UNIT V NATIONAL INCOME & RELATED AGGREGATES

Transcription

1 UNIT V NATIONAL INCOME & RELATED AGGREGATES

2 Unit no: 5 NATIONAL INCOME ACCOUNTING AND RELATED AGGREGATES National Income Accounting(MARKS 15) Mind Map Circular Flow of Income PRODUCTION DISPOSITION DISTRIBUTION NATIONAL INCOME AND RELATED AGGREGATES GDP (MP) GDP (FC) NDP (MP) NDP (FC) GNP (MP) GNP (FC) NNP (MP) NNP (FC) GNDI NNDI Domestic Income to Pvt.Sector Private Income Personal Income Personal Disposable Income

3 Methods of Measuring National Income Value Added Method Income Method Expenditure Method Gross Value Added(GVA)= GVA of P.S+ GVA of S.S+ GVA of T.S GDP (MP) Compensation of employees+ Operating Surplus + Mixed Income NDP (FC) (+)Net Factor Income from Abroad Pvt. Final Consumption Expenditure+ Govt. Final Consumption Expenditure+ Gross Investment Expenditure+ Net Exports (-)Depreciation (-)Net Indirect Taxes (-)Depreciation (-)Net Indirect Taxes NNP (FC) NDP (FC) (+)Net Factor Income from Abroad NDP (FC) (+)Net Factor Income from Abroad NNP (FC) NNP (FC)

4 Macro Economics Meaning It is a branch of economics which deals with aggregates or economy as a whole. Exampleof aggregates are, National Income, Aggregate demand, Aggregate supply. Distinguish between Micro Economics and Macro Economics. Micro Economics a) It deals with individual economic units Macro Economics It deals with aggregates or Economy as a whole. b) It deals with partial equilibrium It deals with general equilibrium c) concerned with allocation of resources Concerned with fuller utilization and growth of resources. Circular flow of income in a two sector model It refers to flow of money income or flow of goods and services across differentsectors of an economy in a circular form. Stock and flow: Stock : It is an economic variable measured at particular point of time. Eg: Wealth Flow : It is an economic variable measured over a period of time.eg: National income. Intermediate goods and final goods Intermediate goods: The goods which are used to produce other goods.eg.raw materials. Final goods : The goods which are either used for consumption or for investments.eg. Food items National income aggregates: a) GDP MP :It is the sum of money value of all final goods & Services produced with in the domestic territory during an accounting year. b) GNP MP = GDP MP + Net factor income from abroad. c) NNP M P = GNP MP Depreciation d) NDP MP = NNP MP NFIA

5 e) NDP Fc = NDP MP Net Indirect Taxes f) GDP Fc = NDP Fc + Depreciation g) MNP Fc or NI= NDP Fc + NFIA Private Income It is the total of factor incomes and transfer incomes received from all sources by private sector in the economy. Personal Income It is the actual income received by a person from all sources Personal income = Private income undistributed profit corporate tax. Personal Disposable Income It is defined as the income retained with the individual after deducting direct personal taxes and miscellaneous receipts of Government. National Disposable Income It is the total income available to a country for the disposal(spending)on consumption of goods or services. NDI = NNP MP + other current transfer from rest of the world. Three Measurement of measuring National Income I.Output or value added method Divide the economy into three industrial sectors Estimate the net value added at factor cost of each sector Estimate net factor income from abroad and add with domestic income to get National Income. II. Income method Classify the factor payments as compensation of employees, operating surplus and mixed income of self employed. Add them to get NDP FC Estimate net factor income from abroad Add this with the domestic income to get national income. Add Net factor income from abroad to get NI III.Expenditure Method Identifying spending units which incur on final expenditure. Estimate GDP at Market Price (By adding various components of final expenditure)

6 From GDP subtract depreciation and NIT to get domestic income (NDP FC ) Estimate Net factor income from and add with domestic income to get NI. Real and Nominal National Income Real NI NI measured on the basis of base year price. It is affected by change in physical output only. Nominal NI NI is measured on the basis of current year price. It is affected by both change in output and prices. Items are included in NI Value of own account production All factor payments Expenditure incurred on final goods. Commission paid to a broker for sale of second hand goods. Items which are excluded in NI All Transfer payments Value of second hand physical goods. Income from the sale of shares and bonds. GDP and welfare As an indicator of economic welfare GDP has certain limitations GDP may rise due to rise in prices. It may rise due to the production of war equipment. GDP does not include house hold activities. If the GDP is not distributed equally it may not indicate the economic welfare. FREQUENTLY ASKED CBSE BOARD QUESTIONS 1. Give two examples of macroeconomics (1) 2. Differentiate micro and macroeconomics (3) 3. Distinguish between intermediate goods and final goods. (3) 4. Distinguish between domestic product and national product (3) 5. What do you understand by net factor income from abroad? Explain (3) 6. While estimating national income how will you treat the following? Give reasons for your answer (4) a) Imputed rent of self-occupied houses. b) Interest received on debentures c) Financial help received by flood victims

7 d) Capital gains 7. Distinguish between transfer payments and factor payments. Give an example of each. (4) 8. From the following data calculate national income by income method and expenditure method (6) Rs in Crores a) Interests 150 b) Rent 250. c) Govt. final consumption expenditure 600 d) Private final consumption expenditure 1200 e) Profit 640 f) Compensation of employees 1000 g) Net factor income from abroad 30 h) Net indirect taxes 60 i) Net exports (-) 40 j) Depreciation 50 k) Net domestic capital formation 340 Tips for Solving Numerical Problems in Economics TIPS FOR WORKING SUMS 1. To convert National to Domestic, Subtract Net factor Income from abroad. 2. To convert Domestic to National Add Net factor income from abroad. 3. To convert Market Price to Factor Cost subtract Net indirect taxes. 4. To convert Factor Cost to Market Price Add Net indirect taxes. 5. Net factor income from abroad is the difference between factor income from abroad and factor income to abroad. 6. Net indirect tax is indirect taxes minus subsidies. 7. Net Exports is Export minus Import. 8. Gross Domestic Capital formation is Gross domestic fixed Capital formation plus Change in stock. 9. Change in stock is Closing stock minus Opening stock. 10. To convert Gross to Net, subtract depreciation. 11. To convert Net to Gross, Add depreciation. 12. Depreciation is otherwise called as Capital consumption or consumption of fixed capital. 13. Income Method is otherwise known as Factor income method. 14. Expenditure Method is otherwise known as Final expenditure method. 15. Value added Method is otherwise known as Net Output Method or Production Method. 16. Compensation of Employees includes Wages and Salaries and which are paid in Cash or Kind and Employers contribution to social security schemes. 17. Operating Surplus is the sum of Rent, Interest and Profit. 18. Profit includes dividend, corporate tax, and corporate savings. 19. Corporate saving is otherwise called as retained earnings or undistributed profits. 20. Personal disposable income is the sum of household savings and household consumption. (or) Personal disposable income = Personal savings + Personal consumption.

8 UNIT VI MONEY AND BANKING

9 Unit 6 : MONEY AND BANKING (8 Marks) Very Short Answer Questions: (1 mark each) 1. Define Barter economy. Ans: It refers to exchange of goods for goods. It is also known as C-C economy. 2. What is meant by double coincidence of wants? Ans: It refers to simultaneous fulfillment of mutual wants by buyers and sellers. 3. What is a central bank? Ans: A central bank is an apex level financial Institution which controls, operates, regulates and directs the entire banking and other financial institutions and monetary system of the country. 4. What is money supply? Ans: Money supply refers to the total volume of money held by public at a particular point of time. 5. State components of money supply. Ans (i) currency and coins with the public (ii) Demand deposits with commercial banks. 6. What are the components of Legal Reserve Ratio. Cash reserve ratio (CRR) and Statutory liquidity ratio.(slr) 7. What are demand deposits? Ans; Demand deposits are the deposits which can be encased by issuing Cheques. 8. Money supply is a concept. (a) Variable (b) stock (c) flow (d) none of these 9. Which of the following is not a component of money supply (a) Currency with the Households (b) Currency with the firms (c) Gold coins with the RBI (d) none of these 10. Money multiplier is calculated with which of the following: (a) 1 SLR (b) 1 CRR (c) 1 LRR 11. Who regulates money supply? (a) Reserve Bank of India (c) Government of India (d) None of these. (b) Reserve Bank of India (d) NitiAyog 12. If CRR is 7% and SLR is 18%, what is money multiplier? (a) 20 (b) 4 (c) 5 (d) none of these 13. When an economy faces deflationary gap, the Central bank

10 (a) Buy securities (c) Increase government expenditure (b) Sells securities (d) Both (a) and (b) SHORT ANSWER QUESTIONS (3/4 Marks each) 14. Explain Medium of exchange function of Money. Explain how it solved the problem of double coincidence of wants. Ans: Money as a medium helps in buying and selling of goods as it is commonly accepted measure of value. Money also solved the problem of double coincidence of wants because it removed the difficulty in buying and selling and now buying and selling becomes independent activity. Money reduced the time and energy spent in barter. Use of money allows purchase and sale independently of one another. 15. How money solved the problem of store value under barter system. Ans: In barter system it is very difficult to store the wealth for future use. It is difficult to store some goods for longer period of time because of its lack of durability and cost of storage. Money solved the problem of store of wealth. Money can be stored in the form of land, securities, jewels etc. Money is easily portable and saving of money is more secured than in terms of goods. 16. State four functions of money. Explain any one of them. The following are the functions of money: Ans:(i) Money as a measure of value (ii) Money as a medium of exchange (iii) Money as a store of value (iv) Money as a standard of deferred payment. Money as a measure of value: Money as a measure of value means that money is used as a common denomination to measure the value of goods and services. With the help of money the value of good or service are expressed in terms of price. This function of money also helps to compare the prices of goods and services. This function of money makes possible to keep business accounts easily.

11 17. What are time deposits? Ans. The time deposits or Fixed deposits are those deposits,in which the amount is deposited with the bank for a fixed period of time. These deposits do not enjoy cheque facilities. These deposits carry high rate of interest than saving deposits. 18. State the draw backs of barter system. Explain how money solved this problem on any one of them. Ans (i)lack of measure of value (ii) Lack of double coincidence of wants (iii) Lack of store of value (iv) Lack of standard of deferred payment Lack of standard of deferred payment(future payment): In barter system there is no facility of making future because of lack of any satisfactory unit. There is a problem of borrowing and lending. Money as a standard of deferred (future) payments solved future payments in terms of buying ad selling. Since money is generally acceptable it is easier to make payments for borrowing and lending. 19. What do you mean by statutory liquidity ratio (SLR) It refers to the minimum percentage of the total deposits which commercial banks are required to keep in the form liquid assets with themselves. 20. Explain lender of last resort function of central bank. Ans: This is an important function of central bank. The central bank acts as a lender of last resort for commercial banks. When commercial banks are in crisis or unable meet their borrowing requirements from any other source the central bank helps them by giving credit to them. This function of central bank helps commercial banks to recover from financial burden. Long Answer questions (6 Marks) 21. Explain the process of money creation (or credit creation or deposit creation) by commercial banks.

12 Ans: Money creation is one of the important functions of commercial banks. Money creation by the banks is determined by the following factors: (i) the amount of initial deposits, and (ii) the Legal reserve ratio (LRR) that is the minimum ratio of deposit legally required to be kept as cash by the banks. The process of money creation can be better understood with the help of he following assumptions: (i) There is only one bank in the economy. (ii) All receipts and payments are made only through this bank. (iii) the initial deposit is Rs.100 and LRR is 20%. Let us now understand the process of money creation with the help of an example: Round of Deposits Loans LRR 20% transactions Initial deposit Round I Round II Total With the initial deposit of Rs.100, and LRR is 20%,the banks keep 20%of cash that is Rs20,and the remaining Rs.80 is given as loan. Those who borrow use this money for making payments and those who receive this money put the money back into the banks. In this way the bank receive fresh deposits of Rs.80. The banks again keep 20% of Rs.80 as LRR that is Rs.16as cash and lend (give loans) remaining Rs.64. The money again comes back to the bank leading to fresh deposits of Rs.64. The money goes on multiplying in this way,and ultimately total money creation is Rs.500 and LRR is Rs100. The money creation stops when Initial deposit and LRR are equal. Given the amount of fresh deposit and the LRR, the total money creation is: Total money creation = Initial deposit x 1 Total money creation = 100 x 1 20% LRR = 100 x 5 = Rs.500.

13 (NOTE: Suppose LRR is 10% Total money creation = 100 x = 100 X 10 = Rs.1000 Higher the LRR lower the money creation and lower the LRR higher the money creation) 1 10% 22. How does a central bank control credit (or money supply) with the help of the following instruments: (a) Bank rate (b) Open market operations (c) Repo rate. (a) Bank rate: Bank rate is the rate at which the central bank lends (give loans) to commercial banks. Central bank reduces the bank rate in order to correct deflation or deficient demand in the economy. When central bank reduces the bank rate the commercial banks also reduces the rate of interest and the credit becomes cheaper, the public get more loans from the banks and the money supply in the economy increases. Central bank increases the bank rate when economy faces inflation or excess demand. When central bank increase bank rate the banks increases rate of interest and the credit becomes costlier, the public gets less loans and thus money supply in the economy decreases. (b) Open market operations: It refers tobuying and selling of government securities to the commercial banks (to the public and commercial banks) by the central bank. The central bank sells securities to the commercial banks. When the central bank sells securities the commercial banks gives money to the central bank. This reduces the money in the hands of the banks and thus money supply decreases. Aggregate demand decreases and Excess demand or inflationary situation is corrected. When central bank buys securities it gives money to the commercial banks and collect securities. Now money in the hands of commercial banks increases and they will lend more as a result money supply in the economy increases and aggregate demand increases and thus deficient demand and deflationary gap will be solved. 23. What is meant by margin requirement? How can it be used to control the money supply? Explain with the help of example. Ans: Margin is the difference between the amount of loan and market value of the security offered by the borrower against the loan.if the margin fixed by the central bank is 40%, then commercial banks are allowed to give a loan up to 60% of the value of security.

14 An increase in the margin requirements reduces the borrowing capacity of and thus money supply decreases. A decrease in the margin requirements encourages the people to borrow more and thus money supply will increase. 24. Explain the meaning of (a) Cash reserve ratio, and (b) Reverse repo rate, How central bank uses above instruments to control credit. (a) Cash reserve ratio: (CRR) It is legally compulsory by the commercial banks to keep certain part of their total deposits with the central bank this known as Cash reserve ratio. When central bank increases the CRR the cash reserves of the commercial banks decreases and its credit giving capacity decreases and thus money supply in the economy will also decrease. When Central bank decreases the CRR the cash reserves of the commercial banks increases and its credit giving capacity increases and thus money supply in the economy will increase. 25. How is Repo rate used by central bank in influencing credit creation by commercial banks? Explain. Repo rate is the rate at which the central bank of the country lends money to the commercial banks on short term basis (Bank rate is for long term basis) on the basis of securities. An increase in the repo rate increases the cost of borrowings from the central bank and it forces the commercial banks to increase the lending rates, which discourages the borrowers from taking loans. It reduces the credit giving capacity of the commercial banks. A decrease in Repo rate decreases the cost of borrowings from the central banks and it forces the commercial banks to decrease the rate of interest, which encourages the borrowers to borrow more from the banks and it increases the credit giving capacity of the banks. 26. Explain the following functions of central bank: (a) Currency Authority (b) Bankers bank and supervisor. (a) Currency Authority: Central bank has the sole authority for issue of currency in the country. This function of central bank leads to uniformity in note circulation.

15 It also gives the central bank power to control money supply in the economy. It enables the central bank to have supervision and control over the central bank with respect to issue of notes. It ensures public confidence in the currency system. (b) Bankers bank and supervisor: Central bank as an apex body to all the banks in the country it acts as a banker s bank and supervisor in the following capacity: (i) Commercial banks keep all its cash reserves (cash deposits) with the central bank. (ii) Central bank give short term as well as long term loans to commercial banks. (iii) When commercial banks fail to meet their credit requirements, the central bank as a lender of last resort gives loans to the commercial banks. (iv) the central bank clears the bills related to various commercial banks and acts as a clearing house. (v) The central bank conducts periodic supervision to regulate and control the commercial banks. 27. Explain the function of a central bank as a banker to the government. Banker to the Government; The central bank acts as a banker to the government in the following capacities: (i) The government maintains current account with the central bank. (ii) The central bank accepts receipts and makes payments on the behalf of the government. (iii) The central bank also gives loans on short term basis to the government. (iv) It manages the buying and selling of securities of the government. (v) As a financial advisor to the government it gives advises to govt. on financial matters. PREVIOUS YEARS CBSE QUESTIONS 1. What are Time deposits? 2. What is bank money? 3. Define money supply and explain its components. 4. What is barter system? Explain the drawbacks of barter system. 5. Explain the problem of double coincidence of wants. How has money solved it? 6. Explain the significance of store of value function of money. 7. Explain the components of Legal reserve ratio. 8. Explain the lender of the last resort function of central bank. 9. Explain the distinction between statutory Liquidity ratio and Legal reserve ratio

16 10. How does central bank control credit creation by commercial banks through open market operations? 11. Explain any two methods of credit creation by central bank. 12. Government of India has recently launched Jan DhanYojana aimed at every household in the country to have at least one bank account. Explain how deposits made under the plan are going to affect national income of the country. 13. Currency is issued by the central bank, yet we say that commercial banks create money. Explain. How is this money creation by commercial banks likely to affect National income? Explain. 14. Why do we say that commercial banks create money while we also say that the central bank has the sole right to issue currency? Explain. What is the likely impact of money creation by the commercial banks on national income? 15. What are the instruments of monetary policy of RBI? Instruments of Credit control by RBI Quantitative Instruments Qualitative Instruments Bank rate Open market operations Margin Requirements Selective credit control CRR & SLR Repo rate Moral suasion Reverse Repo rate

17 FUNCTIONS OF MONEY UNIT OF VALUE MEDIUM OF EXCHANGE STANDARD OF DEFFERED PAYMENTS STORE OF VALUE

18 UNIT VII DETERMINATION OF INCOME & EMPLOYMENT

19 Unit 7: DETERMINATION OF INCOME AND EMPLOYMENT (12marks) 1. WHAT IS AGGREGATE DEMAND? Ans. Aggregate demand refers to total demand on final goods and services in the economy during a year. 2. What is Aggregate supply? Aggregate supply refers to the values of final goods and services planned to be produced in an economy during a given year. 3. Define deficient demand? When AD falls short of AS at the full employment level of income. The difference between AS and AD is called deficient demand. 4..Define involuntary unemployment? Involuntary unemployment refers to a situation in which people are ready to work at prevailing wage rate but do not find work. 5. Define Investment Multiplier? Investment multiplier (k) is defined as the ratio of change in income to change in investment, i.e. i. K= ΔY/ΔI 6. In an economy marginal propensity to save is 0.2 Investment increases by Rs.1000 crore. Calculate total increase in national income. K=1/MPS =1/0.2 = 1/2/10 =1/1/5 =5 Increase in income = K x increase in investment Increase in income ( Y) = 5 x 1000 = 5,000 corers 7. How investment multiplier works? Investment multiplier (k) is defined as the ratio of change in income to change in investment, i.e.k= ΔY/ΔI WORKING OF MULTIPLIER Given MPC=0.6,suppose there is an increase in investment by Rs. 100 crores. Initially, it will lead to an increase in income by Rs. 100 corers and when MPC =0.6,consumer will spend Rs. 60 corers on consumption which becomes income for the producer in round 2. 3 Round given MPC =0.60 consumer again spend 60% of 60 crores that is Rs.36 corers on consumption. This leads to another increase in income of Rs. 36 crores of the producer s of consumer goods In this way national income goes on increasing round after round This process will continue till ΔI = ΔS Resulting in an increase in national income.

20 K=1/1-MPC, So K = 1/1-0.6=2.5. Here, Multiplier =ΔY/ΔI Y= K x I, Y=2.5 X 100= 2,500.so, increase in income will be Rs.2,500 crore 8. Relationship between Multiplier (k)andmarginal Propensity to consume (MPC)? There is a direct relationship between Multiplier and MPC. Higher the value of MPC, higher the multiplier and vice-versa.infact, multiplier can also be estimated.using the following formula,k=1/1-mpc 9. If in an economy MPC is 0.8 and investment is increased by Rs. 1,000 crore,calculate total increase in income. K= 1 = 1 = 1 = 5. 1 MPC Total increase in income = Increase in investment x K Y =1000 X 5= 5000 crores 10. Explain national income determination through the two alternative approaches. Use diagram. ANS:- Given saving curve,derive consumption curve and state the steps in doing so.use diagram Steps:- (i) SS is the given S. Curve.Draw a 45 line from origin (ii) Take OC equal to OS on the axis. (iii) Draw a perpendicular(or line parallel to the Y-axis) from B 1 till if intersects the 45 line at B (iv) Join C and B and extend the same to get C-curve.

21 Ans:- 11. What changes will take to bring an Economy in Equilibrium if (i) AD< AS ii)ad > AS Ans :- (i) When AD < AS inventories accumulate. As a result producers reduce production, AS falls. This process continue till AD = AS. (ii) If AD > AS, inventories fall. To make up for this producer s increase production. AS increases. This process continues till AD= AS. 12. What is inflationary gap? Explain the role of Cash Reserve Ratio in removing this gap. Ans :- The Inflationary Gap is the amount by which aggregated demand exceeds aggregate supply at the full employment level. It is called inflationary because it leads to rise in the price level. Cash Reserve Ratio: is that percentage of bank deposits which are held as reserves with the central bank. Central Bank has the right to fix CRR. The central bank can reduce inflationary gap by raising CRR. Raising CRR will reduce lending capacity of the commercial banks. Less lending will leads to fall in aggregate demand helpful in reducing inflation. 13. What is deficient demand? Explain the role of Margin Requirements in removing this gap. Ans :-Deficient Demand: is the amount by which the aggregated demand falls short of aggregate supply at full employment level. It causes fall in price level.a margin requirements: is the difference between the amount of the loan and market value of security

22 offered by the borrower against the loan. If the margin imposed is 40%, then the bank is allowed to give loan only upto 60% of the value of security. By reducing margin the lending capacity of the banks can be raised. More lending will leads to more aggregate demand, that is helpful in reducing deficient demand. 14. Give two reasons which led to an inflationary gap in the economy and state its two effects. Give two reasons which led to a deflationary gap in the economy and state its two effects. Or A Reasons for inflationary gap (or excess demand): Increase in consumption due to rise the propensity to consume. Decrease in tax rates also leads to higher disposable income with people Effects of inflationary gap It cause a continuous rise in the price of goods and producers are able to get abnormal profits due to this. It may result in a price wage spiral i.e. due to rise in prices, the labour unions will demand higher wages. Higher wager will increase the cost of production and it will again lead to a rise in prices. Or Reasons for deflationary gap (or deficient demand): Decrease in consumption due to fall in the propensity to consume. Decrease in government expenditure or decrease in exports of the country. Effects of deflationary gap It cause a gradual fall in income, prices, employment and overall output in the economy. Due to falling prices, the purchasing power of the consumer increase. On the other hand, producers may suffer losses in deflationary situation. 15. Explain the concept of inflationary gap. Also explain the role of legal reserves in reducing it. A Inflationary gap refers to the excess of aggregate demand over aggregate Supply at full employment level of income.it is called inflationary because It brings in inflationary tendencies. Legal reserve refer to that part of bank deposits which commercial banks are legally required to keep in the form of cash partly with themselves (statutory liquidity ratio) and partly with the central bank can increase the legal reserve ratio(lrr) so that less money is available to the banks for lending. Borrowings are reduced. AD falls.

23 UNIT VIII GOVERNMENT BUDGET & ECONOMY

24 Unit 8 : GOVERNMENT BUDGET AND THE ECONOMY Marks for CBSE : 8 Budget: It is an estimated revenue and expenditureof the Government during a fiscal year. Objectives of Budget: 1.Economic Growth 2.Reduction of poverty and employment 3.Reduction of inequalities. 4.Reallocation of resources 5.Price Stability 6.Financing and management of public enterprise. STRUCTURE OF GOVERNMENT BUDGET: Budget Receipt Revenue receipt,capital receipt Budget Expenditure revenue expenditure,capital expenditure Revenue receipt: Neither creates liability nor reduces assets Ex-Tax and Nontax revenue Capital Receipts: Either creates liability or reduces assets. Ex Borrowing, disinvestment Revenue Expenditure: Expenditure which neither creates assets nor reduce liabilities.ex- salary, interest payment. Capital Expenditure: Expenditure which creates assets or reduce liabilities. Ex-Repayment of loan, Construction of building. Balanced Budget: Estimated government Receipts = Estimated govt expenditure. Surplus Budget: Estimated govt receipts > Estimated govt Expenditure. Deficit Budget: Estimated govt expenditure > Estimated govt receipts.

25 Revenue Deficit: Total revenue expenditure Total revenue receipts Implication: It reduce asset and brings inflation. Fiscal deficit: Total expenditure total Receipts excluding borrowings Implication: Debt trap, Inflation. Primary Deficit: Fiscal Deficit Interest payments. Implication: Leads to borrowing. What is a Tax? Ii is a legally compulsory payment made by an individual or a firm without any benefit in return. Direct Tax: Liability to pay tax,the burden of tax fall on the same person. Ex- income tax, wealth tax. Indirect tax: Liability to pay tax is on one person and the burden to the tax fall on some other person. Ex- Sales tax customs duty. What is deficit financing? Government may borrow from RBI against its securities to meet the fiscal deficit. RBI issues new currency for this purpose This process of printing new currency to meet the deficit is called Deficit Financing.

26 UNIT IX BALANCE OF PAYMENT

27 UNIT 9 BALANCE OF PAYMENTSANDFOREIGN EXCHANGE RATE (marks 7) BASIC CONCEPTS: Foreign Exchange means foreign currency. Foreign Exchange refers to all currencies other than the domestic currency of a given country. 1. Foreign Exchange Rate: -The rate at which currency of one country can be exchanged for currency of another country is called the rate of foreign exchange. 2. Foreign Exchange Market The market in which national currencies of various countries are converted, exchanged or traded for one another is called foreign exchange market. 3. Fixed Foreign Exchange Rate:-When the exchange rate between a country s currency and foreign currency is fixed by the monetary authority (Central Bank) of that country, it is called fixed foreign exchange rate. It does not mean that this rate does not change it only means that only the Central Bank can change it. 4. Devaluation:-Devolution means a deliberate lowering or reducing the value of domestic Currency in term of foreign currencies. 5. Floating exchange rate: - Floating or flexible exchange rate is the rate which is determined by forces of demand and supply of foreign exchange 6. Depreciationof currency Depreciation of currency refers to decrease in the value of domestic currency in terms of foreign currency. It occurs when there is an increase in the domestic currency price to buy a unit of foreign currency eg. if price of one dollar ($) rises from Rs.40 to Rs. 50. This is currency depreciation 7.Appreciation of currency refers to increase in the value of domestic currency in terms of Foreign currency. It occurs when there is a decrease in the domestic currency price to buy a unit of foreign currency e.g. if 1 dollar is exchanged for Rs. 50 and now the exchange rate falls to Rs 40 for one dollar. This is appreciation of currency Managed Floating rate It is a system in which exchange rate is determined by the forces of supply and demand in the international money market, but the Central Bank intervenes to manage the exchange rate so that it does not slip out of the desired limits. Frequently asked questions 1. Define foreign exchange rate. 2. What is fixed exchange rate? 3. Define flexible exchange rate. 4. What do you mean by managed floating? 5. What are causes for demand of foreign exchange?

28 6. What is parity value? 7. What are the causes for supply of foreign exchange? 8. Write True or False with reason. (i) Flexible exchange rate depends upon supply and demand parameters of foreign exchange in the international market. (ii) Flexible exchange rate is determined by the WTO. (iii) Greater flow of foreign exchange from rest of the world always indicates higher level of development of the domestic economy. 9. What do you mean by the term foreign exchange? How is the exchange rate determined under a flexible exchange rate regime? 10. How is foreign exchange rate determined? Explain with help of a diagram. High Order Thinking Questions. 1. Give two reasons for a rise in demand for a foreign currency when its price falls. 2. The market price of US dollar has increased considerably leading to rise in rupee value of imports of essential goods. What can the RBI do to ease the situation? 3. Distinguish between devaluation and depreciation of domestic currency. 4. Recently Government of India had doubled the import duty on gold. What impact was it likely to have on foreign exchange rate and how? Dirty floating: If the countries manipulate the exchange rate without following theguidelines issued by the I.M.F is called as dirty floating. BALANCE OF PAYMENTS: MEANING AND COMPONENTS Meaning: The balance of payments of a country is a systematic record of all economic transactions between residents of a country and residents of foreign countries during a given period of time. BALANCE OF TRADE AND BALANCE OF PAYMENTS Balance of trade: Balance of trade is the difference between the money value of exports and imports of material goods (visible item) Balance of payments: Balance of payments is a systematic record of all economic transactions between residents of a country and the residents of foreign countries during a given period of time. It includes both visible and invisible items. Hence the balance of payments represents a better picture of a country s economic transactions with the rest of the world than the balance of trade.

29 STRUCTURE OF BALANCE OF PAYMENT ACCOUNTING A balance of payments statement is a summary of a Nation s total economic transaction undertaken on international account. There are two types of account. 1. Current Account: It records the following 03 items. a) Visible items of trade: The balance of exports and imports of goods is called the Balance of visible trade. b) Invisible trade: The balance of exports and imports of services is called the balance of invisible trade E.g. Shipping insurance etc. c) Unilateral transfers: Unilateral transfers are receipts which resident of a country receive (or) payments that the residents of a country make without getting anything in return e.g. gifts. The net value of balances of visible trade and of invisible trade and of unilateral transfers is the balance on current account. 2. CAPITAL ACCOUNT: It 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. VARIOUS FORMS OF CAPITAL ACCOUNT TRANSACTIONS 1.Private transactions: These are transactions that are affecting assets (or) liabilities by individuals. 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 and control of it. 4.Portfolio investment: It is the acquisition of assets that does not give the particular Control over the asset.the net value of balances of direct and portfolio investment is called the balance on capital account. OTHER ITEMS IN THE BALANCE OF PAYMENT They are included since the full balance of payments account must balance. These items are as follows. 1) Errors and Omissions: They may arise due to the presence of sampling and due to his honesty. 2) Official reserve transactions: All transactions except those in this category may be termed as autonomous transactions. They are entered into with some independent

30 motive. Balance of payments always balances. AUTONOMOUS AND ACCOMMODATING ITEMS 3) Autonomous items: Autonomous items in the B.O.P refer to international economic transactions that take place due to some economic motive such as profit maximization. These items are often called above the line items in the B.O.P. The balance of payments is in a deficit if the autonomous receipts are less than autonomous payments. The monetary authorities may finance a deficit by depleting their reserves of foreign currencies, or by borrowing from I.M.F. 4) Accommodating items: Accommodating items in the B.O.P. refer to transactions that occur because of other activity with the B.O.P such as government financing. Accommodating itemsare also referred to as below the line of items. DISEQUILIBRIUM THE BALANCE OF PAYMENTS There are a number of factors that cause disequilibrium in the balance of payments showing either a surplus or deficit. These causes are categorized into 3 factors. I.Economic factors: Large scale development expenditure that may cause large imports. II Cyclical fluctuations in general business activities such as recession or depression. III.High domestic prices may result in imports. IV. Political factors: Political instability may cause large capital outflows and hamper the inflows of foreign capital. V. Social factors : Changes in tastes, preferences and fashions may affect imports and exports. SHORT ANSWER QUESTIONS. 1. Define foreign exchange rate. What do you mean by Foreign Exchange Market? Ans: Foreign exchange rate is the rate at which currency of one country can be exchanged for currency of another country. The foreign exchange market is the market where international currencies are traded for one another. 2.What is equilibrium rate of exchange? What is meant by Fixed Exchange Rate? Ans: Equilibrium exchange rate occurs when supply of and demand for foreign exchange are equal to each other. Fixed Rate of exchange is a rate that is fixed and determined by the government of a country and only the government can change it. 3. Define flexible exchange rate. Ans: Flexible rate of exchange is that rate which is determined by the demand and supply of different currencies in the foreign exchange market. 4. Distinguish between appreciation of currencies and depreciation of currencies

31 Ans: Appreciation of a currency occurs when its exchange value in relation to currencies of other country increases. When the exchange value of the domestic currency decreases in terms of foreign currencies it is known as depreciation 5. Distinguish between balance of payments and balance of trade. Ans: Balance of payments refers to the statement of accounts recording all economic transactions of a given country with the rest of the world. Balance of trade is the difference between the value of imports and exports of only physical goods. 6.The balance of trade shows a deficit of Rs. 600 crores, the value of exports isrs.1000crores. What is value of Imports? Ans: Balance of Trade = Exports of goods import of goods Import of good = Export of goods (B.O.T)= 1000-(-600)= Rs What do you mean by disequilibrium in BOP? Ans:-Disequilibrium in BOP is means either there is a surplus or deficit in balance of payment account. 8. List two items of the capital account of BOP account. Ans:- i) external assistance ii) Commercial borrowing iii) foreign investment 9. Which transactions bring balance in the BOP account? Ans:- Accommodating transactions bring balance in the BOP account. 10. Define autonomous items in BOP. Ans:-Autonomous items in BOP refers to international economic transaction that take place due to some economic motive such as profit maximization. These items are independent ofthe state of the country balance of payments. 11. What is the other name of autonomous items in the BOP? Ans:-The other name of autonomous items in BOP is above the line item. 12. When does a situation of deficit in BOP arise? Ans:- A situation of deficit in BOP arise when autonomous receipts are less than autonomous payments. 13. What is meant by managed floating? Ans:-It is a system that allows adjustments in exchange rate according to a set of rules and Regulations which are officially declared in the foreign exchange market. 14 Why do we need foreign exchange? Ans: Foreign exchange is needed for the following purposes.

32 a)payment of International loans b)gifts and grantsto rest of the world c) Investment in rest of the world. d) Direct purchases abroad for goods and services as well as imports from rest of the world. e)tourism. f)education abroad. 15.What determines the flow of foreign exchange in to the country? Ans:-Following factors contribute to the flow of foreign exchange in to the country. a) Purchases of domestic goods by the foreigners b)direct foreign investment and portfolio investment in the home country. c)speculative purchase of foreign exchange. d)when foreign tourists come to India. e)treatment f)education 16.Why does the demand for foreign exchange rise, when it price falls? Ans:-With a fall in price of foreign exchange, the exchange value of domestic currency increases and that of foreign currency falls. This implies that foreign goods become cheaper and their domestic demand increases. The rising domestic demand for foreign goods implieshigher demand for foreign exchange. So there is inverse relationship between price anddemand for foreign exchange. 17. When price of a foreign currency falls, the supply of that foreign currency also fall why? Ans: When price of a foreign currency falls it makes exports, investment by foreign residents Costlier as a result supply of foreign currency falls. 18. Distinguish between autonomous and accommodating transaction of balance of payment account. Ans: Autonomous transactions are done for some economic consideration such as profit, such transactions are independent of the state of B.O.P. Accommodating transactions are under taken to cover the deficit/surplus in balance of payments. 19. Give two examples explain why there is a rise in demand for a foreign currency when its price falls. Ans: When price of foreign currency falls, imports are cheaper. So, more demand for foreign exchange by importers. Tourism abroad is promoted as it becomes cheaper. So demand for foreign currency rises.

33 20. Distinguish between fixed and flexible foreign exchange rate. Ans: When foreign exchange rate is fixed by Central Bank/government, it is called fixed exchange rate. When foreign exchange rate is determined by market forces/mechanism, it is flexible exchange rate. Multiple choice questions 1. BOT refers to balance of exports and imports of : a) Visible Items b) Invisible Items c) Bothd) None 2. Unilateral Transfers are a part of : a) Capital Account b) Current Account c) Balance of trade Account b) Balance of Payment Account and Current Account 3.The Exchange rate determined by the free play of the forces of demand and supply of foreign exchange is : a)flexible exchange Rate. B) Fixed Exchange Rate. c) Floating Exchange rate d) none. 4. If price of 1 US Dollars has fallen from Rs. 56 to RS the Indian Currency has : a) Depreciated b) Appreciated c) Devalued d) None 5..The Exchange Rate officially declared by the government is : a) Managed Floating b) Flexible Exchange Rate c) Fixed Exchange Rate d) None. BOARD PAPER QUESTIONS Q) Indian investors lend abroad. Answer the following questions: a) In which sub-account and on which side of the balance of payments account such lending is recorded? Give reasons. b) Explain the impact of this lending on market exchange rate. Ans) a) Indians lending abroad is recorded in capital account of BOP account because it leads to creation of foreign exchange assets. It is recorded on debit side because it leads to outflow of foreign exchange. B) lending abroad increases demand for foreign exchange remains unchanged, exchange rate may rise ******************************************************************************