Managed by NIRAJ SIRSYJC (XII) - ECONOMICS

PRELIMINARY TEST PAPER - 1

Q.1 (A) Fill in the blanks using proper alternatives given in the brackets :[5]

1. Income elasticity of demand for inferior goods is __________ (positive / negative / zero / greater than one)

2. __________ is the primary function of commercial bank. (Purchase and sell securities / Accept deposits / Safe deposits vault / Letter of credit)

3. Personal Income – Direct Tax = __________. (Private income / Disposable income / National income / Total income)

4. Other factors remaining constant, when price of a commodity rises, there is __________ of supply. (Extension / Contraction / Decrease / Increase)

5. National Income is a _______ concept. (Stock / Final / Intermediate / Flow)

(B) Match the correct pairs : [5]

Group ‘A’ Group ‘B’1. Railway2. Dr. Marshall3. TC ÷ TQ4. Reward of Capital5. Disposable Income

a. Interestb. Personal Income – Direct

Taxc. Public monopolyd. Average coste. Principles of economicsf. Profit

1-C, 2 –e, 3- d, 4- a, 5- b(C) State whether the following statements are true or false : [6]

1. GDP includes net income from abroad. False2. Cheque is optional money. True3. A demat account is useful to investors who deal in shares. True4. The Central bank does not work as a banker’s bank. False5. Budget is not prepared for each and every year. False6. The budget is a monthly statement. False

Q.2 (A) Define/ Explain the following concepts : (Any three) [6]1. Bank Rate

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SOLUTIONS

Time : 3 Hrs.

Marks : 80

Managed by NIRAJ SIRAns. It is the minimum rate of interest at which central banks lends

money to commercial bank by rediscounting commercial paper, bills of exchange etc. It is also called as rediscount rate and it affects the volume and cost of credit. The central bank changes the bank rate depending on the situation in the economy.

2. Letter of CreditAns. A Letter of Credit (LC) is a document issued by the customer’s bank

in one country to the supplier’s bank in another county to honour the cheques or drafts of the person whose name appears in the document. The LC gives an assurance to the supplier that he will get paid for the goods that will be supplied by him. The bank charges a certain percentage of the LC amount as commission.

3. Double co-incidence of wantsAns. The double co-incidence of wants is a pre-requisite or basic

requirement in a barter system. If refers to simultaneous need of each other’s goods and willingness to accept it.E.g. Mr. Ali has earthen pots and wants a can of oil in exchange Now, there has to somebody who has a can of oil and wants earthen pots in exchange.This double co-incidence of wants was not always possible and was one of the major difficulties in the barter system.

4. Propensity to consumeAns. Propensity to consume refers to the actual amount of consumption

that is expected to take place at various levels of income. The propensity to consume is also called as consumption function. to put it simply, propensity to consume shows the relation between aggregate consumption expenditure (C) and aggregate income (Y). According to Lord Keynes, other things, other things being equal, consumption is a function of income.

5. General Equilibrium AnalysisAns. Macro-Economics analysis is based on “general equilibrium

anlaysis”. It studies a number of economic variables at a time. It studies the functional relationship and interdependence between such economic variables. For e.g. : Macro-Economics explain how equilibrium is achieved between aggregate demand and aggregate supply and how it determines price level, income and employment in the economy. Macro-Economic approach assumes “everything depends on everything else”.When equilibrium is based and related to many variables or economy as a whole, it is called as general equilibrium. The method if general equilibrium is applied to study the determinants of general price level and total output.

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Managed by NIRAJ SIR(B) Give reasons or explain the following concepts : (Any three) [6]

1. The supply of land is inelastic.Ans. 1. Land is the most basic and primary factor of production.

2. Land includes all those natural resources which are found :(i) On the surface of earth like soil, river, mountains, forest,

agricultural land.(ii) Below the surface of earth like coal, gold, silver, oil etc.(iii) Above the surface of earth like air, sunlight, heat etc.

3. Land is a natural resource and a free gift of nature.4. By applying labour & capital, the utility of land can be

increased but the area or number of plots cannot be increased.

5. Therefore, supply of land is perfectly inelastic as there cannot be an increase in the total supply of land.

2. Selling cost is incurred by a firm in monopolistic competition.Ans. 1. There are a fairly large number of sellers in a monopolistic

competitive market.2. The products sold by the firms in monopolistic competition are

not close substitutes.3. Each product has certain differentiating quality.4. Therefore, in order to enlighten and attract the customer

about such different qualities / features, the firms have to incur selling cost. It helps to increase sales of the product.

5. Selling cost includes advertising the product over T.V. radio, in newspaper, incentives to sales staff, free gifts, etc.

3. Supply cannot exceed stock.Ans. 1. Stock is the total quantity of goods that are available for sale

at a particular point of time.2. It is the outcome of production.3. Stock includes the current output and also the balance of the

previous output (i.e. unsold goods).4. Stock is the basis of supply. An ability of a seller to supply

depends on the availability of stock.5. Therefore, stock can exceed supply but supply can never

exceed stock.4. Perfectly inelastic demand curve is parallel to Y-axis.

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Managed by NIRAJ SIRAns. 1. When there is no change in demand inspite of a change in

price, it is called as perfectly inelastic demand.2. In case of perfectly inelastic demand, Ed (price elasticity) = 0.3. Ed = %Q/%P = 04. Draw diagram of perfectly inelastic demand on (Smart notes

page 3B.12 of the notes). 5. In the diagram, when price increases from P1 to P2, the

quantity demanded does not change. It remains constant at (Smart Notes Q.1). The demand curve DD represents perfectly inelastic demand.

6. Thus, perfectly inelastic demand curve is parallel to Y-axis.5. All desires are not demand.Ans. 1. Human being have unlimited desires. We are always striving

for better things in life.2. In order to acquire all that is desired, we need to have the

ability to pay and even when we have the ability to pay, we need to have the willingness to spend.

3. Demand is a desire backed by ability to pay and willingness to spend.

4. Therefore, a desire or wish can become demand only when the person desiring the product has the ability to pay for the product and also willingness to pay.

5. Hence, all desires are not demand.6. Utility is a relative concept.Ans. 1. Utility refers to the want satisfying power of a commodity.

2. Utility of a commodity changes from time to time and place to place.

3. A commodity that has utility now may not have utility after a month. Similarly, a commodity that has utility in Delhi, may not have utility in Mumbai.

4. Thus, utility is a relative concept.Q.3 (A) Distinguish between the following : (Any three) [6]

1. Individual Demand and Market Demand.Ans.

Individual Demand Market Demand1. Individual demand is the

amount of goods demanded by an individual (single) buyer at different prices during a

1. Market Demand is the aggregate amount of goods demanded by all individual buyers at different prices

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given period of time. during a given period of time. It is the sum total of all individual demand.

2. Individual demand can be represented by individual demand schedule and individual demand curve.

2. Market demand can be represented by market demand schedule and market demand curve.

3. Individual demand is always less than market demand.

3. Market demand is always more than individual demand.

4. For a producer, individual demand is less important for the purpose of analysis.

4. A producer analyses market demand before taking any decision.

2. Natural Monopoly and Legal Monopoly.Ans.

Natural Monopoly Legal Monopoly1. Natural monopoly comes into

existence on account of availability of certain natural resources or natural advantage in some regions.

1. When a seller enjoys monopoly position due to legal permission from the government, it is known as legal monopoly.

2. Natural advantages may be in the form of suitable location, favourable climate, business reputation etc.

2. Legal permission is in the form of patent, trademark, copyright or any other exclusive right.

3. Legal action cannot be taken if any other firm sells the same or similar product in which the seller had natural monopoly.

3. Legal action can be taken against any other firm which tries to violate the right of the seller.

4. For e.g. : Oil reserve in Gulf countries.

4. For e.g. : Patent on a technology developed by a company.

3. Complimentary Demand and Competitive Demand.Ans.

Complementary Demand Competitive Demand1. When two or more goods are

demanded jointly to satisfy a same or similar want, it is known as joint demand or complementary demand.

1. The demand for substitute goods is competitive demand.

2. E.g.: Car and petrol, pen and refill, mobile and charger.

2. E.g.: Red label tea and Society tea, Lexi pens and Linc pens, Pepsi and Coke etc.

3. The cross elasticity of demand is negative.

3. The cross elasticity of demand is positive.

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Managed by NIRAJ SIR4. If price of one product rises,

the demand for the complementary product will fall.

4. If the price of one product rises, the demand for its substitute will also rise.

5. The demand curve slopes downward from left to right. It has a negative slope.

5. The demand curve slopes upward from the left to right. It has a positive slope.

4. Gross National Product (GNP) and Net National Product (NNP).Ans.

Gross National Product (GNP) Net National Product (NNP)1. GNP is the gross market value

of all final goods and services produced in a country during a year. It includes net income from abroad and depreciation.

1. NNPMP is the net market value of goods and services produced by the residents of a country during a year.

2. GNPMP = C+I+G+(X-M)+(R – P)

2. NNPMP = GNPMP - Depreciation

3. It is greater than NNP because it includes depreciation.

3. It is lesser than GNP since depreciation is deducted.

4. GNP cannot be calculated by adding depreciation to NNP. It has to be calculated separately.

4. NNP can be calculated by deducting depreciation from GNP.

5. Percentage Method and Total Outlay Method.Ans.

Percentage Method Total Outlay Method1. Under this method, price

elasticity of demand is calculated by dividing the percentage change in quantity demanded with the percentage change in price.

1. In this method, the total expenditure by the consumer at original price is compared with the total expenditure by the consumer at new (changed) price to ascertain or calculate the elasticity of demand.

2. It is also called as arithmetic method or ratio method.

2. It is also called as total expenditure method.

3. Ed= Percentage change in quantity demandedPercentage change in price

3. Total outlay = Price x quantity demanded.

4. Elasticity is determined by the value of Ed.

4. Elasticity is determined by the direction in which the total outlay moves.

(B) Write short notes on : (Any two) [6]1. Variation in Demand

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Managed by NIRAJ SIRAns. Demand is a desire backed by ability to pay and willingness to

spend. Demand is that quantity that a person is ready to buy at a particular price during a specific period of time.VARIATION IN DEMAND(a) Meaning : When the demand for a product changes due to a

change in its price, it is known as “variation in demand”.(b) Reason : Variation in demand takes place only due to a

change in price. All other factors remain constant.(c) Demand Curve : Variation in demand is shown by movement

along the same demand curve.(d) Types : Variation in demand is of the following two types :

(1) Expansion in demand(2) Contraction in demand(1) Expansion in Demand

(a) Meaning : Expansion (extension) in demand refers to a rise in the demand only due to fall in price.

(b) Reason : Expansion in demand takes place only due to a fall in price. All other factors are constant and have no effect on demand for the commodity.

(c) Demand Curve : Expansion in demand is shown by a downward movement on the demand curve.

(d) Representation :

QUANTITY DEMANDED(Fig. Smart Notes Page 3A.17)In the above diagram, downward sloping curve DD is the demand curve. The Y-axis represents price and the x-axis represents corresponding quantity demanded. When the price falls from P1 to P2, the demand rises from Q1 to Q2. This downward movement on demand curve from point a to be represents expansion of demand.

(2) Contraction in Demand(a) Meaning : Contraction in demand refers to a fall in

the demand only due to rise in price.7

Managed by NIRAJ SIR(b) Reason : Contraction in demand takes place only

due to a rise in price. All other factors are constant and have no effect on demand for the commodity.

(c) Demand Curve : Contraction in demand is shown by an upward movement on the demand curve.

(d) Representation :

QUANTITY DEMANDED(Fig. Smart Notes Page 3A.17)In the above diagram, downward sloping curve DD is the demand curve. The Y-axis represents price and the x-axis represents corresponding quantity demanded (market demand). When the price rises from P1 and P2, the demand falls from Q1 to Q2. This upward movement on the demand curve from point a to be represents contraction in demand.

2. Total OutputAns. (i) In simple words, output means quantity produced. Therefore,

total output refers to total quantity produced.(ii) It is defined as “the sum total of the quantity of the

commodity produced at a given period of time in the economy”.

(iii) This quantity is produced with the help of all factors of production.

3. Types of CapitalAns. According to Bohm Bawark, an Austrian Economist, “Capital is a

produced means of production.”Capital can be classified in the following four groups :

TYPES OF CAPITAL(Classified on the Basis of)

OWNERSHIP DURABILITY MOBILITY NATURE

PRIVATE FIXED SUNK REAL

PUBLIC WORKING FLOATING MONEY

NATIONAL(1) ON THE BASIS OF OWNERSHIP

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Managed by NIRAJ SIR(i) Private Capital : The capital owned by individuals or

private organisation is called private capital.Eg.: Plant and Machinery of Reliance Industries Ltd. air conditioners in a coaching class, a laptop owned by a share broker.

(ii) Public or Social Capital : The capital owned by government or local bodies is called public or social capital.Eg.: Aircrafts owned by Air India Ltd. (owned by government), government schools, railways etc.

(iii) National Capital : The capital that is owned by the whole nation is called national capital. It is the sum total of private and public capital.

(2) ON THE BASIS OF DURABILITY(i) Fixed Capital : Fixed capital refers to that capital which

is used again and again in production process for a long period of time. They enjoy longer life and depreciate slowly. They are durable in nature.Eg.: Machinery, building, computers, etc.

(ii) Circulating / Working / Variable Capital : Working capital refers to that capital which is used only once in the production process. It gets completely consumed once it is used.Eg.: Raw materials, fuel, spare parts, etc.

(3) ON THE BASIS OF USE(i) Sunk Capital : The capital that can be used for specific

or single purpose only is called sunk capital.Eg.: Benches in a college, railway lines, printing machine etc.

(ii) Floating Capital : The capital which can be used for multiple purpose is called floating capital.Eg.: Computers, fuel, vehicles, etc.

(4) ON THE BASIS OF NATURE(i) Real Capital : All physical goods used in production of

goods and services directly are called Real Capital.Eg.: Machine, building, raw material, etc.

(ii) Money Capital : In simple terms, cash invested or re-invested in business is called money capital. Money

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Managed by NIRAJ SIRcapital does not contribute in production directly but it

can be used to acquire real capital.4. Aggregate DemandAns. Aggregate demand refers to,

– the amount of sales proceeds– which is actually expected– from the sale of output produced– at a given level of employment– during the year.Consumers demand agricultural goods, industrial goods and various services. In order to acquire the goods and services demanded, the consumers have to pay an amount to the producer. ie. they have to incur an expense. Therefore, the ‘demand’ for goods and services is measured in terms of ‘expenditure’ on goods and services. In other words, “how much goods and services people demand” is measured in terms of “how much people spend” on goods and services. Thus, aggregate demand in an economy is measured in terms of total expenditure on goods and services.

Q.4 Write short answers for the following questions : (Any three) [12]1. What are types of elasticity of demand?Ans. Elasticity of demand refers to the responsiveness of the quantity

demanded to a change in price of that commodity. In simple words, elasticity of demand is the ratio of percentage change in demand to a percentage change in its price.The following are the three types of elasticity of demand :

ELASTICITY OF DEMAND

PRICE ELASTICITY INCOME ELASTICITY CROSS ELASTICITY(1) PRICE ELASTICITY

(a) Definition or Meaning : According to Prof. Marshall, “Price elasticity of demand is a ratio of proportionate changes in quantity demanded of a commodity to a given proportionate change its price”.

(b) Main Factor : Is simple words, price elasticity is responsiveness of demand due to a change in price only. Other factors remain constant.

(c) Values : Price elasticity of demand may be infinite, zero, unit (1), greater than one and less than one.

(d) Symbolic Representation :10

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Price elasticity (Ed)=

Percentage change in quantity demandedPercentage change in price

Ed = %ΔQ%ΔP

OR Ed = ΔQ /QΔP / P

Ed = Price elasticityQ = Original Quantity demandedP = Original Price of the commodityQ = Change in quantity demanded (i.e. New demand after

the change in price – original demand)P = Change in price ( i.e. New Price – Original Price)

(e) Example : Suppose, the demand for Cello Gripper pen is 200 at Rs.10. When the price is increased to Rs.15, the demand for the pen reduces to 75.

Ed = ΔQ /QΔP / P

=

ΔQQ

x PΔP

= 75−200200

x1015−10

= 125200

x105

= 1.25In this case, the elasticity of demand is greater than 1.

(2) INCOME ELASTICITY(a) Meaning : Income elasticity of demand is a ratio of

proportionate change in quantity demanded of a commodity to a proportionate change in income of the individual.

(b) Main Factor : In simple words, income elasticity is responsiveness of demand due to a change in income only. Other factors including price remain constant.

(c) Value :

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Managed by NIRAJ SIR- Income elasticity of demand may be zero, one, greater

than one and less than one.- Income elasticity is positive when quantity demanded

increases with increase in income.- Income elasticity is negative when quantity demanded

decreases with increase in income.- Income elasticity is positive in case of normal goods.- Income elasticity is negative in case of inferior goods

(Giffen Goods)(NOTE : Here, negative does not mean less than zero)

(d) Symbolic Representation :

Income Elasticity (Ey) =

Percentage change in quantity demandedPercentage change in income of an individual

Ey = %ΔQ%ΔY

OR Ey = ΔQ /QΔY /Y

Ey = Price ElasticityQ = Original Quantity demandedY = Original income of the individualQ = Change in quantity demanded

(ie. new demand after change in income – original demand)Y = Change in income of the individual

(ie. ne income – original income)(e) Example : Suppose, the income of Mr. Karan increases from

Rs.10,000 per month to Rs.12,000 per month. His demand for food products increase from 8 kgs to 12 kgs.

Ey = ΔQ /QΔY /Y

=

ΔQQ

x YΔY

=

12−88

x 10 ,00012 ,000−10 , 000

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=

48

x10 , 000−2 , 000

= 2.5(NOTE : Negative sign is to be ignored)It can be observed that Mr. Karan has responded favourably to the demand due to the increase in his income. Generally, the income elasticity is always positive as a person increases his consumption when his income increases. However, income elasticity will be negative in case of inferior goods (Giffen goods) and it will be zero in case of commodities like salt, water, cooking oil, etc. as a person won’t eat more salt just because his income has increased.

(3) CROSS ELASTICITY OF DEMAND(a) Meaning : Cross elasticity of demand is a ratio of

proportionate change sin quantity demanded of a commodity to a proportionate change in price of related goods (ie. complementary goods and substitute goods).Eg.: Tea and Sugar, refill and pen, T.V. and set top box (Tata Sky) are examples of complementary goods. An increase in the cost of set top box may reduce the demand for T.V.Surf and Tide, Coca Cola and Pepsi, Munch and Perk are examples of substitute goods. An increase in price of Pepsi will not only lead to a fall in demand for Pepsi but will also increase the demand for Coca cola.

(b) Main Factor : In simple words, cross elasticity is responsiveness of demand due to a change in price of related goods only. Other factors including price remain constant.

(c) Value : Cross elasticity of demand may be zero, one, greater than one and less than one.

(d) Symbolic Representation :

Cross Elasticity (Ec) = Percentage change in quantity demanded of com mod ity A

Percentage change in price of a related com mod ity B

Ec =

%ΔQA

%ΔPB

OR Ec =

( ΔQ of A )/Q( ΔP of B )/ P

Ec = Cross Elasticity of DemandA = Original Commodity

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Managed by NIRAJ SIRB = Related Commodity (i.e. Substitute or Complementary)

Q = Change in quantity of A demanded(i.e. new demand after change in price of related commodity – Original demand)

P = Change in price of related commodity B(i.e. new price - old price)

Q = Original quantity of A demandedP = Original price of B

(e) Example :(1) When the price of Pepsi is Rs.10 the demand for Coca

cola is 100 bottles. When the price of Pepsi is reduced to Rs.8, the demand for Coca cola is 70 bottles.

Ec =

%ΔQof CocaCola%ΔPof Pepsi

= 30 %20 % = 1.5

Here, it can be observed that when price of Pepsi reduced by 20%, the demand for Coca Cola fell by 30% Therefore, it can be said that cross elasticity between Pepsi and Coca cola is high.

(2) When the price of petrol is Rs.70, demand for cars is 1000 units. When the price of petrol is Rs.100, demand falls to 700 units.

Ec =

%ΔQ of Cars%ΔPof Petrol

=

(1000−700÷1000 x100 )(70−100÷70 x100 )

= 30 %43 % = 0.70

Here, it can be observed that when price of petrol increased by 43%, the demand for cars fell by only 30%. Therefore, it can be said that cross elasticity between car and petrol is less.

SMART RECAP

Particulars Price Elasticity Income Elasticity Cross-ElasticityMeaning Ratio of Ratio of Ratio of

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proportionate change in quantity demanded of a commodity due to proportionate change in its price.

proportionate change in quantity demanded of a commodity due to the proportionate change in income of individual.

proportionate change in quantity demanded of one commodity due to a proportionate change in price of a related commodity.

Main Factor Price of commodity Income of consumer Price of substitute / complementary good

FormulaEd =

%ΔQ%ΔP Ey =

%ΔQ%ΔY Ec =

%ΔQ A

%ΔPB

2. What are the features of Pure Competition?Ans. ‘Market is defined as an arrangement where buyers and sellers come in

contact with each other directly or indirectly, to sell and buy goods.Pure competition is a part of perfect competition. According to Chamberlin, “A market becomes pure when monopoly is kept away”.Pure competition has only few features of perfect competition. The following are the features of pure competition :(1) Large number of Sellers(2) Large number of Buyers(3) Free entry and exit(4) Homogeneous product(5) Single price

3. What are the various methods of measuring national income?Ans. National income is defined as the aggregate monetary value of all goods

and services produced in a country during a given period of time, generally a year.The following are the three methods of measuring national income.

OUTPUT METHOD INCOME METHOD EXPENDITURE METHODOR OR OR

PRODUCT METHOD FACTOR COST METHOD OUTLAY METHODOR

INVENTORY METHOD(1) OUTPUT METHOD

This method is also known as product method or the inventory method. This method approaches national income from output side. For the purpose of this method, the economy is divided into various

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Managed by NIRAJ SIRsectors like agriculture, transport, commerce, mining,

communication, manufacturing etc. Under this method, the national income is calculated in either of the following two ways :(a) Adding the market value of all the final goods and services

produced during the year.(b) Adding up all the values at each stage of production till the

final stage of production.In order to avoid double counting in this method, two approaches have been suggested.

(A) (B)THE FINAL GOODS APPROACH THE VALUE ADDED APPROACH

(A) The Final Goods Approach : The final goods are those goods which are ready for final consumption. The intermediate goods are those goods which are used in the production of the final goods under this method, only the value of final goods and services produced in the primary, secondary and tertiary sector is taken into account to estimate GDPMP. The value of intermediate goods and raw material is not taken into account separately as its value is already included in the value of the final goods and services. If the value of the intermediate goods is also added, it would result in double counting.Eg.: When the value of cloth is considered in the national income, value of raw cotton is not to be included as the value of cloth includes the value of raw cotton.

(B) The Value Added Approach : Under this method, the value added at each stage of production is determined and finally the values added at each stage are summed up to derive the total value of output produced ie. GDPMP. The value added at each stage is the difference between the output and input at each stage.

This approach can be explained with the help of the following table :

Stage of Production

Value of output(in Rs.)

Value of Input

(in Rs.)

Value Added(in Rs.)

CottonYarnClothShirt (Final Good)

405575

100

0405575

40 15(55 – 40) 20(75 – 55) 25(100 – 75)

Total Value Added 100

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Managed by NIRAJ SIRNOTE : The cotton is produced by a farmer on a farm. The value of

inputs is negligible and hence it has been considered as Nil.In this table, market value of final output ie. Shirt is Rs.100. The sum total of value added at each stage of production is also Rs.100. Thus, GNP by value added approach is equal to value by final goods approach.The following precaution is necessary while following this method :(i) Only value of final goods and services must be taken into

account to avoid double counting.(ii) Goods which are used for self-consumption should be

estimated and valued at market prices.(iii) The effect of indirect taxes and subsidies has to be eliminated

i.e. indirect taxes have to be subtracted and subsidies are to be added back in the value of goods and services.

(iv) Changes in price level between years must be considered i.e. inflation / deflation must be taken into account.

(v) The depreciation on capital assets has to be deducted.(vi) Sale and purchase of second hand goods must not be

considered as it is not a part of the production of the year.Conclusion :(i) This method is used widely in underdeveloped countries.(ii) This method is less reliable because there is a scope of error.(iii) In India, this method is used for agriculture, mining and

manufacturing sectors but not for service or tertiary sectors.(2) INCOME METHOD

This method is also known as factor cost method. This method approached national income from the distribution side. Under this method, national income is obtained by adding the income received by and accrued to all persons and enterprises in the country during a year.The following incomes should be considered :(i) Labour Income : It is received by employees and labourers for

their work done and includes bonus, commission, salaries, wages, etc.

(ii) Rent : It is received when a property of land is given on lease or hire.

(iii) Interest : It is received when money is given as loan or deposited in interest bearing securities.

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Managed by NIRAJ SIR(iv) Profit : It is the net earnings of business firms before payment

of taxes.(v) Mixed Income : Self-employed persons may earn mixed type

of income i.e. their income is a combination of rent, wages, interest, profits, etc.

(vi) Net income from Abroad : The net income from abroad includes the net export value (X – M) and net receipts (R – P).National Income as per Income Method= Rent + Wages + Interest + Profit + Mixed Income + (X–M)+(R–P)

The data pertaining to income are obtained from different sources like income tax returns, published financial statements, reports, books of accounts, estimates, etc.The following precautions are necessary while following this method :(i) Transfer incomes in the form of pension, gifts, charity, lottery

– winning. etc. are to be excluded as they do not represent earnings from productive services.

(ii) All unpaid services (like services of a housewife or house husbands) are not to be included. Only services for which payments are made should be included.

(iii) Income from sale of second hand goods should not be considered.

(iv) Income from sale of shares and bonds should be ignored as it does not add anything to real national income. The gains on trading in shares or securities are not a factor income from contribution in the process of production.

(v) Direct tax revenue of the government should be ignored as it is not income in the real sense. It is a part of income which is transferred to the government. It is a transfer income.

(vi) The following should be also included in income :- Undistributed profits of companies (profits left after

dividend)- Income from government property- Profits from provision of public amenities like water supply,

electricity, transport, etc.- Value of production kept for self consumption. (Had it been

sold, the producer would have earned income against it)- Rent of house which are occupied by the owner and not

leased out.18

Managed by NIRAJ SIRConclusion

In India, the CSO uses the income method for calculating the income arising from tertiary or service sector, trade, transport, public administration, domestic services, professional and liberal arts, etc. In advanced developed countries the income method is more popular.

(3) EXPENDITURE METHODThis method is also known as outlay method. Under this method, national income is obtained by adding all the consumption expenditure and investment expenditure incurred by individuals, households, business firms and government during a year.Thus, under this method, NI = C + I + G + (X – M) + (R – P)The following are the components of national income under this method :(i) Consumption Expenditure (C) : This is the expenditure that is

incurred by individuals and households on various durable and non-durable goods and services for daily consumption. durable goods are goods like television, furniture, car, mobile, etc. which are used for a longer period of time. Non-durable goods are goods like foodstuffs which are used immediately.

(ii) Investment Expenditure (I) : This is the expenditure incurred by business firms on plant and machinery, building, other new investments, etc.

(iii) Government Expenditure (G) : Government’s consumption expenditure includes expenditure on education, defence, health, police, judiciary, etc.Government’s investment expenditure includes expenditure on creating infrastructure facilities like roads, dams, hydro-electric projects, information technology, communication, etc.

(iv) Net Exports (X – M) : It is the different between exports and imports of a country during the period of a year.

(v) Net Receipts (R – P) : It is the difference between :- Expenditure incurred by foreigners in the country.- Expenditure incurred by residents in foreign country.

The following are the precautions necessary while following this method :(i) Only expenditure on final goods and services should be

included. Expenditure on intermediate goods should not be considered to avoid double counting.

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Managed by NIRAJ SIR(ii) Expenditure on purchase of second hand goods should not be

included.(iii) The effect of indirect taxes and subsidies has to be eliminated

i.e. indirect taxes have to be subtracted and subsidies are to be added back in the value of goods.

(iv) Expenditure on transfer payment like charity, gifts, pension, etc. should not be included.

(v) Expenditure on purchase of financial assets such as shares, bonds, debentures, etc. should not be included as such transactions do not add to the flow of goods and services.

Conclusion :Practically, it is difficult to follow or adopt the expenditure method. Therefore, it is rarely used by any country. In India, the Central Statistical Organisation (CSO) adopts a combination of output method and income method.

4. What are the types of investment expenditure?Ans. Investment Expenditure refers to the use of savings for the purpose of

capital formation. Capital formation refers to an addition to the country’s physical stock i.e. new factory, machinery, raw material, finished goods, work-in-progress (i.e. semi finished goods) etc. This is over and above the replacements that are made to the existing capital goods due to their wear and tear.The following are the types of investment expenditure :

TYPES OF INVESTMENT EXPENDITURE

Gross Net Autonomous Induced Financial RealInvestment Investment Investment Investment Investment Investment(1) Gross Investment : It refers to the entire expenditure incurred on

acquiring a new capital asset like plant, machinery, building, etc. without deducting depreciation on existing capital.

(2) Net Investment : It refers to entire expenditure incurred on acquiring a new capital asset like building, plant, machinery, etc. after deducting depreciation on existing capital assets. Net Investment = Gross Investment – Depreciation.

(3) Autonomous Investment : This investment is not dependent on income, profit and rate of interest. This investment is not made with profit motive. It is influenced by government’s fiscal & monetary policies, size of population, change in the level of income, technological changes, etc. Autonomous investment is generally made by the government with a view to maximize public welfare. Investment by the government for infrastructure, communication,

20

Managed by NIRAJ SIRirrigation projects, railways, etc. can be called as autonomous

investment.(4) Induced Investment : This investment is completely dependent on

income, profit and rate of interest. This investment is made with profit motive. It is influenced by change in price level, change in income level, interest rate, consumption pattern, savings, supply of money, availability of credit etc.Induced investment is generally made by business firms, entrepreneurs, industrialists, etc.

(5) Financial Investment : It refers to investment in financial assets like shares, bonds, securities, debentures, etc. It does not directly help in production of goods and services. However, the business firm which issue such shares and debentures, collects the money and invests it in capital assets to increase production.

(6) Real Investment : It refers to the investments done for the purchase of capital goods like building, machinery, raw material, etc. It directly helps in production of goods and services.

5. What are the various classifications of money?Ans. According to Prof. Crowther, “Money is anything that is generally

acceptable, as a means of exchange and which, at the same time, acts as a measure and store of value.Money can be classified on the following basis :

CLASSIFICATION OF MONEY

On the Basis of Acceptability On the Basis of Circulation

Legal Tender Non-Legal Tender Actual MoneyMoney OR Optional Money Money of Account

Limited LegalTender Money

Unlimited LegalTender Money

[A] ON THE BASIS OF ACCEPTABILITY(1) Legal Tender Money : It is the money which is backed by the

law. It cannot be refused as a medium of exchange by anybody for any reason. It has to be compulsorily accepted. It is used as a standard medium of exchange.Eg.: the coins and currency notes in India are legal tender money, legal tender money is of two types :

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Managed by NIRAJ SIR(a) Limited Legal Tender Money : It is that money which is

accepted as a medium of exchange only upto a certain limited amount. Beyond a certain limit, a person can refuse to accept it.Eg.: In India, coins of 25 paise are legal tender only upto a limit of Rs.25 (ie. only 100 coins of 25 paise). If a person wants to make a payment of Rs.30 using 25 paise coins, the receiver can refuse to accept it above Rs.25.

(b) Unlimited Legal Tender Money : It is that money which has to be accepted as a medium of exchange upto any amount. There is no limit to its acceptance.Eg.: In India, all the coins (except 25 paise coins) and currency notes are unlimited legal tender money.

(2) Non-Legal Tender or Optional Money : It is the money which is used to make payments but has no legal compulsion of acceptance (unlike legal tender money). It can be refused. The acceptance of optional money depends upon the choice of the individual. However, it is generally accepted.Eg.: Bills of Exchange, cheques, promissory notes, etc.

[B] ON THE BASIS OF CIRCULATION(1) Actual Money : Actual Money is the money which is used to

make payment for any transaction. It is the generally accepted tender which circulates in the country.Eg.: In India, the currency notes and coins are actual money.

(2) Money of Account : The currency in which the books of accounts of a country are maintained is called as money of account.Eg.: Rupees in India, Dollars in USA, Pound in UK, etc.

6. What are the factors determining elasticity of demand?Ans. According to Prof. Marshall, “Price elasticity of demand is the ratio of

proportionate changes in quantity demanded of a commodity to a given proportionate change in its price.” In simple words, price elasticity is responsiveness of demand due to a change in price only.The following are the factors that determine the elasticity of demand :(SMART CODE : SPEND CHIP TP)(1) Substituted Goods : If substituted of a commodity are available,

then the demand for that commodity will be elastic as people will switch to the substitute if the price of the commodity is increased. If

22

Managed by NIRAJ SIRthere is no substitute of a product (for eg. water, electricity, etc.)

the demand for such a product shall be inelastic.(2) Price : Generally, commodities having very low price or very high

price have an inelastic demand.For Eg. :(i) High priced good – BMW / Audi Car, diamond necklace, MF

Hussain painting.(ii) Low priced good – Match Box, Rs.2 pen, stapler pins, etc.

(3) Elasticity also depends on uses of the Commodity : When a commodity can be put to several uses, its demand is elastic.Eg.: The demand for water, electricity is elastic.NOTE : The author is of the opinion that if a commodity has several uses, the demand will actually be inelastic.

Eg.: Electricity has several uses. If the price of electricity increases by 20%, the consumer may reduce the consumption of electricity to a certain extent but not substantially.

(4) Nature of Commodities : Commodities which are necessities have relatively inelastic demand (ie. change in price will have no effect on quantity demanded) as it is necessary for survival. On the other hand, comfort goods or luxury goods have an elastic demand (ie. change in price will have an effect on quantity demanded)

(5) Durability of the Commodity : A commodity which is durable (for Eg.: tea powder, home appliances, jewellery, etc.) will have an elastic demand. If the price of durable commodity increases, people will postpone their demand and therefore, the demand will fall.On the other hand, demand for perishable products (For Eg.: milk, sweets, vegetables) is inelastic. consumer cannot postpone the demand as the commodity will get spoilt and therefore, the demand will remain constant.

(6) Complementary Goods : The demand for complementary goods is generally inelastic.Eg.: Gun and bullet, tea and sugar, ink cartridge and printer. A person having a printer will have an inelastic demand for ink cartridge.

(7) Habits, Tastes and Preferences : The demand for goods which are consumed as a habit or preference is inelastic.Eg.: (i) Demand for gutka, paan, cigarette. A smoker will pay

any price to get his puff of cigarette.(ii) A person who prefers to wear only, “Levi’s Jeans” will

demand only those jeans even if its prices increases.23

Managed by NIRAJ SIR(8) Income of the Consumer : Consumer with higher income will have

an inelastic demand as compared to consumer having lower income.Eg.: Mukesh Ambani will not reduce his consumption of food even if prices increase whereas a daily wage labourer will consume less when prices rise.

(9) Proportion of Income Spent : If consumers spend a large amount of their income on consumption of various goods and services, then their demand is likely to be inelastic. However, if they are spending a small portion of their income, then they would spend it carefully and are likely to have elastic demand.

(10) Time of Purchase : Certain goods which have elastic demand normally may have inelastic demand during certain periods.Eg.: Flower garlands during Ganesh Chaturthi / Dussera, sweets during Diwali, nimbu pani during summers, notes during exams, etc.

(11) Possibility of Postponement of Demand : If the demand for a certain commodity can be postponed, then the demand for such commodity will be elastic.Eg.: Fridge, car, sofa, mobile, etc.If the demand for a certain commodity cannot be postponed, then the demand for such commodity will be inelastic.Eg.: Medicines, academic books, etc.

NOTE : In the above answer, the words elastic and inelastic imply relatively elastic and relatively inelastic.

Q.5 Explain with reasons whether you ‘Agree’ or ‘Disagree’ with the following statements: (Any three) [12]1. GNP and GDP are same concepts.Ans. No. I do not agree with the above statements.

Gross National Product :(1) GNP is the gross market value of all final goods and services

produced in a country during a year. It includes net income from abroad and depreciation.

(2) GNPMP = C + I + G + (X – M) + (R – P)(3) It is greater than GDP because it includes net income from Aborad

(R – P).(4) The income earned by Indian citizens outside the country i.e. in

foreign countries is also included.Gross Domestic Product :(1) GDPMP is the gross market value of final goods and services

produced in the country during a year. Since, it is gross “domestic” 24

Managed by NIRAJ SIRproduct, the net income from abroad is not considered in its

calculation.(2) GDPMP = C + I + G + (X – M)(3) It is lesser than GNP.(4) The income earned by Indian citizens in foreign countries is not

included.2. Commercial banks cannot create credit money.Ans. No, I do not agree with the above statement. Credit creation is one of the

most important functions of a commercial bank.3. During the period of inflation, surplus budget is advisable.Ans. Yes, I agree with the above statement.

(1) A budget in which the estimated revenue of the government during the year is more than the estimated expenditure is called as a surplus budget.i.e. Government estimated revenue > Government estimated expenditure

(2) When there is inflation in the economy, the cost of basic necessities rises rapidly. This causes hardships to the people in the country.

(3) At such times, the government increases the tax rate and reduces the disposable income of the people. Also, the government reduces its expenditure.

(4) As a result, aggregate demand falls and the prices of goods start coming down.

(5) Thus, for the period of inflation, surplus budget is prepared.4. Introduction of money is the most important invention of human economic

history.Ans. (1) Prior to the introduction of money, the barter system was in

existence. The barter system had many difficulties.(2) The limitations of the barter system gave rise to the money. Money

overcame the difficulties of barter.(3) Money now serves as a medium of exchange and measure of value.(4) It has various secondary and contingent functions. Most notably it

has store of value and it forms the base of credit system in the world.

(5) Money has become an indispensable part of human life.(6) Thus, introduction of money is the most important invention of

human economic history.5. Issuing currency is the only one function of the central bank.

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Managed by NIRAJ SIRAns. No, I do not agree with the above statement. The central bank performs

various other functions apart from issuing currency.(1) The central bank is an apex monetary & banking authority and

occupies a pivotal position on the banking structure of the country.(2) The main motive of central bank is to safeguard the financial and

economic stability of the country.(3) Central bank controls credit in the economy.(4) It is banker to the government and banker’s bank.(5) There is only one central bank in a country.

6. The concept of national income has an important place in economic development.

Ans. (1) National income refers to the monetary value of goods and services produced in a country, during a given period of time, generally a year.

(2) National income is an indicator of the economic health of a nation. It helps to determine how strong or weak an economy is.

(3) The economic performance of a nation is calculated with the help of national income data.

(4) It helps to determine the earning of the citizens and their general standard of living.

(5) Further, it also helps the government in formulating policies.(6) Also, it helps an economy to compare their performance with

another similar economy.(7) Thus, the concept of national income has an important place in

economic development.Q.6 Write explanatory answers: (Any two) [16]

1. What is the scope and subject matter of Macro-Economics?Ans. According to Prof. K.E. Boulding, “Macro Economics deals not with

individual quantities as such, but with the aggregates of these quantities, not with the individual incomes but with the national income, not with the individual prices but with the price level, not with individual output but with the national output”.The scope of Macro Economics can be explained with the help of the following chart :

MACRO-ECONOMIC THEORY

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Theory of Income and Employment

Theory of General Price Level & Inflation

Theory of Economic Growth and Development

Macro Theory of Distribution

Managed by NIRAJ SIR

(1) THEORY OF INCOME AND EMPLOYMENT(i) Macro Economics explains what determines the level of

national income and employment in the country. It also analyses the cause of fluctuations in income, output and employment.

(ii) Therefore, Macro Economics is also called as “Theory of Income and Employment”.

(iii) In order to understand what determines the level of income and employment in the country, the following needs to be studied :- Determinants of aggregate demand.- Determinants of aggregate supply.- consumption function.- Investment function.

(iv) The analysis of consumption function and investment function are also important parts of macro-economic theory.

(v) The theory of Business Cycles is also a part and parcel of theory of income.

(2) THEORY OF GENERAL PRICE LEVEL AND INFLATION(i) Macro Economic analysis shows how the general level of

prices is determined. It also explains the factors that cause fluctuations in the general price level.

(ii) The fluctuation of price level either leads to inflation or deflation. Both inflation and deflation are harmful for the economy and are one of the serious problems that many countries face.

(iii) The theory of general price level and inflation studies the causes and effects of inflation and deflation. Moreover, it suggests economic policies to tackle these problems.

(3) THEORY OF GROWTH AND DEVELOPMENT(i) The theory of growth and development studies the causes of

under – development and poverty in poor countries. It

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Theory of Consumption Function

Theory of Investment

Theory of Fluctuation (OR Business Cycles)

Managed by NIRAJ SIRsuggests strategies for accelerating growth and development

in them.(ii) The theory of growth deals with the problem of full utilization

of the increasing productive capacity in developed countries. It explains how sustainable growth can be achieved in them.

(4) MACRO THEORY OF DISTRIBUTION(i) The Macro Theory of Distribution deals with the relative share

of rent, interest, wages and profits in the total national income.

(ii) It explains what factors determine the share of various classes (especially workers and capitalist) in the national income.

Apart from the above theories, study of public finance, international trade, fiscal and monetary policies are also a subject matter of Macro Economics.

2. What is propensity to consume? Explain average propensity to consume and marginal propensity to consume.

Ans. Propensity to consume refers to the actual amount of real consumption that takes place or is expected to take place at various levels of income. It does not mean a mere desire to consume. The propensity to consume is also called as consumption function. To put it simply, propensity to consume shows the relation between aggregate consumption expenditure (C) and aggregate income (Y).According to Lord Keynes, other things being equal, consumption is a function of income. symbolically, C = f(Y)Where, C = Aggregate consumption expenditure

f = function ofY = Aggregate Income

SCHEDULE :The schedule of propensity to consume is a statement showing the functional relationship between the level of aggregate consumption and aggregate income at each level of income.

Aggregate Income (Y)

Consumption

Expenditure (C)

Average Propensity to

Consume (APC) (C/Y)

Marginal Propensity to

Consume (MPC) (C/Y)

010001800

100014001800

--1.41

-0.40.5

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Managed by NIRAJ SIR

2600320040004800

2400275032003800

0.920.860.800.79

0.750.580.560.75

AVERAGE PROPENSITY TO CONSUME (APC)(1) Meaning : Average propensity to consume (APC) refers to the

percentage of income that is spent on consumption rather than on savings.

(2) Calculation : The APC can be obtained by dividing the consumption expenditure (C) with the aggregate income (Y).

(3) Definition : Thus, average propensity to consume can be defined as the ratio of aggregate consumption to aggregate income in a given period of time.

(4) Symbolic Representation : It can be symbolically represented as :

APC = CY

(5) Observation : It is obvious that as the aggregate income increases, the proportion of income spent on consumption decreases. This is further proven from the above schedule. It can be observed that the APC keeps falling as the aggregate income increases. The APC is 1.4, 1, 0.85, 0.81, 0.75 and 0.71. It clearly shows a declining trend.

MARGINAL PROPENSITY TO CONSUME (MPC)(1) Meaning : Marginal propensity to consume (MPC) represents that

portion of increase in aggregate income that is spent on consumption rather than being saved. Suppose, the aggregate income has increased by Rs.800 crores, then, MPC is that pat of this Rs.800 crores which is spent on consumption.

So, the basic difference between APC and MPC is that APC is that portion of ‘total’ income which is spent on consumption.

(2) Calculation : It can be obtained by dividing change in consumption by change in income.

(3) Definition : MPC can be defined as the ratio of the change in the level of aggregate consumption to a change in the level of aggregate income.

(4) Symbolic Representation : It can be symbolically represented as :

MPC = ΔCΔY

Where,C = Change in consumption

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Managed by NIRAJ SIRie. revised consumption after change in income (-) original

consumptionY = Change in incomeie. revised income (-) original income.

(5) Observation : From the above schedule, it can be observed that MPC is always positive but below 1. There is no particular trend.Lord Keynes stated that MPC will not be constant during cyclical fluctuations in the economy. Therefore, MPC will fall when the economy is in the growth stage because at this stage income increases at a faster rate but consumption expenditure increases at a diminishing rate. On the other hand, during depression, MPC will rise. Further, it has been observed that MPC is higher in the case of poor than that if rich people.

3. Explain the credit control measures by Central Bank.OR

What are the qualitative and quantitative measures adopted by RBI to control credit?

Ans. Prof. P.R. Kent has defined central bank in his book “Money and Banking” as “An institution charged with the responsibility of managing the expansion and contraction of volume of money in interest of the general public welfare”. The central bank is responsible for safeguarding the financial stability of the economy. The central bank controls the volume and direction of credit in the economy in order to achieve the objective of growth with stability.Credit control measures mean the measures undertaken by central bank to control the volume and direction credit or money supply in the economy.The money supply in the economy has an effect on the price level in the economy. If the money supply is more, it will lead to inflation and if the money supply is less, it will led to deflation. Inflation and deflation have negative impact on exchange rates, the level of production and economic growth. Therefore, the central bank has to take various measures in order to control credit in the economy.The Central Bank adopts the following measure for credit control in the economy :

MEASURES OF CREDIT CONTROL(A) QUANTITIATIVE (General) (B) QUALITATIVE (Selective)

(i) Bank Rate (i) Credit Rationing(ii) Open Market Operations (ii) Issue of Directives(iii) Cash Reserve Ratio (CRR) (iii) Direct Action

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Managed by NIRAJ SIR(iv) Statutory Liquid Ratio (SLR) (iv) Moral Suasion

(v) Repo Rate and Reverse (v) Regulation of consumer credit(SMART CODE : Box Office (vi) PublicityCollection Show Results) (SMART CODE : CID MRP)

(A) QUANTITATIVE MEASURESQuantitative measures focus on stabilization of inflation and deflation by expansion of credit and contraction of credit. It also affects liquidity position.(i) Bank Rate : Lends money to

Central Bank Commercial Banks@ Bank Rate

(1) It is the minimum rate of interest at which central banks lend money to commercial bank by rediscounting commercial paper, bills of exchange, etc.

(2) It is also called as rediscount rate and it affects the volume and cost of credit.

(3) The central bank changes the bank rate depending on the situation in the economy.

(4) When there is inflation in the economy the central bank increases the bank rate. As a result, cost of borrowing increases for commercial banks. Now, commercial banks also have to increase their rates of lending (ie. they charge high rate of interest) in order to recover the high cost of borrowing> Businessmen and individuals are discouraged from borrowing funds at a high rate of interest. This leads to reduction in flow of credit or money supply in the economy. The aggregate demand in the economy will reduce and therefore prices will fall. Thus, inflation will be brought under control. This policy of the central bank is called as the Dear Money Policy and is followed during inflation.

(5) On the other hand, when there is a deflation in the economy, the central bank decreases the bank rate, and it leads to expansion of credit or increase in money supply in the economy. This is called as Cheap Money Policy of the central bank.

(6) In India, the bank rate as on October 2014 was 9%.(ii) Open market Operations :

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Managed by NIRAJ SIR(1) It refers to the deliberate buying and selling of

government securities and treasury bills (T-Bills) by central bank in the open market to control liquidity.

(2) OMO affects money supply directly and interest rates indirectly.

(3) During inflation, the central bank sells the government securities to the public. The public buys the securities and makes payment for the same by bank cheques. Therefore, the demand deposits of the public reduce. As a result, banks also have less money to lend as loans. This reduces the flow of money supply in the economy and leads to contraction of credit. Further, since supply of money is low, the rates of interest increase. People are discouraged to borrow, their spending reduces, the aggregate demand reduces and prices also fall. Thus, inflationary pressure in the economy is reduced and controlled.

(4) During deflation, RBI purchase government securities from the public. Thus, money is supplied back in the economy. The money available with the banks for lending also increases. Thus, the supply of money in the economy increases and there is expansion of credit. Gradually, the interest rates falls and demand for money increases. (ie. people tend to borrow funds)

(iii) Cash Reserve Ratio (CRR) :(1) Commercial Banks have to keep a certain percentage of

the total demand and time deposits as cash reserve with the central bank. This percentage is called as cash Reserve Ratio (CRR). Only the balance amount is available to the banks for lending activities.

(2) CRR has an effect on the volume of credit and interest rates.

(3) During inflation, the central bank increases the CRR. As a result, the commercial bank has to keep a higher amount as reserve with central bank and the amount available for lending is reduced. Thus, there is a contraction of credit. The banks further increase the interest rates to maintain profitability. People are discouraged from borrowing at high rates of interest. This reduces the flow of money supply in the economy. As a result, the inflationary pressure in the economy is controlled.

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Managed by NIRAJ SIR(4) On the other hand, a decrease in CRR leads to

expansion of credit. Further, it leads to a reduction in lending interest rates and this leads to an increase in money supply in the economy. The central bank decreases the CRR during deflation.

(5) In India, the CRR as on October 2014 was 4%.(iv) Statutory Liquid Ratio (SLR)

(1) Commercial Bank are required to maintain a percentage of demand and time deposits with the central bank in the form of liquid assets like cash, gold and government securities. This is referred to as statutory liquidity requirement. This amount is not available to the bank for lending purpose.

(2) When there is inflation in the economy, the central bank reduces the supply of money by increasing the SLR. This reduces the credit creation by commercial banks and leads to an increase in interest rates. As a result, borrowing in the economy reduces and flow of money decreases.

(3) When there is deflation in the economy, the SLR is reduced by the central bank. As a result, the liquid cash with bank increases which they can further lend. Also, the interest rate reduces. This leads to an overall increase in credit supply in the economy.

(4) In India, the SLR as on October 2014 was 23%.(v) Repo Rate and Reverse Repo Rate :

Borrows Funds FromCommercial Banks Central Bank

@ Repo Rate

Borrow funds FromCentral Bank Commercial Banks

@ Reverse Repo Rate(1) The Repo rate or repurchase rate is a rate at which

commercial banks borrow funds from the central banks by selling securities and at the same time agree to buy those securities at a later date.

(2) The Reverse Repo Rate is the rate at which central bank borrows funds from commercial bank for short duration. Commercial Banks deposit their short term excess funds with central bank and earn interest on it.

(3) When there is inflation in the economy, the central bank increases the reverse repo rate ie. it offers higher

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Managed by NIRAJ SIRreturns to banks for depositing their funds with the

central bank. As a result, banks transfer more funds to the central bank because they earn higher interest and it is also extremely safe. Thus, the amount available for lending with the bank reduces and liquidity in the economy reduces. This helps to control inflationary pressure in the economy.

(4) When there is deflation, the central bank reduces the repo rate. As a result, commercial banks can borrow money from central bank for a low rate of interest. This helps to increase liquidity in the economy.

The measures of Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) and Repo Rate & Reverse Repo Rate are all a part of “Variable Cash Reserve Ratio” measure of credit control. This measure of credit control by the central bank has been popularised by Lord J.M. Keynes.Thus, Central Bank uses the quantitative measures to control flow of credit in the economy. The quantitative measures have to be used very carefully by the central bank as they also have to keep in mind the objective of growth of the economy. Liquidity in the economy should not be reduced to such an extent that it hampers growth.SMART RECAP

Measures During Inflation

Effect on Lending Rates

Result on Liquidity

During Deflation

Effect on Lending Rates

Result on Liquidity

Bank Rate Increase by Central Bank

Increases Decreases Decreased by Central Bank

Decreases Increases

O.M.O. Sell more securities in market

Increases Decreases Buy more securities in market

Decreases Increases

CRR Increased by Central Bank

Increases Decreases Decreased by Central Bank

Decreases Increases

SLR Increased by Central Bank

Increases Decreases Decreased by Central Bank

Decreases Increases

Reverse Repo Rate

Increased by Central Bank

Increases Decreases Decreased by Central Bank

Decreases Increases

Repo Rate Increased by Central Bank

Increases Decreases Decreased by Central Bank

Decreases Increases

(B) QUALITATIVE MEASRUES34

Managed by NIRAJ SIR(i) Credit Rationing

(1) The central bank may impose a ceiling or limit on credit offered by commercial bank to control the purpose for which credit is offered.

(2) The credit is rationed by limiting the amount available to each applicant.

(3) Credit rationing is adopted to avoid black marketing, speculation and short selling by industries.

(4) It is a good tool when there is shortage of money in the economy and the gold reserves are declining.

(ii) Issue of Directives :(1) The central bank issues directives to commercial bank

to follow the credit norms set by the central bank.(2) The directives may be in the form of oral or written

statements, declaration in newspapers, appeals and warnings.

(3) It may ask commercial banks to be rigid or liberal in granting loans considering the condition of the economy.

(4) The central bank tries to ensure that overall credit policy followed by banks is in line with the monetary policy followed by the central bank.

(iii) Direct Action :(1) The central bank takes strong disciplinary action against

commercial banks which violate the directives issued by the central bank.

(2) The central bank could take the following action against defaulting commercial banks :- It may refuse to rediscounting facilities to commercial

banks.- It may charge penal rate of interest to banks who

borrow from the central bank above a prescribed limit.

- The central bank may refuse to grant loans and advances to commercial banks against some collateral securities.

- It may threaten the commercial bank to be taken over by it if it continues to default.

(iv) Moral Suasion :

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Managed by NIRAJ SIR(1) Moral Suasion implies persuading the commercial banks

by the central bank to co-operate with it in following a proper credit policy.

(2) Moral suasion is a psychological instrument of monetary policy.

(3) The governor or chief of the central bank calls a meeting with the heads of commercial banks and explains the need of adopting a particular monetary policy. He appeals to them to co-operate with the central bank.

(4) This method is effective as the commercial banks are apprehensive of strict action that may be taken by the central bank if the credit policy is not followed.

(v) Margin Requirement :(1) Every bank collects some collateral security in the form

of real estate, shares, securities, gold etc. before granting a loan to a customer. The bank does not grant a loan equal to the value of the collateral security. It keeps a certain percentage of margin. This margin is kept to safeguard the bank in case of devaluation (fall in value) of the collateral security or default by the customer.

(2) Eg.: If Mr. Kamlesh keeps gold worth Rs.3 lacs as collateral security, the bank will not give him loan of Rs.3 lacs. It will keep certain percentage of security as margin and grant loan of balance amount. Say the margin requirement is 25%. In this case, the loan amount will be Rs.2.25 lacs (3 lacs x 75%).

(3) The central bank uses margin requirement as a measure to control credit. If the margin requirement is increased, people will get lower amount of loan against their collateral security. It discourages people from taking loans and automatically the flow of credit in the economy is controlled.

(4) Also, margin requirement is an effective instrument used to control speculative activities ie. misuse of funds for wrong purpose is avoided.

(vi) Regulation of Consumer Credit :(1) Now-a-days, almost all consumer goods can be bought

on EMI Basis. The banks finance the purchase and the consumer has to pay the EMI’s to the banks.

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Managed by NIRAJ SIR(2) This is a facility generally used by consumer to buy car,

motorbikes, TV, furniture, fridge, camera, mobile phones, etc.

(3) This measure is used to regulate the terms and conditions when banks directly finance purchase of consumer goods through EMI facility.

(4) This method is implemented by determining the minimum down payment and maximum possible equated monthly instalments (EMI).Eg.: The central bank can set guidelines for purchase of consumer products that on purchase of goods of Rs.1 lack, the minimum down payment has to be 30% and the balance payment should be made through 5 EMIs maximum.

(5) The central bank can control credit by increasing the initial down payment and reducing the number of equated monthly instalments (EMI). This discourages the buyers from buying these products.

(6) Consumer credit needs to be regulated to bring about a balance in demand for consumer goods. If the credit facilities of the bank are too liberal, there will be excess demand for these items which disturbs production. Similarly, if credit facilities are too rigid, people will demand less of such goods which also is not favourable.

(vii) Publicity :(1) The central bank uses publicity as a tool to influence

credit policies of the banks as well as for educating the public.

(2) The central bank publishes periodic review of business and economy conditions, report on money market, banking, trade, industry, agriculture, etc.

(3) The central bank provides guidelines to the banks regarding their credit creation activities through these publications.

According to Prof. Dekock, “Publicity includes publishing regularly the weekly statements of their assets and liabilities, monthly reviews or credit and business conditions and comprehensive annual reports on their operation and activities, money market and banking conditions generally, public finance, trade, industry, agriculture, etc.”Big Banks in developed and developing countries have gone bankrupt due to lack of proper credit controls. Therefore, it is

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Managed by NIRAJ SIRnecessary that commercial banks follow the credit policy prescribed

by the central bank. The central bank regulates credit with a view to maintain stability in the economy and the commercial banks need to support the central bank.

4. What are the components of Government budget?Ans. A budget is an annual financial statement of the expenditure and revenue

of the government prepared by the financial authority (ie. the Finance Ministry) which covers the preceding year, current year and the following year.According to the constitution of India, a budget is referred to as “the annual financial statement of estimated receipts and expenditure of the government”.As per the constitution of India, the budget has to distinguish expenditure on “Revenue account” from “other expenditure” and therefore, the budget is bifurcated into “Revenue Budget” and “Capital Budget”.REVENUE BUDGETIt consists of the revenue receipts of the government and the allocation of the same towards various revenue expenditures. The following are the two parts of revenue budget “(i) Revenue Receipts(ii) Revenue expenditureCAPITAL BUDGETIt consists of the capital aspect of the government budget. The following are the two parts of capital budget:(i) Capital Receipts(ii) Capital ExpenditureThe components of budget are discussed as follows:[A] BUDGET RECEIPTS

As the name suggests, budget receipts are the receipts budgeted or estimated by the government from all sources during a fiscal year. Budget receipts are further classified as follows :[I] Revenue Receipts[II] Capital Receipts[I] REVENUE RECEIPTS

Revenue receipts are the earnings of the government and they are recurring in nature. Revenue receipts neither create any liability (ie. it is not a loan) nor cause any reduction in the assets of the government. (ie. it is not recovery of any loan given by the government earlier)

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Managed by NIRAJ SIRREVENUE RECEIPTS

(i) TAX REVENUE (ii) NON-TAX REVENUE(i) Tax Revenue :

Tax revenue is the biggest and main source of revenue receipt of the government tax is a compulsory payment made by people & various business, organisations in the country to the government without expecting anything directly in return. The tax revenue collected by the government is supposed to be utilized for public welfare.Tax Revenue = Receipts from tax + Receipts from other

duties levied by the government

Tax Revenue is collected from two types of taxes :(a) Direct Tax : It is the tax on income of individuals

and profits of business organisations. Direct tax also includes tax on wealth (ie. wealth tax), corporate tax, property tax, etc. Direct tax has to be borne by the person who pays the tax. The tax payer and tax bearer are one and the same. In short, the burden on tax cannot be shifted.

(b) Indirect Tax : It is the tax on commodities and services manufactured/sold/provided by business organisations. The business organisations shift the burden of indirect tax on the final consumer. Therefore, in this case, the tax payer is the organization but the tax is borne by the final consumer.For Eg.: Sales tax, VAT, Service tax, Excise duty etc.

NOTE : Restaurants add service tax to your total bill amount. This is actually the liability of restaurants but it recovers that amount from the customers.

(ii) Non-Tax Revenue :It includes revenue from all sources other than tax revenue. The sources of non-tax revenue are :(SMART CODE : I Fund Girl’s Full Education)(a) Interest and Dividend : The government receives

interest from loans given to state governments, union territories and private organisations. It receives dividend from the companies in which

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Managed by NIRAJ SIRthe government is shareholder. (ie. public sector

undertaking).(b) Fees : The government charges fees for various

services provided by it to the citizens of the country. Eg.: Court fees, registration fees, franking charges, stamps, etc. The government basically tries to recover the cost of providing the services by charging these fees.

(c) Gifts and Grants : The government may receive monetary gifts and grants from other nations or from some international funds. Also, citizens of the country may donate money to support the various initiatives of the government or during a natural disaster.Eg.: A lot of people donate huge amount to the PM’s National Relief Fund.

(d) Fines and Penalties : The government also earns revenues from various fines and penalties levied on citizens and business organisation in the country.Eg.: Fine of Rs.350 crores was collected from Bharti Airtel for violating telecom license conditions.- Penalty for not paying taxes on due date, not

disclosing proper income, not maintaining proper books of accounts etc.

The government levies fines and penalties to maintain law and order.

(e) Escheats : “Escheats” refers to the power of the government to acquire right over a property which has no owner. The government acquires this power only when a person dies and he has no heir or he has no will mentioning who will inherit the property. The government may sell the property and earn revenue. (Jo property ka koi waaris nahi hota, woh property government ki ho jati hain)

[II] CAPITAL RECEIPTSCapital Receipts are not recurring in nature. Capital receipts are monetary receipts which create a liability (ie. borrowing or loan) or reduce the assets of the government. (ie. recovery of a loan)

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Managed by NIRAJ SIR(i) Borrowings : The revenue and capital receipts of the

government may not be enough to meet the budgeted expenditure. Hence, the government borrows money from the :(a) Reserve Bank of India (RBI)(b) The citizens of the country by way of issuing

government securities.(c) International institutions like World Bank, International

Monetary Fund (IMF) etc.It increases liability of the Government.

(ii) Recovery of Loans : The government gives loans to state government, union territories and private organisations in time of need. The recovery of such loans is a capital receipt and leads to a reduction in assets of the government.(NOTE : When the government had given a loan, it will be an asset for the government. Therefore, when the loan is repaid, it will lead to reduction of assets.)

(iii) Other Receipts :(a) Disinvestment : Disinvestment means selling of shares

of central public sector enterprises (CPSEs) held by the government to private organisations. Disinvestment, if conducted in a proper manner, brings in huge amount of receipts for the government. Disinvestment leads to reduction in assets of the government.Disinvestment also helps to ensure better corporate governance in CPSEs and promotes people’s ownership in CPSEs.

Companies recently disinvested by the Indian government (April 2009 onwards) :(1) Oil and Natural gas Corporation (ONGC)(2) Coal India Ltd.(3) Rural Electrification corporation(4) Power Grid corporation of India Ltd.(5) Oil India Ltd. etc.NOTE : Government maintains 51% stake (ie. majority share) in all the CPSEs even if they are divested.SOURCE : Website of Department of Disinvestment (Ministry of Finance)

(b) Small Savings : The government raises funds from the public in the form of post office deposits, national savings certificate, public provident fund, etc. People

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Managed by NIRAJ SIRinvest a part of their savings in such instruments. It

increases the liability of the government because this amount is payable by the government to the people on maturity. However, the government can use these funds till the time of maturity.

[B] BUDGET EXPENDITUREThe government incurs expenditure in order to maintain law and order, maximize public welfare and bring about overall development of the nation.

BUDGET EXPENDITURE INCLUDES

Plan Non-Plan Development Non-DevelopmentExpenditure Expenditure Expenditure Expenditure

(a) Plan Expenditure : It refers to the expenditure incurred on the various programmes in the five year plan of the government.For Eg.: The employment programmes, education programmes, poverty eradication programmes, rural development programmes, irrigation, transport, communication, etc.

(b) Non-Plan Expenditure : It refers to expenditure incurred by the government on activities which were not planned earlier or which are out of scope of government plans.For Eg.: The government has to spend a huge amount for the relief of the affected people and redevelopment of the affected area in case of natural disasters.

Prime Minister Mr. Narendra Modi announced a Rs.1000 crore relief package in October 2014 for Andhra Pradesh wherein Vishakhapatnum and surrounding areas were damaged by “Hudhud” cyclone. This is a recent and practical example of non-plan expenditure.

(c) Development Expenditure : All expenditures that promote economic growth and social development are termed as development expenditure. Expenditure on development of infrastructure, agriculture, rural areas, education, health, scientific research, etc. increase productive capacity in the economy and hence can be termed as development. expenditure.

(d) Non-Development Expenditure : Expenditures in the nature of consumption and which are incurred on essential services. Such as defence, interest payments, expenditure on law and order, public administration are called as non-development

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Managed by NIRAJ SIRexpenditure. This expenditure does not create any productive

asset which can bring income or returns to the government.Budget Expenditure is classified as follows :(I) REVENUE EXPENDITURE

Revenue expenditure is recurring in nature. This expenditure does not create any asset (ie. it is not a loan given) nor causes reduction in liability of the government. (ie. it is not repayment of loan). It is incurred by the government for running of the various departments and providing services. Revenue expenditure can be development as well as non-development expenditure.Revenue Expenditure includes expenditure on,(i) General Services (ie. defence, police, judiciary, administration,

etc.)(ii) Social and Community Services (ie. Health, education,

employment, etc.)(iii) Economics Services (ie. transport, banking, infrastructure,

trade, etc.)(iv) Grants (not loans) given to state governments.Revenue expenditure is to be met out of the revenue receipts.

(II) CAPITAL EXPENDITURECapital Expenditure is not recurring in nature. Capital expenditure either creates an asset (for eg.: loan given to state government) or reduces the liability for eg.: repayment of any loan). Capital expenditure is generally developmental or productive in nature and helps to increase productive capacity of the nation. However, expenditure on constructing gardens, parks, statues, government guest houses, etc. is a non-development or unproductive capital expenditure.Capital expenditure includes the following :(i) Expenditure on land and building(ii) Expenditure on plant and machinery(iii) Investment in shares(iv) Loans given to state government(v) Loans given to corporations and private organisationsCapital Expenditure is to be met out of capital receipts.

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