase of an
asset from another country appears as
a negative item on the capital account
for the purchasing country (there is
outflow of foreign exchange). Thus,
capital outflows are awarded a negative
sign and capital inflows are awarded a
positive sign.
The net value of the balances of
direct and portfolio investment is called
the balance on capital account.
Other items in the Balance of Payments
The remaining items that cannot be
categorised into the two preceding
categories constitute the other items in
the balance of payments. They are
included since the full balance of
payments account must balance. These
items are as follows:
1. Errors and omissions: These are to
take into account the difficulty of
accurately recording all the wide
variety of transactions that take
place in the accounting period. They
may arise due to the presence of
sampling of transactions rather
than recording each individual
transaction (for example instead of
recording each of a thousand
exports of lemons, they may
multiply an average lemon export
figure by thousand), due to
dishonesty, i.e. businessmen
under-reporting sales abroad to
143
avoid taxes, or when smuggling

occurs, etc.
2. Official reserve transactions: All
transactions except those in this
category may be termed as
autonomous transactions. They are
so called because they are entered
into with some independent motive,
i.e. not with a view to bring their
consequences on the balance of
payments or on the exchange rate.
In contrast to this, official reserve
transactions are carried out by the
government and the central banks
in pursuit of some international
economic policy objective; while
keeping an eye on such
transactions effect on the BOP and
the exchange rate. As a result such
transactions are not autonomous.
The first of these items is the
change in the domestic countrys
official reserve assets. These reserves
of a country are held in the form of
foreign currency or foreign currency
securities, gold and Special Drawing
Rights (SDR) with the IMF. SDR allows
a country to avail of foreign exchange
in proportion to the quantum of the
countrys deposit of its currency with
the IMF under the SDR scheme. The
changes in the countrys reserves
must reflect the net value of all other
items in the BOP. Reduction in these
assets will be used to finance
expenditures abroad. Reductions
appear as a credit item in the BOP
(because their sale causes foreign
exchange inflow into the country). An
increase in these reserves will appear
as a debit because purchasing assets
144
Table 10.1: Indias Balance of Payments
Sl. Item
No
1990-91 2001-02
1 Exports
18477
44915
2 Imports
27915
57618
3 Trade Balance
-9438
-12703
4 Invisibles (net)
-242
14054
(i) Non-factor services
980
4199
(ii) Investment income
-3752
-2654
(iii) Private Transfers
2069
12125
(iv) Official transfers
461
384
-9680
1351
6 External assistance
(net)
2210
1204
7 Commercial
borrowing (net)
2248
-1147
8 IMF (net)
1214
9 NR deposits (net)
1536
2754
10 Rupee debt service
-1193
-519
103
5286
97
3266
(ii) FIIs
1505
(iii) Euro equities

& others
515
12 Other flows (net)
2284
2828
13 Capital account
total (net)
8402
10406
14 Reserve use
(-increase)
1278
-11757
5 Current Account
Balance
11 Foreign investment
(net) of which
(i) FDI (net)
Source:
Economic Survey, 2002-03,

Government of India.
will cause an outflow of foreign

exchange.
The second of these transactions is

the change in foreign official assets in
India. Foreign central banks will hold
part of their reserve assets in the form
of rupees. If foreign central banks
increase the amount of official reserve
assets held in India it will appear as a
positive item because their purchase of
our rupee securities or rupees will
cause inflow of foreign exchange into
India. The table 10.1 gives the
components of Indias Balance of
Payments and changes over the last
decade.
Autonomous and Accommodating
Items
In the discussion of these various
balances in BOP account, economists
use the terms such as autonomous
items, accommodating items, above the
line items and below the line items in
the balance of payments. Let us explain
their meaning.
Autonomous items in the BOP refer
to international economic transactions
that take place due to some economic
motive such as profit maximization.
These transactions are independent of
the state of the countrys balance of
payments. These items are often called
above the line items in the BOP.
The balance of payments is in deficit
if the autonomous receipts are less than
autonomous payments. This means
that the foreign country has some net
claims against the domestic country.
The BOP is in surplus if the
autonomous receipts are greater than
autonomous payments. This means
that the domestic country has some net
claims against the foreign country.
BALANCE
OF
PAYMENTS: MEANING
AND
COMPONENTS
The monetary authorities may

finance a deficit by depleting their
reserves of foreign currencies, or by
borrowing from the IMF, or by
borrowing from foreign monetary
authorities. This will be shown as
decrease in reserves. The monetary
authority may deploy a surplus by
purchasing foreign securities, foreign
currency or gold. This appears as an
increase in reserves.
Accommodating items in the BOP
refer to transactions that occur because
of other activity in the BOP, such as
government financing. Accommodating
items are also referred to as below the
line items. The official settlements are
seen as an accommodating item in
order to keep the BOP identity. The
official settlements approach to the
balance of payments looks at the net
monetary transfer that has been made
by the monetary authorities in
settlement. The assumption made in
this approach is that the monetary
authority is the ultimate financier of any
deficit in the balance of payments or the
ultimate recipient of any surplus.
Note that the official settlements
approach assumes importance in a
fixed exchange rate set-up. In a flexible
rate set-up, much of the deficit and
surplus will be automatically wiped out
by an adjustment in the exchange rates,
leaving less settlement work for the
monetary authorities.
Disequilibrium in Balance of
Payments
There are a number of factors that cause
disequilibrium in the balance of
payments showing either a surplus or
145
deficit. These causes are broadly

categorized into (a) Economic factors (b)
Political factors and (c) Social factors.
Economic Factors
Large-scale
development
expenditure that may cause large
imports.
Cyclical fluctuations in general
business activity such as
recession or depression.
High domestic prices may result
in imports.
New sources of supply, new and
better substitutes to existing
products and changes in costs
will bring about a change in trade
flows and hence BOP over a
period of time.
Political Factors
Political instability may cause large
capital outflows and dampen the
inflows of foreign capital.
Social Factors
Changes in tastes, preference and
fashions may affect imports and
exports.
Balance of payments disequilibrium
is a serious issue for policy makers. A
chronic BOP deficit leads to
downgrading the economy in the world
community. Domestic sectors also
receive the impact of BOP deficit. Hence,
the monetary authority of the country
concerned and the IMF undertake
certain corrective measures to deal with
the disequilibrium in the BOP. So, every
country in its economic agenda strives
hard to perform well in its international
trade in order that it will not enter into
problems of BOP disequilibrium.
146
SUMMARY
l
l
l
l
Balance of Payment accounts is an integral part of the national income

accounts.
BOP accounts are maintained in a double-entry accounting structure.
Overall balance of payments is important for economic policy.
Disequilibrium in the BOP undermines the economic fundamentals of a nation.
EXERCISES
1.
2.
3.
4.
5.
6.
7.
Define Balance of Trade and Balance of Payments

Explain the five categories of classifying transactions.
Give the structure of Balance of Payment Accounts in India.
Explain the relationship between Balance of Payments and National
income Accounts.
Define accommodating and autonomous items.
Explain the components of: (a) Current Account, and (b) Capital
Account.
Describe the causes for disequilibrium in the BOP.
GLOSSARY
Accommodating Items
A term used in BOP Accounts, that refer

to transactions that occur because of
other activity in the BOP, such as
government financing.
Accounting Period
An accounting period or a financial year
often does not coincide with a calendar
year. Ordinarily, a financial year refers to,
for example, April 1, 2003 to March 31,
2004
Actual Investment
The actual amount of investment that took
place, measured after the fact.
Actual Savings
The actual amount of savings that took
place, measured after the fact.
Adjustable Peg
Adjustable peg system is one in which
member countries fix or peg their
currencies rate of exchange against one
particular currency. The fixed or pegged
exchange rate could be adjusted under
certain conditions, hence the term
adjustable peg.
Administrative Revenue
Revenue that arises on account of the
administrative function of the government.
Aggregate Demand
The total demand for goods and services
in the economy.
Aggregate Supply
Total supply of goods and services in the
economy.
Autonomous Items
A term used in the BOP Accounts, that
refer
to
international
economic
transactions that take place due to some
economic motive such as profit
maximization.
Average Propensity to Consume At any particular level of income, the ratio
of consumption to income is called the
Average Propensity to Consume. (APC).
The APC gives the average consumption
income relationship at different levels
of income.
148
Average Propensity to Save
At any particular level of income, the

Average Propensity to Save (APS) is the
ratio of savings to income.
Balance of Payments
The balance of payments of a country is a

systematic record of all economic
transactions between the residents of the
reporting country and residents of foreign
countries during a given period of time.
Balance of Trade
Those transactions that arise out of the

exports and imports of goods. It does not
consider the exchange of services rendered
such as shipping, insurance and
banking, payment of interest and dividend
or expenditure by tourists
Balanced Budget
It is a budget where the estimated revenue

equals the estimated expenditure.
Bank Rate
The bank rate is the rate at which the

central bank lends funds as a lender of
last resort to banks, against approved
securities or eligible bills of exchange.
Barter Exchange
The exchange of goods for goods is called

barter exchange.
Base Year
It is a reference year in the past, i.e. it is a

year chosen to be the basis for comparison
of the value of a particular variable with
the value of that variable in another year.
For example, if we are comparing the price
level in 2003 with that in 2000, then 2000
is the base year.
Bearer of Options
Money is a bearer of options because it

gives the freedom to its possessor to either
hold it or to spend it on any commodity,
which can be purchased from anyone.
Bills of Exchange
A document acknowledging an amount of

money owed in consideration for goods
received.
Budget
The budget is an annual statement of the

estimated receipts and expenditures of the
government over the fiscal year, which
runs from April 1 to March 31.
GLOSSARY
149
Budget Deficit
The budget deficit is the difference between

the total expenditure on one hand, and
current revenue and net internal and
external capital receipts of the
government. It has to be financed by net
internal and external capital receipts.
C-C Economy
An economy in which commodities are

exchanged for commodities.
Capital Budget
A statement of the estimated capital

receipts and payments of the government
over the fiscal year, which runs from April
1 to March 31.
Capital Consumption
Allowance
Monetary value assigned to the rate of

depreciation of a physical asset in one
year.
Capital Expenditure
Consists mainly of expenditure on

acquisition of assets like land, buildings,
machinery, equipment; investments in
shares, etc. and loans and advances
granted by the central government to state
and union territory governments,
government companies, corporations and
other parties.
Capital Receipts
Items included in capital receipts are loans

raised by the government from the public
(these are called Market Loans),
borrowings by the government from the
Reserve Bank of India and other parties
through the sale of treasury bills, loans
received from foreign governments and
other international bodies (For example,
World Bank, Asian Development Bank,
etc.), recoveries of loans granted to state
and union territory governments and other
parties, small savings and deposits in the
public provident fund (PPF), etc.
Cash Credit
Credit which is advanced against the

value of the borrowers current assets,
which comprise mainly stocks of goods
raw materials, semi-manufactured or
finished goods, and bills receivable (dues)
from others.
150
Cash Reserve Ratio
Circular Flow
Commercial Revenue
Consumption Function
Constant Prices
The portion of net demand and time
liabilities every bank is required to deposit
with the RBI.
A pictorial illustration of the inter dependence between the major sectors of
economic activity.
Revenue received by the government in
the form of prices paid for government
supplied commodities and services, i.e.
revenues derived from the government
from their public enterprises.
The relationship between consumption
and income.
Prices prevailing in the base year.
Crawling Peg
A scheme by which a country specifies a

parity value for its currency and permits
a small variation around that parity (such
as 1 per cent from parity). However, the
parity rate is adjusted regularly by small
amounts as warranted by the position of
international reserves held by a country,
changes in money supply or prices, or
variations in the exchange rate .
Credit Money
This refers to money, whose value is

greater than the commodity value of the
material from which the money is made.
Currency
Currency consists of paper currency, that

is all the notes issued by the Central Bank,
as well as coins.
Currency Appreciation
A situation in which there is a decrease

foreign currency.
Currency Authority
The authority for the issue of currency in

the country.
A situation in which there is an increase
foreign currency.
Deposits in current accounts that are
payable on demand. They can be drawn
upon by cheque without any restriction.
No interest is paid on these deposits.
Currency Depreciation
Current Account Deposits
Deferred Payments
Payments which are to be made in the

future.
GLOSSARY
Deficient Demand
Deficit Budget
Deflationary Gap
Demand Loans
Depreciation
Developmental Expenditure
Direct Tax
Dividend
Double Counting
151
If the aggregate demand is an amount of
output which is less than the full
employment level of output, then it is
known as deficient demand.
A budget where the estimated revenue is
less than the estimated expenditure.
The difference between the actual level of
aggregate demand, and the level of
aggregate demand required to establish
the full-employment equilibrium. It is a
measure of the amount of aggregate
demand deficiency.
A demand loan is one that can be recalled
on demand. It has no stated maturity. The
entire loan amount is paid in lump sum
by crediting it to the loan account of the
borrower.
The value of the existing capital stock that
has been consumed or used up in the
process of producing output.
Development expenditure includes plan
expenditure of Railways, Posts and
Telecommunications
and
nondepartmental commercial undertakings
financed out of their internal and extra
budgetary resources, including market
borrowings and term loans from financial
institutions to State Government public
enterprises. It also includes developmental
loans given by the Central and State
Governments to non-departmental
undertakings, local bodies and other
parties
Those taxes that are levied immediately
on the property and income of persons,
and those that are paid directly by the
consumers to the state. Income tax,
interest tax, wealth tax, corporation tax
are all examples of direct taxes.
The amount paid out annually to
shareholders, by the company whose stock
is owned by the shareholders.
Counting product two or more times is
called double counting. Double counting
will exaggerate or over -estimate the
value of GDP.
152
Double-entry Accounting
Durable Goods
Effective Exchange Rate
Equilibrium
Escheat
Excess Demand
Factor Incomes
Factor Market
Fee
Fiat Money
An accounting principle requiring funds
that come in to be entered in an account
that shows where they came from and also
in an account that shows where they are
put. Funds that go out are entered in an
account that shows for what they are
spent on and also in an account that
shows where they came from.
Goods that have a long life span in their
use to consumers.
The measure of average relative strength
of a given currency with respect to other
currencies.
The equilibrium between aggregate
demand and aggregate supply occurs,
when at a particular price level, the
aggregate demand is equal to the
aggregate supply. It is the point at which
the total output of goods and services
produced equals the total demand for
those goods and services.
All the claims of the government on the
property of a person who dies without
having any legal heirs or without leaving
a will.
If the aggregate demand is for a level of
output more than full-employment level of
output, then it is known as excess
demand.
Incomes received by the factors of
production for their contribution to the
production process. Land receives rent,
labour receives wages, capital receives
interest and entrepreneurs receive profits.
The market for factors of production.
A payment to defray the cost of each
recurring service undertaken by the
government, primarily in the public
interest, but conferring a measurable
special advantage on the fee payer. For
example, college fees in government
colleges.
Money that serves as money on the fiat
(order) of the government.
GLOSSARY
Fiduciary Money
Final Goods
Financial Intermediaries
Fine
Fiscal Deficit
Fiscal Discipline
Fiscal Policy
Fiscal Year
Fixed Deposits
Fixed Exchange Rate
Flexible Exchange Rate
Forfeitures
153
Money which is accepted as money on the
basis of the trust that its issuer
commands.
Those that are meant for final use by
consumers or firms. These goods are not
required to enter into further stages of
production or resale to change their form
and content. They are finished goods
meant only for final consumption or
Investment.
Institution that receive funds from savers
and lends them to borrowers. These include
depository institutions such as banks and
non-depository institutions such as
mutual funds, pension funds, etc.
Fines are amounts levied for an
infringement of a law.
The difference between the total
expenditure of the government and the
revenue receipts plus those capital
receipts which are not in the nature of
borrowing, but which finally accrue to the
government.
Fiscal discipline is having control over
expenditures, given the quantum of
revenues.
Governments expenditure and tax policy
together is known as its fiscal policy.
The fiscal year runs from April 1 to March
31.
These are deposits for a fixed term (period
of time) varying from a few days to a few
years.
Under this system exchange rate is
officially declared and it is fixed. Only a
very small deviation from this fixed value
is possible.
A situation where there is no official
intervention in the foreign exchange
market. The exchange rate is determined
by the interaction of supply and demand
in the foreign exchange market.
Penalties imposed by courts for noncompliance with orders or non-fulfillment
of contract, etc.
154
Forward Rate
Frictional Unemployment
Full-bodied Money
Full-employment Equilibrium
GNP Deflator
Hedging
Inconvertible Currency
Inflationary Gap
Intermediate Goods
Indirect Taxes
Inventory
Exchange rate that prevails in a forward
contract for the purchase or sale of foreign
exchange.
Temporary unemployment of people who
are between jobs. Since it takes time for a
person to switch from one job to another,
at any one point of time there will be a
small
amount
of
temporary
unemployment.
Full-bodied money is money whose value
as a commodity for non-monetary
purposes is as great as its value as money.
An equilibrium where all
resources in
the economy are fully utilised.
The average level of the prices of all the
goods and services that make up GNP. It
is calculated as the ratio of nominal GNP
to real GNP, multiplied by 100.
Activity that is designed to minimize risk
of loss
Currency that is not convertible into the
precious metal (gold), or other assets that
back it.
It is the amount by which the actual
aggregate demand exceeds the level of
aggregate demand required to establish
the full-employment equilibrium. The
inflationary gap is a measure of the
amount of the excess of aggregate demand.
Intermediate goods are those goods which
are used to produce other goods and
therefore they always move from one stage
of production to another in the
manufacture of a final product.
Those taxes that are levied on goods and
services. They only affect the income and
property of persons indirectly, through
their consumption of goods and services.
Stocks of final goods awaiting sale, semifinished goods, or of materials used in the
production process (inputs).
Investment Demand Function The relationship between investment

demand and the rate of interest.
GLOSSARY
Legal Tender
155
Money that has the legal power to

discharge debts, and a creditor who
refuses it may not demand anything else
in payment of an existing debt.
License Fee
Fees that are paid in those instances in which
the government authority is invoked simply
to confer a permission or privilege rather than
to perform a service of a more tangible and
definite sort. For example, registration fee for
an automobile, firearm, etc.
Liquidity
The ability to convert an asset into money
quickly and without loss of value.
Lump Sum Tax
Taxes that do not change with income or
other economic variables.
M1, M2, M3, M4
These are measures of the money stock
that are reported by the RBI, and decrease
in liquidity from M1 to M4.
Macroeconomics
Study of relations between broad economic
aggregates
Managed Floating
This is a hybrid of fixed and flexible
exchange rates. It is characterized by some
intervention in the exchange rate
movements but the intervention is
discretionary on the part of monetary
authorities.
Marginal Propensity to Consume The change in consumption per input
change in income.
Marginal Propensity to Save
The change in savings per unit change in
income
Minimum Reserve System
A system of note issue whereby the Central
Bank has to keep a minimum reserve of
assets backing its notes, against which it
may issue any amount of notes.
Monetary Liability
It is the liability of the Central Bank
arising out of its currency issue. This
means that the Central Bank is obliged to
back the currency with assets of equal
value
Monetary Policy
The policies of the Central Bank in
exercising its control over money, interest
rates and credit conditions. The
instruments of monetary policy are mainly
open-market
operations,
reserve
requirements, and the bank rate.
156
Monetary Standard
Type of standard money used in the

economy.
Monetizing Debt
The process of converting government debt

(whether existing or new), which is a nonmonetary liability, into Central Bank
currency, which is a monetary liability.
Money Flow
All the payments to factors of production

and expenditure on goods and services in
the circular flow of income .
Money Supply
Total stock of moneys of various kinds at

any particular point of time in an economy.
Moneyness
Having characteristics of money.
Moral Suasion
This is a combination of persuasion and

pressure that the Central Bank applies
on the other banks in order to get them to
fall in line with the Central Banks policy.
Multiplier
It is the number by which the change in

investment must be multiplied in order to
determine the resulting change in output.
Natural Monopoly
A natural monopoly is a situation where

there are economies of scale over a large
range of output; then one firm can produce
at a lower average cost than could more
than one firm. Industries which are
potential natural monopolies are railways,
electricity, etc
Nominal GNP
GNP measured in terms of current market

prices.
Nominal Effective Exchange

Rate (NEER)
The measure of average relative strength

of a given currency with respect to other
currencies without eliminating the effect
of price change.
Non-developmental Expenditure Expenditures on defence, interest

payments, tax collection, police. It also
include
expenditure
on
general
administration, pensions, ex-gratia
payments to former rulers, famine relief,
subsidies on food and controlled cloth,
grants and loans to foreign countries and
loans for non-development purpose to
other parties, etc.
Non-durable Goods
Goods that have a short life span in their

use to consumers.
GLOSSARY
Non-market Goods
Non-plan Expenditure
Non-tax Revenue
Open Market Operations
Overdraft
Paper Currency Standard
Parity Value
Penalty
Plan Expenditure
Planned Investment
Planned Savings
Price Index
Price Level
Primary Deficit
157
These are goods that have been consumed
without using organized markets.
Is that public expenditure which does not
represent current development and
investment outlays that arise due to plan
proposals.
All revenue receipts that do not arise out
of taxes.
Buying and selling of securities by the RBI
in the open market. This is a tool of the
Central Bank for monetary control.
An advance given by allowing a customer
to overdraw his current account upto an
agreed limit.
When a monetary authority adopt a
standard currency made of paper in a
country, that country is on a paper
currency standard.
In a fixed exchange rate system, the value
of a currency will be fixed in terms of
another currency or in terms of gold. This
value is known as the parity value of the
currency.
An amount levied for an infringement of a
law.
That public expenditure which represents
current development and investment
outlays that arise due to plan proposals.
The amount of planned or desired
investment given by the investment
demand function.
The amount of planned or desired savings
given by the savings function.
An index number that shows how the
average price of a bundle of goods has
changed over a period of time.
The average level of prices prevailing in
an economy. It is measured by the price
index.
Fiscal deficit minus interest payments. It
indicates how much of the government
borrowing is going to meet expenses other
than interest payments.
158
Promissory Notes
A promissory note is a promise to pay the

bearer of the note a certain sum.
Real GNP
GNP that is computed as per constant

prices.
Real Effective Exchange Rate

(REER)
An effective exchange rate based on real

exchange rates instead of nominal rates.
Real Exchange Rate
The exchange rate that is based constant

prices.
Real Flow
The flow of factor services and goods and

services in the circular flow of income.
Representative Full Bodied

Money
It is equivalent to a circulating warehouse

receipt for full-bodied coins or their
equivalent in bullion. The representative
full-bodied money itself has no value as a
commodity, but it represents in circulation
an amount of money with a commodity
value equal to the value of the money.
Representative Token Money
This is usually in the form of paper, which

is in effect a circulating warehouse receipt
for token coins or an equivalent amount
of bullion that is backing it.
Resource Allocation
The manner in which an economy

distributes its resources among the
potential uses in order to produce a
particular set of final goods.
Rest of the World
The rest of the countries in the world,

excluding the domestic country.
Revenue Budget
A statement of the estimated revenue

receipts of the government and the
expenditure met from such revenues.
Revenue Deficit
The excess of governments revenue

expenditures over revenue receipts.
Revenue Expenditure
Expenditure incurred for the normal

running of government departments and
provision of various services, interest
charges on debt incurred by the
government, subsidies, etc. In general,
any expenditure that does not result in
the creation of assets.
Saving
Income which is not consumed and not

paid out in the form of taxes.
GLOSSARY
159
Savings Account Deposits
These deposits combine the features of

both current account deposits and fixed
deposits. They are payable on demand and
also withdrawable by cheque, but with
certain restrictions on the number of
cheques issued in a period of time. Interest
is paid on the deposits in these accounts.
Savings Function
The relationship between savings and

income.
Says Law of Markets
Supply creates its own demand. If goods

are produced then there will automatically
be a market for them. This means that
there cannot be a general overproduction
or glut in an economy that is based on a
market system of production and
exchange.
Search Cost
It is the physical cost of searching the time

spent in searching.
Selective Credit Controls
Measures used to channel the flow of credit

to particular sectors, usually the priority
sectors.
Short-term Loans
Loans given for a short period of time. They

are given as personal loans, working
capital finance or as priority sector
advances.
Spot Rate
Exchange rate that prevails in the spot

market for foreign exchange.
Standard Money
Legal money by which the government of

a country discharges its obligations.
Statutory Liquidity Ratio
The SLR requires the banks to maintain

a specified percentage of their net total
demand and time liabilities in the form of
designated liquid assets.
Subsidies
Payments by government to firms or

households that provide or consume a
commodity. For example, government may
subsidize food by paying for a part of the
food expenditures of low-income
households.
Surplus Budget
It is one where the estimated revenues are

greater than the estimated expenditures.
160
Tax Revenue
All the proceeds of taxes and other duties

levied by the Central Government.
Token Coins
Coins whose value as money is far above

the value of the metal contained in them.
Trading Costs
The cost of engaging in trade.
Transfer Payments
Payments made where there is no good or

service received in exchange.
Under-employment Equilibrium
A state of equilibrium where all resources

are not fully utilised, that is, some
resources are under-employed.
Value Added
Value added is defined as the difference

between total value of output of a firm and
value of inputs brought from other firms.
It measures the value which the firm
concerned has added by its production
process.
Wage-price Flexibility
A situation in which (money) wages and

prices are flexible, that is, they can
increase or decrease freely and quickly.
The effect of wage-price flexibility is that
the market for labour and the markets for
goods and services will always be in
equilibrium.
Wider Band
It is a modification of the Bretton Woods

system that states that the permissible
variations around parity should be set at
10 per cent, for all member-countries to
carry on balance of payments adjustment
easily.

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U N I T- I

Economic decisions of individual

happening in the economy. Perhaps, it

an output and its price. But in

happens in India, to take away a part

in macroeconomics aggregate output is

namely households and firms.

setback to the economy. Classical

the way for Keynesian theory. This is the

STRUCTURE OF THE MACRO ECONOMY :

investment and tax payments are all

income for the economy as a whole. It is

3. National income accounting helps

NATIONAL INCOME ACCOUNTING

simply means that every economic

(b) Goods and services3 flow in one

would be a helpful pre-requisite to

Households spend their entire

Firms sell all that is produced to the

Such an economy as described above

(i) Household sector has the

NATIONAL INCOME ACCOUNTING

This flow of money payments

2. Factor Payments by Firms =

This simple circular flow highlights

Households and Firms can lend and

NATIONAL INCOME ACCOUNTING

Factor Se rvi ces

funds flow between sectors as

inclusion of the Government sector.

Fig 2.3: The Circular Flow of Income in a Three-sector Economy

taxes from Households and Firms in

is connected with circular flow of

NATIONAL INCOME ACCOUNTING

Fig 2.4 : The Circular Flow of Income in a Four-sector Economy

X M = Net exports (Where, X = Exports,

What are the uses of national income accounting?

NATIONAL INCOME ACCOUNTING:

aggregate output equals the value of

assess the rate of growth of an economy

taken into account in the measurement

A seminal contribution to the field of National Income and

NATIONAL INCOME ACCOUNTING : CONCEPTS

Another important contribution in this field is that of

in the final stage of the assembly line is

is, no product should be counted two

is through the method of value added.

a goods value increases at each stage

Table 3.1 : Numerical Illustration of GNP Measurement

Total (in Rs.) 1.00

NATIONAL INCOME ACCOUNTING : CONCEPTS

farmer. Therefore, the farmers valueadded in the cultivation stage will be

(iii) Net-value added at Market Price =

from Firm B imports by

(iii) Government Purchases of

goods and services that are purchased

NATIONAL INCOME ACCOUNTING : CONCEPTS

Durable goods also have their limited

Investment is an addition to the stock of

(b) Inventory investment

awaiting sale, semi-finished goods, or

Now the investment component as

NATIONAL INCOME ACCOUNTING : CONCEPTS

total value of payments made by