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UNIT : 4 FORMS OF MARKET -10 marks 1. Define market. It is a real or imaginary place where goods and services are purchased and sold by buyers and sellers respectively and payment is made in return for it. 2. Define perfect competition market. It is a market in which there are large number of buyers and sellers, selling homogenous goods. There is free entry into and exit from the market and firm is price taker and industry is price maker. 3. Define monopoly market. It is a market where there is only one seller selling a good which does not haveany substitute. Firm is the price maker and there is restricted entry into and exit from the market. 4. Define monopolistic competition market. It is a market in which there are large number of buyers and large number of small sellers, selling differentiated goods, which are close substitutes. There is free entry into and exit from the market and firm is price maker. 5. Define oligopoly market. In this market there are few large sellers selling homogenous or differentiated good. Firms are mutually interdependent for deciding prices either competitively or through competition.There is restricted entry into and exit from the market. Collusive oligopoly – In this type of oligopoly firms decide price of goods through mutual cooperation with each other by forming groups or cartels. Nom collusive oligopoly - In this type of oligopoly firms decide price of goods through competition with each other Note: If unable to understand any indirect or hot question based on feature of market do mention the features of market given in question 1 6. Explain the implication of following features of various markets (Eachpart is for 2 or 3marks):(a)Large number of buyers and sellers in perfect competition market! Implications(i) As there are large number of sellers’ individual seller cannot influence market supply or price. Similarly one buyer cannot affect market demand or price. (ii) Firms become price takers as they have to accept the equilibrium price that market demand & supply decide. So market or industry is price maker. (iii) Due to large number of buyers firm can sell any amount of good at equilibrium price. Hence they have perfectly elastic,horizontal Average Revenue (AR) curve. (b) Homogenous goods in perfect competition market! Implications: -Perfect competition market has homogenous goods which are same in shape, size, colour, price etc. (i) So it is easy for new firms to enter into and exit from the market. (ii) There is no selling cost as there is no need for advertising the good (iii) So one firm cannot effect price market decides the price. (c) Free entry into and exit from the market in perfect competition market! Implications:- If in Short Run there is abnormal profit firms will enter the market & if there are abnormal losses firms will exit the market. Hencein theLong run firms will earn Normal Profits. (d) Differentiatedgoods monopolistic competition market! Implications:- Differentiated goods are different in shape, size, colour, packaging etc. (i) New firms can easily enter the market by adding new feature in their product. 2 (ii)Non price competition occurs firms compete on the basis of different features in good and not on the basis of prices. (iii) Selling costs are high as differentiated goods of competitors are close substitutes so firms have to advertise & change the product qualities. (e) Downward sloping AR curve in monopoly & monopolistic competition market! Implications:- Due to downward slope of AR curve & demand curve in both the markets the firms have to simultaneously decide price and quantity to be sold. If firm decides to sell at a high price then AR curve indicates that less quantity will be sold. If they decide on larger quantity to be sold then AR curve will show the low price to be charged by firms. More good can be sold at lower price and lessgood can be sold at higher price. 7. Differentiate between the following:perfect competition market 1 .Large number of buyers and sellers. 2. Firm is price taker and industry is price maker. 3. Average Revenue (AR) curve is perfectly elastic & horizontal. 4. There is no Selling cost perfect competition market 1. Large number of buyers and sellers. 2. There is free entry into and exit from the market. 3. Firm is price taker and industry is price maker. 4. Average Revenue (AR) curve perfectly elastic & horizontal. monopolistic competition market 1. There are large number of buyers and large number of small sellers. 2.Firm is the price maker 3. Average Revenue (AR) curve is downward sloping & elastic. 4. Selling costs are high. monopoly 1. There is only one seller. 2. There is restricted entry into and exit from the market. 3. Firm is the price maker 4. Average Revenue (AR) curve is downward sloping & inelastic. 3 monopoly market 1. There is only one seller. monopolistic competition market 1. There are large number of buyers and large number of small sellers. 2. There is free entry into and exit from the market. 3. Selling costs are very high. 2. There is restricted entry into and exit from the market. 3.Selling costs are low & are onetime costs 4 .Average Revenue (AR) curve is 4. Average Revenue (AR) curve is downward sloping and inelastic. downward sloping elastic. 5. Goods in this market have no close 5. Goods in this market have very substitutes. close substitutes. 8. Average Revenue (AR) curve of monopolymarket moreinelastic compared to AR curve of monopolistic competition market, why?OR Why is Average Revenue (AR) curve of monopolymarketsteeper compared to AR curve of monopolistic competition market? In monopolythere is only one seller, selling a good which has no substitute, firm is the price maker and there is restricted entry into and exit from the market. If the firm increases price buyer do not have any substitute to buy, so quantity demanded by them changes by lesser degree than change in price. So AR curve is inelastic and steeper compared to monopolistic competition. Whereas in monopolistic competitionmarket there are largenumbers of small sellers, selling differentiated goods, which are very close substitutes & there is free entry into and exit from the market and firm is price maker. If the firm increases price of the good buyers will immediately start buying goods from its competitors. Hence quantity demanded changes by greater degree compared to prices so AR curve is more elastic & flatter compared to monopoly. 9(A). What is Price discrimination? In monopoly market firms sell same good at different prices in different markets, to different groups and at different places. This is called Price discrimination. 4 9(B). Q) The firm under monopoly is a price maker- Discuss ( 4 ) Ans- Under perfect competition, the firm is price taker. But under monopoly the firm is price maker. In monopoly there is a single seller of a commodity. He has full control over the price of his product. He can increase or decrease the price of the product. There is no competition of other firms as there is only one firm in the market. There is no close substitutes of the monopoly product. There is no possibility for entry of new firm in the monopoly market. Hence the monopolist or the monopoly market is price maker. 10.) Explain the feature or concept of product differentiation. ( 3 ) Ans Product differentiation- In monopolistic competition market there are large number of firms selling goods which are close substitutes. The product of one firm is different from that of other firm only in colour, size, shape, packaging, branding, advertising etc, this is known as Product differentiation. Because of product differentiation, each firm can decide its price but it has to keep price of competitors in mind. . So each firm is price maker but it has a partial control over price of its product. 11. If abnormal profits are earned in perfect competition market in the short run & there is free entry, what will happen to profits in the long run? Explain. When firms earn abnormal profits in the short run, new firms will be attracted by profits and will enter the market due to free entry. Market supply of goods increases. Share of each firm in market sales falls So firms will compete with each other and reduce prices to sell stock of goods. 5 Profits of each firm declines New firms will continue to enter till the abnormal profits fall And all firms earn only normal profits in the longrun. 12.If abnormal losses are incurred in perfect competition market in the short run & there is free exit, what will happen to losses in the long run? Explain. When firms have abnormal losses in the short run, Some firms will exit the market due to free exit. Share of each firm in market sales increases. Market supply of goods decreases, due to which prices rise And losses of each firm declines New firms will continue to exit till the abnormal losses fall And all firms earn only normal profits in the longrun. 13. Why is the average revenue curve of perfect competition perfectly elastic (horizontal) ? OR How is equilibrium price determined by perfect competition firm? Market Equilibrium Firms Equilibrium S P e P P1 P1 P1=AR=MR D O quantity demanded And supplied O quantity demanded and supplied 6 P is Price, d-demand, S- supply E –equilibrium, P1- equilibrium price In perfect competition market there are large numbers of buyers and sellers, selling homogenous goods, there is free entry into and exit from the market, so no individual buyer or seller can effect market demand, supply or price. Marketdemand & supply decide the equilibrium price and firms can sell any amount of goods at this price as there are infinite buyers . Firms will not sell at a price more than equilibrium price otherwise they will lose their buyers to other sellers selling same good at equilibrium price. Perfect competition firm earnnormal profits at equilibrium price so firms will not sell at a lower price than equilibrium price as it will lead to losses. So demand or AR curve is perfectly elastic and horizontal at equilibrium price. 14. How is equilibrium price determined in perfect competition market? Explain diagrammatically. Excess Supply PriceS P1 A B P2 e P3L MD Excess Demand O Q2 Quantity demanded and supplied Market equilibrium occurs at a price level where quantity demanded is equal to quantity supplied. 7 In the diagram given above Market equilibrium occurs at a price level OP2 at point e , Where, quantity demanded = quantity supplied = OQ2 Disequilibrium occurs at any price level above or below equilibriumprice. If Market price ( e.g.: OP 3 )is more than equilibrium price Then quantity demanded (P3A) is less than quantity supplied (P3B) , so Excess Supply equal to AB occurs. Sellers will compete with each other to sell excess goods in their stocks, they will reduce prices, hence quantity demanded rises and quantity supplied falls. Price is again reduced. This process continues till the excess supply gets wiped out and equilibriumprice is reached where, quantity demanded = quantity supplied = OQ2. If Market price ( e.g.: OP 1 )is less than equilibrium price Then quantity demanded (P1M) is more than quantity supplied (P1N) , so Excess Demand equal to NM occurs. Buyers will compete with each other and some buyers will be willing to pay higher prices to get the good. Sellerswillincrease prices,hence quantity demanded falls and quantity supplied rises. Price is again raised. This process continues till the excess demand gets wiped out and equilibriumprice is reached where, quantity demanded = quantity supplied = OQ2. Questions Based on Market Equilibrium ( Shifts in Demand & Supply Curves) ----------------------------------------------------------------------------------------------NOTE: In all questions below there are only 2 basic answers whose main point will be as follows (1) Excess Demand Buyers will compete with each otherand some buyers will be willing to pay higher prices to get the good. (2) Excess Supply. Sellers will compete with each other to sell excess goods in their stocks, they will reduce prices, 8 Sellerswillincrease prices, hence quantity demanded falls and quantity supplied rises. hence quantity demanded rises and quantity supplied falls. Excess Demand occurs in following cases Factors effecting Demand Increase Demand. Factors effecting Supply Decrease Supply. Increase in Demand is more than Increase in Supply Demand Increase & Supply decrease Excess Supply occurs in following cases Factors effecting Supply Increase Supply. Factors effecting Demand decrease Demand. Increase in Supply is more than Increase in Demand Supply Increase & Demand decrease -------------------------------------------------------------------------------------------15. If income of the consumer increasesand consumer consumes normal goods, explain the effect on equilibrium price with the help of diagram? OR If income of the consumer decreases and consumer consumes inferior goods, explain the effect on equilibrium price with the help of diagram? OR If there is favourable change in fashion, what will happen to equilibrium quantity &equilibrium price. Explain the chain reaction with the help of diagram. OR If there is favourable change in tastes & preferenceswhatwill happen toequilibrium quantity &equilibriumprice. Explain the chain reaction with the help of diagram Or if the price of substitute good rises,whatwill happen toequilibrium quantity &equilibrium price. Explain the chain reaction with the help of diagram Or if the price of complementary good falls,whatwill happen toequilibrium quantity &equilibriumprice. Explain the chain reaction with the help of diagram. 9 Price S P2 e2 P1 e1 Excess Demand A D2 D1 O Q1 Q2 Quantity demanded and supplied Demand will increase Demand curve will shift upwards to the right from D1 to D2 At original equilibriumprice OP1 New quantity demanded = P 1 A New quantity supplied =P 1 e 1 The new quantity demanded (P1 A) is more than new quantity supplied (P1 e1), so Excess Demand equal to (e1 A) occurs. Buyers will compete with each other and some buyers will be willing to pay higher prices to get the good. Sellerswillincrease prices,hence quantity demanded falls and quantity supplied rises. Price is again raised. This process continues till the excess demand gets wiped out and newequilibriumis reached at point e2 where, quantity demanded = quantity supplied = OQ2. So equilibrium price increases from OP1 to OP2 &equilibrium quantity increases from OQ1 to OQ 2 10 16. If the number of firms decreaseswhat will happen to equilibrium quantity &equilibrium price. Explain the chain reaction with the help of diagram. OR If the government policy is unfavourable, explain the effect on equilibrium price with the help of diagram? OR If price of input i.e. raw materials increases what will happen to equilibrium quantity &equilibrium price. Explain the chain reaction with the help of diagram. OR If cost of technology is high what will happen to equilibrium quantity &equilibrium price. Explain the chain reaction with the help of diagram. OR If weather is unfavourable what will happen to equilibrium quantity &equilibrium price. Explain the chain reaction with the help of diagram. S2 Price S1 e2 P2 P1A e1 Excess Demand D1 O Q2 Q1 Quantity demanded and supplied Supply will decrease Supply curve will shift upwards to the left from S1 to S2 At original equilibriumprice OP1 New quantity demanded =P 1 e 1 11 New quantity supplied =P 1 A The new quantity demanded (P 1 e 1) is less than new quantity supplied (P 1 A), so Excess Demand equal to (Ae1 ) occurs. Buyers will compete with each other and some buyers will be willing to pay higher prices to get the good. Sellerswillincrease prices,hence quantity demanded falls and quantity supplied rises. Price is again raised. This process continues till the excess demand gets wiped out and new equilibriumis reached at point e2 where, quantity demanded = quantity supplied = OQ2. So equilibrium price increases from OP1 to OP2 &equilibrium quantity decreases from OQ1 to OQ 2 17.If income of the consumer decreases and consumer consumes normal goods, explain the effect on equilibrium price with the help of diagram? OR If income of the consumer increases and consumer consumes inferior goods, explain the effect on equilibrium price with the help of diagram? OR If there is unfavourable change in fashion, what will happen to equilibrium quantity &equilibrium price. Explain the chain reaction with the help of diagram. OR If there is unfavourable change in tastes & preferenceswhatwill happen toequilibrium quantity &equilibriumprice. Explain the chain reaction with the help of diagram Or If the price of substitute good falls,whatwill happen toequilibrium quantity & equilibrium price. Explain the chain reaction with the help of diagram Or If the price of complementary good rises,whatwill happen toequilibrium quantity &equilibrium price. Explain the chain reaction with the help of diagram. PriceExcess supply S 12 P1A e1 P2 e2 D1 D2 O Q2 Q1 Quantity demanded and supplied Demand will decrease Demand curve will shift downwards to the left from D1 to D2 At original equilibriumprice OP1 New quantity demanded = P 1 A New quantity supplied =P 1 e 1 Then quantity demanded (P 1A) is less than quantity supplied (P 1 e 1) , so Excess Supply equal to Ae 1 occurs. Sellers will compete with each other to sell excess goods in their stocks, they will reduce prices, hence quantity demanded rises and quantity supplied falls. Price is again reduced. This process continues till the excess supply gets wiped out and new equilibriumis reached at point e 2, where new quantity demanded =new quantity supplied = OQ2. So equilibrium price decreases from OP1 to OP2 &equilibrium quantity decreases from OQ1 to OQ 2 18. If the number of firms increaseswhat will happen to equilibrium quantity &equilibrium price. Explain the chain reaction with the help of diagram. 13 OR If the government policy is favourable, explain the effect on equilibrium price with the help of diagram? OR If price of input i.e. raw material decreaseswhat will happen to equilibrium quantity &equilibrium price. Explain the chain reaction with the help of diagram. OR If cost of technology is lowwhat will happen to equilibrium quantity &equilibrium price. Explain the chain reaction with the help of diagram. OR If weather is favourable what will happen to equilibrium quantity &equilibrium price. Explain the chain reaction with the help of diagram. S1 Price Excess Supply S2 P1 e1A P2 e2 D O Q1 Q2 Quantity demanded and supplied Supply will increase Supply curve will shift downwards to the left from S1 to S2 At original equilibriumprice OP1 New quantity demanded = P 1 e 1 New quantity supplied =P 1 A 14 Then quantity demanded (P 1 e 1) is less than quantity supplied (P 1A) , so Excess Supply equal to e 1 A occurs. Sellers will compete with each other to sell excess goods in their stocks, they will reduce prices, hence quantity demanded rises and quantity supplied falls. Price is again reduced. This process continues till the excess supply gets wiped out and new equilibriumis reached at point e 2, where new quantity demanded =new quantity supplied = OQ2. So equilibrium price decreases from OP1 to OP2 &equilibrium quantity increases from OQ1 to OQ 2 19. What will happen to equilibrium quantity & equilibrium price when there is simultaneous decrease inDemand &Supply.(A) Decrease in demand is greater than decrease in Supply PriceExcess supply S2 P1S1 P2A B e1 e2 D1 D2 O Q1 Q2 Quantity demanded and supplied Demand will decrease, 15 Demand curve will shift downwards to the left from D1 to D2 Supply will decrease Supply curve will shift upwards to the left from S1 to S2 At original equilibriumprice OP1 New quantity demanded = P 1 A New quantity supplied =P 1 B Then quantity demanded (P 1 A) is less than quantity supplied (P 1B) , so Excess Supply equal to AB occurs. Sellers will compete with each other to sell excess goods in their stocks, they will reduce prices, hence quantity demanded rises and quantity supplied falls. Price is again reduced. This process continues till the excess supply gets wiped out and new equilibriumis reached at point e 2, where new quantity demanded =new quantity supplied = OQ2. So equilibrium price decreases from OP1 to OP2 &equilibrium quantity decreases from OQ1 to OQ 2 (B)Decrease in demand is less than decrease in Supply 16 S2 Price e 2S1 P2 P1 A B e1 Excess demand D1 D2 O Q2 Q1 Quantity demanded and supplied Demand will decrease Demand curve will shift downwards to the left from D1 to D2 Supply will decrease Supply curve will shift upwards to the left from S1 to S2 At original equilibriumprice OP1 New quantity demanded = P 1 B New quantity supplied =P 1 A Then quantity demanded (P 1B) is more than quantity supplied (P 1 A) , so Excess Demand equal to AB occurs. Buyers will compete with each other and some buyers will be willing to pay higher prices to get the good. Sellerswillincrease prices,hence quantity demanded falls and quantity supplied rises. Price is again raised. This process continues till the excess demand gets wiped out and new equilibriumis reached at point e2 where, quantity demanded = quantity supplied = OQ2. 17 So equilibrium price increases from OP1 to OP2 &equilibrium quantity decreases from OQ1 to OQ 2 (C)Decrease in demand is equal to decrease in Supply S2 P rice P1 S1 e 2 e1 D1 D2 O Q2 Q1 Quantity demanded and supplied Demand will decrease Demand curve will shift downwards to the left from D1 to D2 Supply will decrease Supply curve will shift upwards to the left from S1 to S2 At original equilibriumprice OP1 New quantity demanded =New quantity supplied = P1 e2 So there is neither ExcessDemand norExcess Supply Hence, Soequilibrium priceremains constant at OP1 &equilibrium quantity decreases from OQ1 to OQ 2 20. What will happen to equilibrium quantity & equilibrium price when there is simultaneous increase Demand & Supply? 18 (a) Increase in demand is greater than increase in Supply Price S1S2 P1 P2A e2 B e 1Excess demand D2 D1 O Q1 Q2 Quantity demanded and supplied Demand will increase Demand curve will shift downwards to the left from D1 to D2 Supply will increase Supply curve will shift upwards to the left from S1 to S2 At original equilibriumprice OP1 New quantity demanded = P 1 B New quantity supplied =P 1 A Then quantity demanded (P 1B) is more than quantity supplied (P 1 A) , so Excess Demand equal to AB occurs. Buyers will compete with each other and some buyers will be willing to pay higher prices to get the good. 19 Sellerswillincrease prices,hence quantity demanded falls and quantity supplied rises. Price is again raised. This process continues till the excess demand gets wiped out and new equilibriumis reached at point e2 where, quantity demanded = quantity supplied = OQ2. So equilibrium price increases from OP1 to OP2 &equilibrium quantity increases from OQ1 to OQ 2 (b)Increase in demand is less than increase in Supply S1 Price e 1Excess Supply S2 P1 A P2 B e2 D2 D1 O Q1 Q2 Quantity demanded and supplied Demand will increase Demand curve will shift downwards to the left from D1 to D2 Supply will increase Supply curve will shift upwards to the left from S1 to S2 At original equilibriumprice OP1 New quantity demanded = P 1 A New quantity supplied =P 1 B 20 Then quantity demanded (P 1 A) is less than quantity supplied (P 1B) , so Excess Supply equal to AB occurs. Sellers will compete with each other to sell excess goods in their stocks, they will reduce prices, hence quantity demanded rises and quantity supplied falls. Price is again reduced. This process continues till the excess supply gets wiped out and new equilibriumis reached at point e 2, where new quantity demanded =new quantity supplied = OQ2. So equilibrium price decreases from OP1 to OP2 &equilibrium quantity increases from OQ1 to OQ 2 (C) Increase in demand is equal to increase in Supply S1 21 P rice P1 S2 e1 e2 D2 D1 O Q1 Q2 Quantity demanded and supplied Demand will increase Demand curve will shift downwards to the left from D1 to D2 Supply will increase Supply curve will shift upwards to the left from S1 to S2 At original equilibriumprice OP1 New quantity demanded =New quantity supplied = P1 e2 So there is neither ExcessDemand norExcess Supply Hence, Soequilibrium priceremains constant at OP1 &equilibrium quantity increases from OQ1 to OQ 2 21. What will happen to equilibrium price and quantity when supply is perfectly elastic and demand decreases? Explain diagrammatically. P rice P1 e2 e1 S 22 D1 D2 O Q2 Q1 Quantity demanded and supplied Demand will decrease Demand curve will shift downwards to the left from D1 to D2 Supply curve will remain S1 At original equilibriumprice OP1 New quantity demanded =New quantity supplied = P1 e2 So there is neither ExcessDemand norExcess Supply Hence, Soequilibrium priceremains constant at OP1 &equilibrium quantity decreases from OQ1 to OQ 2 22.What will happen to equilibrium price and quantity whendemand is perfectly elastic and Supply decreases? Explain diagrammatically. S2 P rice P1 S1 e2 e1D1 23 O Q2 Q1 Quantity demanded and supplied Demand curve will remain D1 Supply will decrease Supply curve will shift upwards to the left from S1 to S2 At original equilibriumprice OP1 New quantity demanded =New quantity supplied = P1 e2 So there is neither ExcessDemand nor Excess Supply Hence, Soequilibrium priceremains constant at OP1 &equilibrium quantity decreases from OQ1 to OQ 2 23.What will happen to equilibrium price and quantity whendemand is perfectly inelastic and Supply increases? Explain diagrammatically. D1 S1 Price Excess supply P1 P2 S2 e1A e2 24 O Q1 Quantity demanded and supplied Demand curve will remain D1 Supply will increase Supply curve will shift downwards to the right from S1 to S2 At original equilibriumprice OP1 New quantity demanded = P 1 e1 New quantity supplied =P 1 A Then quantity demanded (P 1 e1) is less than quantity supplied (P 1 A) , so Excess Supply equal to e1A occurs. Sellers will compete with each other to sell excess goods in their stocks, they will reduce prices, hence quantity demanded rises and quantity supplied falls. Price is again reduced. This process continues till the excess supply gets wiped out and new equilibriumis reached at point e 2, where new quantity demanded =new quantity supplied = OQ1. So equilibrium price decreases from OP1 to OP2 &equilibrium quantity remains constant at OQ1 24. What will happen to equilibrium price and quantity whenSupplyis perfectly inelastic and demand increases? Explain diagrammatically. S1 Price P2 e2 e1A P1Excess Demand D2 25 D1 O Q1 Quantity demanded and supplied Supply curve will remain S1 Demand will increase Demand curve will shift downwards to the left from D1 to D2 At original equilibriumprice OP1 New quantity demanded = P 1 A New quantity supplied =P 1 e1 Then quantity demanded (P 1 A ) is more than quantity supplied (P 1e1) , so Excess Demand equal to e1A occurs. Buyers will compete with each other and some buyers will be willing to pay higher prices to get the good. Sellerswillincrease prices,hence quantity demanded falls and quantity supplied rises. Price is again raised. This process continues till the excess demand gets wiped out and new equilibriumis reached at point e2 where, quantity demanded = quantity supplied = OQ1. So equilibrium price increases from OP1 to OP2 &equilibrium quantity remains constant OQ1 25.) With the help of a supply schedule and demand schedule,explain excess demand or excess supply. ( 6 ) OR What will happen in the market if the price is more than or less than the equilibrium price? PRICE SUPPLY DEMAND 26 Ans- 1 2 3 4 5 10 20 30 40 50 50 40 30 20 10 Equilibrium price and quantity of a product is determined at the point where market demand is equal to the market supply. In the above schedule equilibrium price is 3,where demand is equal to supply(30). At priceless than the equilibrium price At price level 1 and 2, Quantity demanded of product is more than Quantity supplied. It is a situation of excess demand. In the situation of excess demand, price increases upto the equilibrium level(3) leading to increase in Quantity supplied (expansion of supply) and decrease in Quantity demanded (contraction of demand) till both are equal at equilibrium. At pricemore than the equilibrium price At price level 4 and 5, Quantity demanded of product is less than Quantity supplied. It is a situation of excess supply. 27 In the situation of excess supply, price decreases upto the equilibrium level(3) leading to decrease in Quantity supplied (contraction of supply) and increase in Quantity demanded (expansion of demand) till both are equal at equilibrium. Note UNIT 5 is not to be evaluated in Exam No marks are allotted to it UNIT 6 NATIONAL INCOME AGGREGATES-15marks NOTE: While Revising in this unit first read and learn following then learn definitions and formula in the end 28 -precautions to be taken in calculation of national or domestic income of the country -Consumer goods or consumption goodsCapital goods -Final goods&Intermediate goods -Factor income & transfer income - Concept of Domestic & National income -Questions at the end based on whether to include or not include in Concept of Domestic & National income 1. Real Flow - It refers to the flow of factor services from households to firms and the corresponding flow of goods and services from firms to households. 2. Money Flow - It refers to flow of factor payments from firms to households for their factor services and corresponding flow of consumption expenditures from households to firms for purchase of goods and services produced by the firms. It is also called nominal flow. 3. CIRCULAR FLOW IN A TWO SECTOR ECONOMY Factor Payments (Rent, Wages, Interest and Profit) Factor Services (Land, Labour, Capital and Enterprise) HOUSEHHOLDS FIRMS Consumption Expenditure (On goods and services) Purchase of Goods and Services Note: outer arrow and lines show Real flow & inner arrow lines show Money flow - There are only two sectors in the economy: Households and firms -Household sectors supplies factor services only to firms and firms hire factor services only from households. - Firms produce goods and services and sell their entire output to the households. - Households receive factor income for the services and spend the entire amount on consumption of goods and services 4. CIRCULAR FLOW IN A FOUR SECTOR ECONOMY 29 Subsidies& Transfer Payments Transfer Payments GovernmentNet Sector Tax Payments Tax Payments Payment for goods and services Factor Payments Savings Financial market Savings Household Sector Firms or Producer Sector Borrowings Net Payment for factor services Foreign Sector (ROW) Payments for Imports Receipts from Exports 5. 1. 2. 3. Leakages from CIRCULAR FLOW of Injections into from CIRCULAR FLOW income of income These flow variables have a negative impact on the process of production. These are withdrawals from the circular flow of income. These causes positive impact on the process of production. Examples: Saving, taxation and imports Examples: Investment, exports and consumption expenditure. These are addition to the circular flow of income. 30 6.Define macroeconomics It is the branch of economics which studies economic activities, issues and economic problems at the level of economy as a whole. 7.Give examples of macroeconomic variables. Aggregate demand, Aggregate supply, national income, per capita income, unemployment. 8.What are the subjects studied in macroeconomics? * Income and employment determination *Problems related to economic growth *unemployment problem in the economy *problem of inflation etc.. -----------------------------------------------------------------------------------------------------NOTE: It is not the economic nature of good BUT the USE of the good that tellswhether the good isConsumer goods or Capital goods; Final goods or Intermediate goods. ------------------------------------------------------------------------------------------------------- 9. Consumer goods or consumption goods 1. These are directly used by ultimate consumer household for satisfaction of wants. 2. These are final goods 3. They are not used in production by producer. 4 . They may be changed during use by consumer like tea leaves are used Capital goods 1. These are fixed assets used by the producers in the production process. 2. These are final goods. 3. They help in production of other goods. 4. They do not change during production process. 31 to make tea. 5.eg: Durable goods- car, washing machine 5. eg: machines , plants and equipment used in production process. 10.Define Consumer goods or consumption goods These are final goods (Durable goods, Semi durable goods, Non-durable or perishable goods,Services) directly used by ultimate consumer household for satisfaction of wants. They may be change during use. For example:- sugar if used by consumer to make biscuits is consumer good. 11.Define Capital goods These are durable final goodsused by the producers in the production process. They do not change during production process. For example fixed assets like machines, plants and equipment used in production process. 12. All capital goods are producer goods , but all producer goods are not capital goods. Explain. Producer goods are all those goods which are used in production process they are:(a) goods used as raw material (b) fixed assets like machines Raw material like coal, wood etc are not capital goods as they lose their identity in production process. They are intermediate or a single use producer goods and cannot be used again in the production process. Capital goods are durable final goods used to help production. Only fixed assets are capital goods like machines,plants and equipment.So all capital goods are producer goods. But all producer goods are not capital goods , as raw materials are not capital goods. 13. Final goods 1. These are ready for final use by consumer for consumption or Intermediate goods 1. These are not ready for use; they are for resale or used 32 By producer for investment. forfurther production. 2.These are:(a)Consumer goods used for satisfaction of wants. They may change during use. (b) Capital goods which help in production process. Thy do not transform during use,; 2. These are purchased by one firm from another for following purpose:(a) Resale during the year (b) Use as raw materialin production process. So they may change during production process 3. Once sold these pass out of production boundary. 4. These are included in national income 3.These are inside the production boundary. 4. These are not included in national income. 14. Define Final goods These refer to the goods used either for consumption or for investment. They are neither resold nor used for further production of goods. 15. Define Intermediate goods These are goods used as raw material in production process or are for resale during the financial year. 16. Stocks 1. Stock variables are measured at a particular point in time. 2. They do not have a time dimension, 3. Eg: Capital stock, inventory, wealth on a particular day. 4.Stock is static concept Consumption of fixed capital Flows 1. Flow variables are measured over a period of time, 2. They have a time dimension, 3. Eg: Capital formation during a year, change in stock, national income during a year. 4.Flow is dynamic concept. Capital Loss 33 1. 2. 3. It is loss in the value of fixed assets due to normal wear and tear and expected obsolescence It is expected loss in the value of asset Provision for depreciation is by maintaining depreciation reserve fund. Factor income or Factor payment 1. 2. 3. It is the income received in return for rendering factor services by the factors of production. These are included in national income. Example: Rent, wages, interest, and profit. Retirement pension. It is loss in the value of fixed assets due to natural calamities and unexpected obsolescence. It is unexpected loss in the value of asset. Provision for capital loss is by getting insurance done. Transfer Income or Transfer payment It is the income received without any corresponding services. These are not included in national income Example: old age pension, scholarship of students, unemployment allowance, charity ,gifts, expenditure on birthday / Marriage, pocket money, remittances from abroad, financial help to earthquake victims, beggars, meals to beggars, compensation given to accident victims etc. 17. Classify the following into factor income and transfer receipt. Give reason for your answer. i) Employer’s contribution to social security schemes. It is a factor income as it is earned because employees are rendered corresponding services to the employer. ii) Scholarship given to students by the government. It is transfer receipt as it is unearned because students are not rendered any corresponding services to the government. iii) Old age pension given by the government. It is transfer receipt as it is unearned because pensioners are not rendered any corresponding services to the government. iv) Bonus given to employees by employer. 34 It is a factor income as it is earned because employees are rendered corresponding services to the employer. 18. Definedepreciation or consumption of fixed capital. It is the loss in the value of fixed assets during use due to (a) Normal wear and tear and (b) Expected obsolescence It does not include capital loss due to unexpected obsolescence like natural calamities, theft or accident. 19. Explain gross investment. Total capital formation (or total investment) in a financial year is called gross investment. It includes:(a) Stock of raw material, work in progress and finished goods, (b) Fixed capital assets like machinery, equipment, buildings etc. It also includes depreciation. 20. Real GDP or GDP at constant prices or GDP at base year prices 1. It is the monetary value of all goods and services produced in an economy during a financial year, estimated using base year prices. Nominal GDP or GDP at market prices or GDP at current year prices 1. It is the monetary value of all goods and services produced in an economy during a financial year, estimated using current market prices. 2. Base year price is taken as constant. 2. Market prices do not remain constant. 35 3. This GDP changes only due to 3. It changes due to change in both change in output of the economy. So price and output of the economy. So it it is a reliable measure of economic is not a reliable measure of economic growth. growth. 21. NOTE: Application based questions come from this topic Explain Normal resident of a country. A normal resident is said to be a person: country. For example: A larger number of Indian Nationals have settled in USA, England etc. as residents (not as nationals) of those countries. For India, they are non-resident Indians but are nationals. Examples of Non-residents: They are called non-residents because they do not fulfil the creation of centre of economic interest: residence of any country but of international area. These are non-resident organizations for the country in which these are situated. countries to which they belong and not of the international area. given country. They are treated as residents of the country where they live and not the residents of the country where they work. treatment, recreation or take part in sports, cultural events etc. These are nonresidents for the country they are visiting. given country. 36 --------------------------------------------------------------------------------------------------------NOTE: These six (6) conceptsgiven below are not definitions but areHINTS to define and differentiate measures of national income While defining aggregates Firstly,define Gross or Net Secondly, definemarket Price or Factor Cost Thirdly, defineDomestic or National product. (1) Net product It is the Net Value of all final goods and services produced in a financial year. (2) Gross product It is the Gross Value of all final goods and services produced in a financial year. It does not include depreciation It includes depreciation Net product= Gross productdepreciation gross product= Net product +depreciation (3) National product It is the value of all final goods and services produced by Normal Residents of a country within or outsidedomestic territoryin a financial year (4) Domestic product It is the value of all final goods and services produced within domestic territory of a country by all producers during a financial year It includes Factor income from abroad It does not include Factor income from abroad It does not include Factor income to abroad It includes Factor income to abroad Factor income from abroad National product = Domestic product +Factor income from abroad Domestic product =National productNet Factor income from abroad 37 (5) Product at Factor Cost It is the Income earned byall the factors of production in a financial year. (6) Product at Market Price It is the Market Value ofall final goods and servicesproducedin a financial year It does not include Indirect taxes It includes Indirect taxes It includes subsidies It does not include subsidies Product at Factor Cost= Product at Market Price – Net Indirect taxes Product at Market Price =Product at Factor Cost +Net Indirect taxes ---------------------------------------------------------------------------------------------------- 22.Definitions formed Using hints given above 1. GDPMP - It is the GrossMarket Value of all final goods and services producedby all producers within domestic territory of a country in a financial year 2. NDPMP- It is the NetMarket Value of all final goods and services producedby all producers within domesticterritory of a country in a financial year 3. GNPMP-It is the GrossMarket Value of all final goods and services producedbyNormal Residents of a country within or outsidedomestic territory in a financial year 4. NNPMP -It is the NetMarket Value of all final goods and services producedby Normal Residents of a country within or outside domestic territory in a financial year 5. NDPFC -It is the Netfactor Income earned by all the factors of production within domestic territory of a countryin a financial year 6. GDPFC-It is the Grossfactor Income earnedby all the factors of production within domestic territory of a countryin a financial year 38 7. GNPFC-It is the Grossfactor Income earnedby ( all the factors of production owned by)Normal Residents of a country within or outsidedomestic territoryin a financial year 8. NNPFC or National Income- It is the Netfactor Income earned by (all the factors of production owned by)Normal Residents of a country within or outside domestic territoryin a financial year. 23. Calculation of Personal disposable income from NDP FC NDP FC - Income from property and entrepreneurship accruing to the government administrative departments 39 - Savings of non-departmental public sector enterprises Income from domestic product accruing to private sector + Net factor income from abroad + Net current transfers from rest of the world + Net current transfers from government administrative departments + National debt interest Private income - Corporate Tax - Retained earnings of private corporations Personal income - Direct personal taxes - Miscellaneous receipts of fees & fines by government administrative departments Personal disposable income Personal disposable income = Private final consumption expenditure + savings of households --------------------------------------------------------------------------------------------------40 NOTE: TheHints in following table will help in understanding definitions given below it Item Type of income Sector earning it Factor or Transfer (government, income Firm, or Household) NDPFC factorIncome Income from NDP FC accruing to Government factorIncome Income from NDP FC accruing to Private sector Private income factorIncome Government Firm household Government Firm household Income earned in Domestic territory or by normal residents (National income) Domestic Domestic Domestic factor& transfer Firm National Income household Personal income factor& transfer household National Income -----------------------------------------------------------------------------------------------------24. Definitions NDPFC -It is the Net factor Income earned by all the factors of production (owned by all sectors government, firm,household) within domestic territory of a countryin a financial year. Income from NDP FC accruing to Government - It is the factor Income earnedby public sector ( government ) within domestic territory of a countryin a financial year. Income from NDP FC accruing to Private sector– It is the factor Income earned by all firms and householdswithin domestic territory of a countryin a financial year. 41 Private Income - It is the Income earned from all sources (factor & transfer Income) by allnormal residentfirms and householdfrom within or outside domestic territoryin a financial year. Personal Income - - It is the Income earned from all sources (factor & transfer Income) by all normal residenthouseholdfrom within or outside domestic territoryin a financial year. Personal Disposable Income – It is the personal income remaining with all households for private final consumption expenditure and savingof household. 25. Net National Disposable Income = National Income (NNPFC)+Net Current Transfers from Abroad + Net Indirect Taxes Gross National Disposable Income = GNPFC +Net Current Transfers from Abroad + Net Indirect Taxes 26. Personal Disposable Income 1. It is the income of all Normal resident households of an economy, from all sources which is left with them for Final consumption and saving, during a financial year 2. It does not include Direct& Indirect taxes. 3. Personal Disposable Income = P is Private Final Consumption Expenditure of household + Savings of Household Net National Disposable Income 1. It is the income of all sectors of an economy (Government, firm & household sector) from all sources during a financial year. 2. It includes both Direct & Indirect taxes. 3. NNDI= NNPFC +NIT + NCTfROW 27. Problem of Double Counting Double counting means counting of the value of same product (or expenditure) for more than once. If certain items are counted for more than once resulting in over estimation of national product to the extent of the value of intermediate goods included, this will cause the problem of double counting e.g there are four producers – farmer, mill owner, baker and shopkeeper. Producers – Product Value of Output (Rs) Intermediate Consumption (Rs) Value Added (Rs) 42 1 Farmer – sells to mill owner 2 2000 0 2000 Mill Owner- sells to baker 2500 2000 500 3 Baker – sells to Shopkeeper 3600 2500 1100 4 Shopkeeper – sells to customers 4000 3600 400 12100 8100 GVA=4000 If for the purpose of calculation we take value of output as (2000+2500+3600+4000) = 12100, this will be double counting. In this, value of wheat has been included four times, flour for three times and bread for two times, whereas value of final product is Rs 4000 only i.e the value of bread (121800-8100 = 4000). To avoid double counting, we should use the following: *Value added method. By this method we take value added only i.e, Value of output – Intermediate consumption i.e 12100 – 8100 = 4000 or, ** Final output method. By this method we take value of final good only i.e, Value of output i.eRs 4,000. 28. Value Added Method for calculation of National Income Step 1 Calculate gross value added by Primary, Secondary & tertiary sectors Formula 1 GVAMP = +GVOMP Formula2 GVAMP = +Sales Formula3 GVAMP = +Domestic Sales Formula4 GVAMP = +Sales to household +Sales to 43 -Intermediate Consumption +Change in stocks +Exports +Closing Stocks -Opening Stocks - Intermediate Consumption - Intermediate Consumption government +Exports +Closing Stocks -Opening Stocks -Domestic purchase of raw material -Import of Raw material Step 2 GDPMP = GVAMP PrimarySector + GVAMP Secondary Sector + GVAMP Tertiary Sector Step 3 NNPFC = GDPMP – Depreciation + Net factor income from abroad + net indirect taxes 29. Income Method for calculation of National Income Step 1 Formula 1 NDP FC = +Mixed Income of self employed Formula 2 NDP FC = +Mixed Income of self employed Formula 3 NDP FC = +Mixed Income of self employed 44 +Compensation of employees +Wages & Salaries +Wages & Salaries in cash +Wages & Salaries in kind +Employers contribution +Employers contribution to social security scheme to social security scheme +Operating Surplus +Interest +Interest +Profit +Corporate taxes +Dividend +Undistributed Profit +Rent +Royalty +Rent +Royalty Step 2 NNPFC = NDP FC + Net factor income from abroad 30. Explain the components of Income method. (1) Compensation of Employees – it is the payment employees receive from the enterprise for work done by them. It includes the following:(a) Wages & salaries in cash for example basic pay , bonus , dearness allowance , house rent allowance , sick leave allowance etc. (b) Wages & salaries in kind for example rent free accommodation, transport facilities, interest free loan,and food, uniform. (c) Employers contribution to social security scheme like their contribution to GPF, medical insurance, retirement pension etc. (2) Operating Surplus – It is the income from property, likerent,interest,royalty,& income for running enterprise is profit. 45 (a) Interest – It is the price paid for borrowing assets like machinery or money borrowed by producers . Interest earned by consumers on their bank deposits is also included. Interest paid by consumers on money borrowed is not included. (b) Profit – It is the payment to the owners of the firm for doing business. Profit is used for the following:(i) To pay corporate taxesi.e. the tax paid by the firm to the government on profit of the firm. (ii) To pay part of firms profit to the shareholders or owners of the firm as Dividend. (iii) The profit remaining with the firm after paying tax & dividend is called undistributed profit or retained Earnings of Private Corporations; it is used for expansion or for future expenditure. (c) Rent – It is the income for giving land, building, machinery etc. on hire by landlords or owners. It includes imputed rent of owner occupied houses. (d) Royalty – It is income earned by owners for renting subsoil assets like mines of iron ores, oil, or payment for use of patents, copyrights, trade mark etc. (3) Mixed income of self-employed - self-employed people like doctors, lawyers, shopkeepers etc., own many factors of production land, labour, capital & enterprise. The contribution of each factor cannot be identified & separated into rent, wages, interest and profit,So their income is called mixed income of self-emplo 31 (A).Expenditure Method for calculation of National Income Step 1 Formula 1 GDPMP = +P +Gross Investment Formula2 GDPMP = +P +GDCF Formula3 GDPMP = +P +GDFCF Formula4 GDPMP = +P +Gross Business fixed investment 46 +Change in Stock +G +G +G +X-M +X-M +X-M Where, P is Private Final Consumption Expenditure +Change in Stock +Gross residential construction investment +Gross public investment +G +X-M G is Government Final Consumption Expenditure Net Exports = X- M = Exports – Imports GDCF = Gross Domestic Capital Formation = GDFCF + Change in Stock GDFCF is Gross Domestic Fixed Capital Formation Step 2 NNPFC = GDPMP – Depreciation + Net factor income from abroad + net indirect taxes ------------------------------------------------------------------------------------------------[ NOTE: when any component of investment in above formula is given as NET value then in 31(B) Step 1 we get NDPMP 47 Formula 1 NDPMP = +P +Net Investment Formula2 NDPMP = +P +NDCF Formula3 NDPMP = +P +NDFCF +Change in Stock +G +X-M +G +X-M +G +X-M Formula4 NDPMP = +P +Net Business fixed investment +Change in Stock +Net residential construction investment +Net public investment +G +X-M Step 2 will be NNPFC =NDPMP + Net factor income from abroad + net indirect taxes ------------------------------------------------------------------------------------------------32. . Explain the components of Expenditure method. (1) Private Final Consumption Expenditure–It is the expenditure done by resident households & non-profit institutions ( like Schools, clubs ) on the purchase of goods & services. Like purchase of :(i) durable goods – TV, washing machine (ii) Semidurablegoods – clothes , shoes (iii) Perishable goods (Non durable goods) - vegetables etc (iv) Services – banking , medical facilities etc. (2) Government Final Consumption Expenditure–It is general government purchases of goods & services in domestic market & from abroad for satisfaction of collective wants like education , health care , defence etc. It includes following :(i) compensation of Employees paid by government (ii) goods& services purchased from domestic market (iii) Net purchases from abroad 48 (3) Net Exports = X- M =It is the difference between Exports of goods & nonfactor servicesminus imports of goods & non-factor services Exports refer to sale of goods (eg. India sells tea, garments etc )& non-factor services like banking, insurance etc. to foreigners in domestic territory or to other country. Imports refer to purchase of goods & non-factor services from rest of the world. (4)Gross Domestic Capital Formation or GrossInvestment–It is the expenditure on Gross Domestic Fixed Capital Formation & change in stock. It includes :(i) Business fixed investment – Expenditure by producer on purchase of plant, machinery etc. (ii) Fixed investment expenditure by households on construction of residential buildings. (iii) public investment by the government like expenditure on construction of roads, bridges etc. (iv) Inventory investment – It refers to the change in stock of raw materials , work in progress & finished goods. It is the difference between closing stock & opening stock. 33. Why is GDP not a good measure of welfare? 1.It does not consider level of prices in the country. If prices are high, even high income will also not lead to high standard of living. 2. It does not show the composition of output. Increase of GDP could also be due to war goods or socially undesirable goods such as drugs etc. if share of wage goods does not increase it may not increase economic welfare. 49 3. Rise in GDP could be due to increase in industrialisation & urbanisation which would lead to pollution, environmental degradation which reduces welfare. 4. Increase in GDP does not indicate distribution of income . Its increase may lead to increasing income inequalities & poverty, which reduces economic welfare, 5. It does not indicate unemployment in the country .Economic welfare will increase by removing unemployment & not just by increasing GDP. 6. It does not indicate the skills of population or resources which will indicate economic welfare of people. 34. What precautions should be taken in calculation of national or domestic income of the country? 1. Transfer incomes should not be included like taxes, subsidies, gifts, donations etc. because these neither lead to flow of goods and services, nor use factors of production in return for money flow. 2.Sale of second hand good should not be included as their production would have been counted in the year in which it was produced. Counting it again would lead to double counting. 3. financial transactions like sale & purchase of share, bonds etc lead to transfer of ownership only. It does not lead to any productive activity, hence it should not be included in the calculation of national income. 4.Windfall gains, lottery capital gains etc also do not result in any productive activity so they should also not be included in national income. 5. Illegal activities like smuggling, gambling, illegal arms sale etc. should not be included as it is black money it is not accounted or reported , it is unlawfully earned to evade tax. 6. Non marketed goods and services are not included like growing vegetables in kitchen garden, because national income includes only those transactions that occur through organised market activities. ------------------------------------------------------------------------------------------50 NOTE: Following items are to be includedin calculation of national or domestic income of the country 1.Imputed rent of owners occupied houses as house providers’ service to the owners. 2.Imputed value of goods and services produced for self-consumption by producer enterprise as these contribute to the current year’s output. 35. Categorize the following into intermediate goods and final goods. Give reason for your answer. intermediate goods final goods ii) Purchase of food items by a hotel. i) A new car purchased by a taxi Ans: Purchase of food item by a hotel driver. is an intermediate product because it Ans: A new car purchased by a taxi is used to prepare food for further driver is a final good since it is an resale. investment and purchased by taxi driver for final investment. iii) Stationary purchased by the iv) Wheat purchased by the government. Households. Ans: It is intermediate goods because it is fully used to produce services. vi) Paper purchased by a publisher. v) Purchase of equipments for installation in a factory. viii) Purchase of sugar by grocery shop vii) Milk purchased by households. ix) Cloths used by tailors x) Construction of houses by consumer household. xii) Chemical fertilizer used by the xi) Purchase of milk by a consumer. farmer. xiv) Coal purchased by a factory. xiii) Machine purchased by a firm xvi) Book purchased by a book seller xv) Text book purchased by a student. xvii) Expenditure on research and development by a company. xviii) Seeds purchased by a farmer. xix) Electricity consumption in a business. NOTE: ( For writing reasons from IV to XIX refer ans. I to III.) -------------------------------------------------------------------------------------------------------------- 51 Note following are parts of compensation of employee in case categorisation question comes in exam. Compensation of employees 1. Wages and salaries in cash. 2. Compensation in kind ance facilities employees. 3. Employer’s contribution to social security schemes such as t is different form old age provision which is transfer 36. Will the following be included or net in the domestic factor income of India? Give reasons for your answer. i) Salaries of non-residents working in India Embassies in Russia. Ans: Yes it will be included because Indian embassy is a part of domestic territory of India. ii) Salaries to Indian residents working in Indian embassy in Russia. Ans: Yes it will be included in the domestic factor income as the Indian embassy is a part of domestic territory of India. 52 iii) Salaries toRussian residents working in Indian embassy in Russia. Ans: Yes it will be included in the domestic factor income as the Indian embassy is a part of domestic territory of India. iii) Salaries to Indian residents working in Russian Embassy in India. Ans: No it will not be included in the domestic factor income as the Russian embassy is not a part of domestic territory of India. iv) Salaries received by Indian workings in American Embassy in India. Ans: No it will not be included in the domestic factor income as the American embassy is not a part of domestic territory of India. v) Salaries paid to non-resident Indians working in Indian Embassy in America. Ans: Refer Ans 1 vi) Salaries paid to Koreans working in Indian Embassy in Korea. Ans: Yes it will be included in the domestic factor income as the Indian embassy is a part of domestic territory of India. vii) Salaries to India working in Japanese embassy in India. Ans: No it will not be included in the domestic factor income as the Japenese embassy is not a part of domestic territory of India. viii) CEO to the residents of Japan working in Indian Embassy in Japan. ix) Ans: Yes it will be included in the domestic factor income as the Indian embassy is a part of domestic territory of India. x) Profit earned by a branch of an American Bank of India. xii) Profit earned by an Indian company from its branch in Singapore. Ans: No it will not be included in domestic factor income of India because Singapore is not a part of domestic territory of India. xiii) Profits earned by a resident of India from his company in Singapore. Ans: refer ans(xiii) xiv) Rent received by an Indian from his building in London. Ans: No, it will not be included in the domestic factor income as the rent is earned outside the domestic territory of India. xv) Rent received by a resident Indian from his property in Singapore. Ans: No, refer Ans(xv) xvi) Rent paid by the embassy of Japan in India to a resident Indian. Ans: No, it will not be included in the domestic factor income as the Japenese embassy is not a part of the domestic territory of India. 53 37. Giving reasons state whether the following are included in national Income. i) Salary received by an Indian resident working in US embassy in New Delhi. Ans: Yes, it will be included in national income as salary received by Indian resident working in US embassy in New Delhi is a part of factor income from abroad. ii) Salaries paid to non-resident Indians working in Indianembassy in America. Ans: This is a exceptional case It is included in the national income of India as salaries paid to non-resident Indians working in Indian embassy in America is a part of compensation of employees from abroad. iii) Salaries received by an Indian resident working in Russian embassy in India. Ans: Yes, it will be included in national income as it is a part of factor income from abroad. iv) Salaries paid to Russian working in Indian embassy in Russia. Ans: No, it will not be included in national income as it is a part of the factor income paid to abroad. v) Wages received by Indian employees working in Pakistan embassy. Ans: Yes, it will be included in national income as it is a part of factor income from abroad. vi) Profit earned by foreign banks in India. Ans: : No, it will not be included in national income as it is a part of the factor income paid to abroad vii) Profits of Reliance industries from its chemicals business in Australia. Ans: Yes, it will be included in national income as it is a part of factor income from abroad. viii) Profit earned by an Indian bank from its branches abroad. Ans: Yes, it will be included in national income as it is a part of factor income from abroad. ix) Profit earned by Indian companies from their branches abroad. Ans: Yes, it will be included in national income as it is a part of factor income from abroad. x) Profit earned by Indian company from its branch in London. Ans: Yes, it will be included in national income as it is a part of factor income from abroad. xi) Rent received by Indian residents on their buildings rented out to foreigners in India. Ans: Yes, it will be included in national income as it is a part of factor income from abroad. 54 Students are suggested to attempt more questions related to concept of National and Domestic Income refer to items above Students are advised to practice more and more numerical Questions from CBSE papers of last five years UNIT - 7 MONEY AND BANKING-8marks Q1 .Define money. Money :- It is anything which is generally acceptable as a medium of exchange and at the same time acts as a measure of value, store of value and means of deferred payments. Q2. Define High Powered Money 55 High Powered Money (H) :- High powered money or monetary base refers to the total liability of the monetary authority of the country i.e. Central Bank (RBI). It consists of currency (notes and coins in circulation with the public and vault cash of commercial banks) and deposits held by Government of India and commercial banks with RBI. Q3. Define Money multiplier or deposit multiplier. Total deposits created due to a new deposit in bank is many times the initial deposit. The multiple by which deposits can increase due to an initial deposit is called money multiplier. Money multiplier =1/LRR, where LRR is legal reserve ratio. Q4. Explain the Process of credit creation by commercial banks. Credit creation (or deposit creation or money creation) by the banks is determined by (i) the amount of the initial fresh deposits and (ii) the Legal Reserve Ratio (LRR), the minimum ratio of deposit legally required to be kept as cash or in liquid form by the banks. It is assumed that all the money that goes out of banks is redeposited into the banks, and LRR consists of CRR and SLR decided by RBI. Example :- Let the LRR be 20% and there is a fresh deposit of Rs.10,000. As required the banks keep 20% i.e. Rs.2,000 as cash. Suppose the banks lend the remaining Rs. 8,000. Those who borrow, use this money for making payments. As assumed those who receive payments put the money back into the banks. In this way bank receives fresh deposits of Rs. 8,000. The bank again keep 20% i.e. Rs.1,600 as cash and lend Rs.6,400, which is also 80% of the last deposits. The money again comes back to the banks leading to a fresh deposit of Rs.6,400. The money goes on multiplying in this way this process continues till new deposit become nil., and ultimately total money creation is Rs.50,000. Total money creation = initial deposit x 1/LRR =10000 x1/20% = 10000 x100/20 Total money creation = 50000. The whole process can be explained through following table:Banks Initial Deposit Rs. Legal Reserve Ratio (20%) Secondary Deposit (Lending) Rs. 56 A B . . . . N 10000 8000 . . . . . 2000 1600 . . . . . 8000 6400 . . . . . Total 50000 10000 40000 Where Money multiplier is 1/LRR=1/20%=1/20*100=10/2= 5 It is the multiple by which total deposits increase due to initial deposit. Q5. Explain Functions of Money. Functions of Money are:(1) Medium of Exchange:- It is generally accepted means of payment for exchange of goods and services. - Facilitates trade, widens area of market by separating act of sale and purchase. - Reduces time and labour needed for trade in case of using goods for trade (Barter System). (2) Measure of Value or Unit of Value:- All goods and services can be given one unique value (Price) by expressing them in terms of money. -It is common unit of measurement of all goods. Thus makes exchange easier. -Helps developing efficient accounting system. Goods and services can be accounted for easily in terms of rupees. It would have been difficult to make account in many units like litres, quintals, meters etc. and adding up different units is not possible. -Comparisons can be made. -Its value remains constant. (3) Store of Value -It is liquid store of value. -It comes in convenient denominations. -Value remains constant, it is not perishable easily portable, requires less place to store& there is no storage cost. 57 (4)Standard of deferred Payments -Or future payments like salaries, pension, interest etc. -Facilitates borrowing and lending. -It led to creation of financial institutions -itovercomes disagreements and risks that are there is Barter system regarding future payments to be made as value of money remain constant. Q6. Explain Quantitative credit control measures used by Central Bank (RBI) Quantitative credit control measures used by Central Bank (RBI) are:1. Cash Reserve Ratio (CRR) :- It is of certain ratio of commercial banks net demand deposits & times liabilities which it has to keep with central bank RBI as cash. If RBI increases CRR, Banks have to keep larger percentage of their deposits with RBI, their credit giving ability decreases and money supply decreases. Conversely, if RBI decreases CRR, money supply Increases. 2, Statutory Liquidity Ratio (SLR) :- It is the ratio or percentage of net total demand & time liabilities of commercial banks which they have to keep in form of liquid assets as excess reserves, they have to invest in government securities or in securities approved by RBI and current account balances with other banks. If RBI increases SLR then credit giving ability of bank decreases and money supply decreases. If RBI decreases SLR banks credit giving ability and thus money supply increases. 3. Open Market Operations (OMO) :- It is the buying and selling of government security by the Central Bank from/to the public and banks on its own account. Sale of government securities will reduce reserves. * RBI sells securities Bank gives RBI a cheque for the securities. * The RBI collects the amount by reducing the bank’s reserves by the particular amount. * This directly reduces bank’s ability to give credit. * Therefore this decreases money supply in the economy. When RBI buys securities from banks 58 * RBI gives the bank a cheque drawn on itself in the payment for the securities. * When cheque clears, RBI increases reserves of the bank by the particular amount. * This directly increases the bank’s ability to give credit. * Thus money supply increases. 4. Bank Rate Policy Bank rate is the rate at which Central Bank lends funds to commercial banks. If bank rate increases: * Cost of borrowing from RBI increases. * So banks borrow less * Their credit giving ability decreases. * Banks also increase lending rates i.e. rate at which they lend to public. * This discourages businessmen from taking loans. This reduces volume of credit and money supply. A decrease in bank rates on the other hand will increase credit and money supply. Q7. Mention various Measures of Money Supply. Measures of Money Supply are:M1 is most liquid measure of money supply M1 = C + DD + OD C = Currency held by public (currency & coins). Demand Deposits (DD):- Only net demand deposits of banks are included in money supply, as other part of demand deposit that represents inter-bank deposits held by one bank with anotherdoes not constitute demand deposit held by public. Other Deposit (OD) with RBI: - These are the deposits held by the RBI of all economic units except the government and banks. OD includes demand deposits of public financial institution (Like IDBI) foreign central banks, foreign government, the IMF, the World Bank etc. M2 = M1 + saving deposits with post office saving banks. M3 = M1 + Net time deposits of banks M4 = M3 + Total deposits with post office savings organisations (excluding National saving certificates). Q8. Define the following terms:- 59 (a) LRR - Legal Reserve Ratio: - It is legally compulsory for the banks to keep a certain minimum fraction of its demand deposits as cash. This fraction is called LRR. It has two components – (a) A part of LRR is to be kept with the Central Bank and this is called cash reserve ratio (CRR) and (b) The other part is kept by the commercial banks themselves in form of cash or liquid assets it is called statutory liquidity ratio SLR. Q9. Explain main functions of Central Bank (RBI). Functions of Central Bank: 1. Currency Authority: - Central Bank has monopoly over issue of notes (currency). Coins and one rupee note are issued by Government of India but Central Bank puts currency notes &coins into circulation and withdraws it from circulation. Issue of notes is monetary liability of Central Bank as it backs currency by assets of equal value gold coins, gold bullions, foreign securities & domestic government’s local currency securities. -Central government borrows money from RBI (Central Bank) and increases money supply. 2. Banker to Government • Banker to State and Central Government:- Carries all banking business of government - Government keeps its cash balances in current account with Central Bank (RBI). - RBI accepts receipts and makes payments for the government, & - RBI carries out exchange & other remittances. - RBI provides short term credit to government. - Agent to Government:• RBI manages public debt by (a) Managing all new issues of govt. loan (b) Servicing public debt outstanding (c) Creating market for govt. securities. - Advises the govt. on banking and finance matters regarding - money market, capital market,Government loans, on economic policy matters etc. 3. Banker to Banks’ • RBI keeps cash reserves of banks as determined by CRR. - Banks also keep their surplus cash with RBI. • RBI supervises and regulates commercial bank through regulations related to:- Licensing of banks, - Branch expansion, liquidity of assets, 60 - Management, amalgamation and liquidation of banks. • RBI controls banks through periodic inspection of banks and returns filed by them. - When banks fail to meet obligations of their depositors and are facing bank failures RBI lends them short term funds as a lender of last resort to commercial banks. • RBI is Clearing house for interbank payments .RBI providescentralisedclearance, settlement &transfer facilities for interbank payments. 4. RBI is Custodian of Foreign Exchange Reserves. - And RBI helps overcome BOP difficulties & maintains foreign exchange rate by Buying & selling foreign currency. 5. Controller of Money Supply and Credit - RBI controls money supply and credit by using monetary measures. (a) Quantitative Credit control instruments like CRR, SLR, Bank rate Policy, and open market operations. (b) Qualitative credit control instruments like moral suasion, selective credit control, Imposing margin requirement on secured loans Q10. ) Explain the Qualitative credit control measures used by Central bank (RBI)? Qualitative credit control measures used by Central bank (RBI) are:(i) Moral suasion – This is a combination of persuasion and pressure that the central bank applies on other banks in order to get them to fall in line with its policy. This is exercised through discussions, letters, speeches and hints to banks. The central bank frequently announces its policy and urges the banks to fall in line. (ii) Selective credit control – It is applied in a positive manner to use it to channel credit to particular sectors, usually the priority areas. It is applied in negative manner to restrict the flow of credit to particular sectors. (iii) Imposing margin requirement on secured loans – a margin is the difference between the amount of the loan and market value of the security offered by the borrower against loan. If margin imposed by central bank is 40% then the bank is allowed to give a loan only up to 60% of the value of security. If Central bank increases margin requirements people take less credit from banks and this prevents price rise or taking loans for speculative purposes. 61 Q11. Explain the Lender of Last Resort Function of Central Bank. Lender of Last Resort Function of Central Bank:When commercial banks fail to meet obligations of their depositors and are facing bank failure due to Bank runs, Central bank supports them by acting as lender of Last resort. Here instead of rediscounting RBI gives short term advances to commercial banks against the bills of exchange, promissory notes, treasury bills, government securities etc. But banks have to first approach all other sources to get credit like call money market, then only approach RBI. RBI stands by commercial banks as a guarantor and extends loans to ensure the solvency of the commercial bank. Q12. Explain the role of Central Bank as clearing house for commercial banks. Central Bank as clearing house for commercial banks OR RBI is bank of central clearance, settlement and transfer RBI settles mutual indebtedness between banks. It makes entire process of collecting bank to bank payments easy and much less time consuming. Central bank has a clearing house where mutual indebtedness between banks is settled. Representatives of different banks meet daily in the clearing house to settle interbank payments by debt and credit entries in the cash reserve account held by commercial bank with RBI. The differences between various banks at the end of the day of each daily clearing are settled by transfer between their respective accounts with RBI. 62 63 UNIT 9Government Budget and the Economy (8 Marks) 1.Government Budget -A government budget is the statement of estimated total revenue and estimated total expenditure of financial year. 2.Components of Government Budget (A) Revenue Budget- It consists of those Government receipts & Government expenditures which neither Create nor Reduce, Assets or Liabilities 1. Revenue Receipts - It consists of those Government receipts which neither Create Liabilities nor Reduce Assets. Types of Revenue Receipts (i). Tax Revenue:- It consists of proceeds of taxes and other duties levied by the Union government. It is a compulsory payment made to the Govt. in return for which no goods or services are provided directly by Govt. -Direct tax - Indirect Tax (ii). Non Tax Revenue: - Income from sources other than taxes is called non-tax revenue. It arises on account of administrative function of the govt.in return for which Govt. either gives goods or services or privileges or permit to perform a service Types of Non TaxRevenue (i)Commercial revenue- It is received by Govt. in the form of prices paid by people for goods or services that Govt. Provides like railway, postage, electricity etc. (ii)Administrative revenue-It arises on account of administrative functions of the Govt. (a) Fees-Payment received for providing certain services for public interest like Govt. college or hospital fees Fines & penalties charged for breaking of laws or disobeying rules & regulations (b)License fee & Permit - Payment received for giving privileges or permit to perform a service. Like registration and license fee for industries or automobile. (c) Escheat-income Govt. gets by taking possession of property which has no claimant or legal heir. (iii) Interest Receipts- interest received by the Govt. credit corporations on loans given by them 64 (iv) Profits of PSU’s –Profits earned by public sector enterprises or dividend received by Govt. on investment made by it. 2. Revenue Expenditure - It consists of those Government expenditures which neither Create Assets nor Reduce Liabilities. Types of Revenue Expenditure (i) Daily expenses in running Govt offices (ii) Compensation of employees of central Govt. (iii) Interest payments (iv) Grants-in-aid to state Govt. (v) Subsidies (B) Capital Budget- It consists of those Government receipts & Government expenditures which Create or Reduce, Assets or Liabilities 1. Capital Receipts:- It consists of those Government receipts which either Create Liabilities or Reduce Assets. Types of Capital Receipts (i) Borrowings (CL) - Borrowings by Govt. from various sources like general public, Reserve bank of India, foreign Govt. and other bodies to meet its financial requirements. (ii) Recovery of loans (RA)-Loans recovered by Govtwhich it gives to State Govt., union territories, local bodies etc. (iii) Disinvestment (RA)- Funds received by Govt. from the sale of the part or the whole of equity shares of the public sector enterprises to private sector. 2. Capital Expenditure - It consists of those Government expenditures which either Create Assets or Reduce Liabilities. Types of Capital Expenditure (i) Repayment of loan (RL) (ii) Expenditure on construction & purchase of Assets (CA) NOTE: in brackets above reason is given why those items are part of Capital Receipts or Capital Expenditure 65 ---------------------------------------------------------------------------------------Following table will help in learning Components of Government Budget Learn only Definition of Capital Expenditure or&Capital Receipts& relate it to define other Components Revenue Receipts Do not CL or RA Do not Create Liabilities(CL) Do not Reduce Assets (RA) Revenue Expenditure Do not CA or RL Do not Create Assets(CA) Do not Reduce Liabilities(RL) Capital Receipts CL or RA Create Liabilities(CL) Reduce Assets (RA) Capital Expenditure CA or RL Create Assets(CA) Reduce Liabilities(RL) ----------------------------------------------------------------------------------------------3. Categories the following into capital and revenue expenditure and Give reasons for your answer. (i)Subsidised LPG given to public Ans. It is revenue expenditure, because it neither Create Assets nor Reduce Liabilities (ii)Construction of Government School building Ans. It is capital expenditure, because it Create Assets (iii)Salary paid to Central government employees Ans. It is revenue expenditure, because it neither Create Assets nor Reduce Liabilities (iv) Old age pension given by government Ans. It is revenue expenditure, because it neither Create Assets nor Reduce Liabilities (v) Help given by govt. to flood victims Ans. It is revenue expenditure, because it neither Create Assets nor Reduce Liabilities 4. Categories the following into capital and revenue Receipts And Give reasons for your answer (i) Profits of PSU’s Ans. It is revenue Receipts, because it neither Create Assets nor Reduce Liabilities (ii) Borrowings Ans. It is capital Receipts, because it Create Liabilities (iii) Disinvestment 66 Ans. It is capital Receipts, because it involves sale of shares of PSU’s to private sector which Reduce Assets. (iv) Gain tax Ans. It is revenue Receipts, because it neither Create Assets nor Reduce Liabilities 5. Direct tax It is levied on income & wealth of individual or firms it cannot be shifted The incidence & the burden of the tax falls on the same person. It cannot be avoided it has to be paid Eg. Income tax ,Corporate or gain tax, wealth tax etc. Indirect Tax It is levied on production of & consumption expenditure on Goods & services it can be shifted The incidence of tax is on one person & the burden of payment of the tax falls on another person It can be avoided by not producing or purchasing goods and services that are taxed. Eg. Sales 6. Categories the following into Direct tax & Indirect Tax and Give reasons for your answer (i)Income tax Ans.It is Direct tax Because it is levied on the income of individual and it cannot be shifted. The incidence & the burden of the tax falls on the same person (ii) Excise duty Ans.It is Indirect tax Because it is levied on the production &transfer of good across states and it can be shifted. The incidence of tax is on one person & the burden of payment of the tax falls on another person. (iii) Service tax Ans.It is Indirect tax Because it is levied on the services given and it can be shifted. The incidence of tax is on one person & the burden of payment of the tax falls on another person (iv) Gain tax Ans.It is Direct tax Because it is levied on the profits of firm and it cannot be shifted. The incidence & the burden of the tax fall on the firm. 7.Types ofBudget Deficit 67 (1) Revenue Deficit:-It refers to the excess of total revenue expenditure of the government over its total revenue receipts. Revenue deficit = Total Revenue expenditure - Total Revenue receipts. OR Revenue deficit = Total Revenue expenditure - Tax Revenue- Non Tax Revenue (2) Fiscal Deficit: Fiscal deficit is defined as excess of total expenditure over total receipts excluding borrowing during a fiscal year. Fiscal deficit shows the borrowings requirements of the govt. during the budget year. Fiscal deficit reflects the borrowing requirements of the govt. for financing the expenditure including interest payments. Fiscal deficit = Total budget expenditure - Total budget receipts excluding borrowings OR Fiscal Deficit = (Revenue expenditure + Capital expenditure) – (Revenue Receipts + Capital receipts excluding borrowings) Fiscal deficit = Revenue expenditure+ capital expenditure- Revenue receiptscapital Receipts excluding borrowings OR Fiscal deficit = Revenue expenditure+ capital expenditure - Tax Revenue- Non Tax Revenue-recovery of loans-disinvestment OR Fiscal deficit = borrowings (3)Primary Deficit: Primary deficit is defined as fiscal deficit minus interest payments on previous borrowings. Primary deficit shows the borrowing requirements of the govt. for meeting expenditure excluding interest payment. Gross Primary deficit = Fiscal deficit - Interest payments Net Primary deficit = Fiscal deficit+ Interest received - Interest payments Deficit met by:(i) Borrow loansing from domestic sources. (ii) Borrowing from external sources. (iii) Deficit financing (printing of extra currency notes): 8.Implications of Budget deficit 68 Debt Trap: Fiscal deficit refers to the total borrowings requirement of the government create problem of repayments of loans and interest payments. Interest payments increase the revenue expenditure, which leads to revenue deficit. Repayments of loans increase capital expenditure & Fiscal deficit. The government has to borrow further to correct deficit. Thus, a vicious cycle of increasing deficit is created called debt trap. Foreign Dependence: Government also borrows from the rest of the world, which results in economic interdependence on them & economic interference by the lending countries. It causes economic slavery, if the lending county dictates its terms on the borrowing country. Causes Inflation: The government resort to borrowing from the Reserve Bank of India (RBI) to meet its fiscal deficit. It is done by ‘Deficit Financing’ Or ’ Monetisation of Debt’ , Which means RBI prints currency 7 gives it to Govt. to finance debt. This increases the circulation of money in the economy and creates inflationary pressure, if there is excess supply of money. Restricts Economic Development: When Govt. has to borrow to finance deficits, to repay loans and interest on loans, less money is left with the Govt. for economic development. Financial burden for future generation: Borrowings lead to burden for future generations as payment of loans and interest on loans get accumulated whose burden is to be borne by the future generations in the form of more tax and non-tax revenues. 9. OBJECTIVES OF A BUDGET i. ii. Redistribution of Income and Wealth. – The government uses fiscal instruments for Equitable distribution of income & wealth to ensure social justice . To improve the distribution of income and wealth in the economy It taxes the rich and gives subsidies on essential items, expenditure is done on social security or public works etc.. Reallocation of resources – The government seeks to reallocate with a view to balance the goals of profit maximization and social welfare. A production 69 iii. iv. of goods which are injurious to health like wine is discouraged through heavy taxation. On the other hand production of socially useful goods like Khadi is encouraged through subsidies. Economic stability –using its revenue and expenditure policy in Budget the government ensures economic stability in the economy by maintaining price stability and high levels of employment. The forces of supply and demand generate trade cycles in the economy, which govt. tries to prevent and control. Direct participation and Economic growth by Managing Public sector Enterprises – The Government targets to increase the rate of growth by establishing public sector enterprises to produce goods and services at low cost to promote social welfare like railways. Provisions are made in the budget for these PSU’s. Often, public sector enterprises are encouraged in areas where private monopolies occur. 70 Unit-10 Balance of Payments Marks : 07 Chapter Foreign Exchange Rate 1. Foreign exchange rate- It is the rate at which currency of one country can be exchanged for currency of another country. For example 1$ = Rs. 45 (In other words, It is the price of domestic currency expressed in terms of foreign currency i.e. 1 Re=1/45$ or It is the price of foreign currency expressed in terms of domestic currency i.e. 1 Re=1/45$) 2. The foreign exchange market is the market where international currencies are traded for one another. 3. Flexible Exchange Rate/ Floating Exchange Rate-In a system of Flexible exchange rate the exchange rate is determined by the demand and supply and there is no intervention by the monetary authority. 4. Fixed Exchange Rate System: It is the exchange rate which is officially fixed by the Govt. or monetary authority or central banks of a country. It is not determined by market forces. 5.Managed Floating- It is a mixture of Fixed Exchange Rate System & Flexible Exchange Rate System .in this system the exchange rate is allowed to change freely due to changes in demand and supply and monetary authorities intervene to manipulate the Exchange Rate when required. There are no rules or conditions as to when to intervene. Dirty Floating- When central bank of a country intervenes excessively in manipulating its exchange rate for its benefit and is detrimental to other country then it is called Dirty Floating 6. Appreciation of currency Appreciation means increase in price of domestic currency due to changes in demand and supply of foreign exchange. Depreciation of currency Depreciation means decrease in price of domestic currency due to changes in demand and supply of foreign exchange. increasing in price of rupee from rupee 55/$ to rupees 45/$ Appreciation occurs in Flexible Exchange Rate decreasing in price of rupee from rupee55/$ to rupees 65/$ depreciation occurs in Flexible Exchange Rate 7. Revaluation of currency the central monetary authority increases devaluation of currency the central monetary authority decreases 71 value of domestic currency in terms of foreign currency. For eg. Central bank revalues rupee by increasing its value from rupee 55/$ to rupees 45/$ monetary authority fixes the the exchange rate value of domestic currency in terms of foreign currency. For eg. Central bank devalues rupee by decreasing its value from rupee 55/$ to rupees 65/$ monetary authority fixes the the exchange rate 8. The price of 1 US Dollar has fallen from Rs. 50 to Rs. 48. Has the Indian currency Appreciated or depreciated? Ans. Indian currency has depreciated. 9. Spot market Foreign exchange Operations of daily nature are termed as spot market or current market A foreign exchange spot transaction is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot. Forward market Foreign exchange Operations for future delivery are termed as Forward market. Forward market refers to the market in which the sale and purchase of Foreign currency is settled on a specified future date at a rate agreed upon today to reduce the uncertainties in the exchange rate. Forward contract is made for two reasons (a) To minimize the risk of loss due to adverse changes in the exchange rate (through hedging) ; (b) To make profit (through Speculation). 10. What are the Sources of demand for foreign exchange? OR Give reasons why people want to have foreign exchange? Ans: People demand for foreign exchange for the following purpose:a) To purchase goods and service from other countries (for Imports) b) To send gifts and grants to abroad c) To purchase i.e invest in Physical and financial assets abroad d) To visit foreign country for education. 72 e) To visit foreign country for medical treatment f) To speculate in the foreign currencies market. g) To visit foreign country as tourists 11. What are the Sources of supply for foreign exchange:Ans: a) Exports of goods of the country to the rest of the world brings in the supply of foreign exchange b) Foreigners visiting a country as tourists c) Foreigners visiting a country for education D) Foreigners visiting a country for purchase (i.e to invest) of Physical and financial assets e) Direct foreign investment or any investment by foreigners in home country c) Speculative purchase of domestic currency by the non- residents in the domestic market. d) Gifts and grants by the foreigners. e) Direct purchase of the goods and services by the non- residents in the domestic Market (exports) ---------------------------------------------------------------------------------------------------Appreciation – Increase in value of domestic currency in terms of foreign currency due to change in demand or supply for foreign exchange in called appreciation. For eg. Change from rupees 55/$ to Rupees 40/ $ is appreciation of rupee & depreciation of $. NOTE: Dollar (Foreign Exchange ) behaves like a Good *If price of a good rises its, quantity supplied rises and quantity demanded falls *Similarly if Foreign Exchange rate rises or dollar Appreciates (i.e. price of dollar rises), its quantity supplied rises and quantity demanded falls 73 # Similarly if there is Excess Demand for a good its price rises , its quantity supplied rises and quantity demanded falls # Similarly if there is Excess Demand for Foreign Exchange i.e.$ Dollar, its price rises (i.e. Dollar Appreciates), its quantity supplied rises and quantity demanded falls * Similarly if there is Excess Supply for a good its price falls , its quantity supplied falls and quantity demanded rises * Similarly if there is Excess Supply for Foreign Exchange i.e.$ Dollar, its price falls(i.e. Dollar depreciates), its quantity supplied falls and quantity demanded rises. Q12. How is equilibrium in foreign exchange rate determined under fixed exchange rate system? Ans. Equilibrium Foreign Exchange rate is rupees55/$ at point e where demand & supply for foreign exchange (i.e. dollar $) is equal . (Rs./$) Excess Supply 60Rs./$ P A Rs.55/$ Rs.40/$ R S B e L M Excess Demand O D Quantity Demanded & Supplied of foreign exchange 74 When market foreign exchange rate in more than Equilibrium exchange rate, i.e it is rupees 60/$ then Quantity Demanded of $=PA Quantity supplied of $ = PB EXCESS SUPPLY for $ occurs equal to AB. so in order to bring the rate back to Equilibrium foreign exchange rate, Monetary authority revalues to rupees 55/ $. But to reach this rate the monetaryauthority or the govt. buys excess $ from the market When market foreign exchange rate in less than Equilibrium foreign exchange ratei.e rupees 40/$ Quantity Demanded of $=RM Quantity supplied of $ = RL EXCESS DEMAND for $ is created equal to LM.so, the central monetary authority will devalue rupee to rupees 55/$ to bring back Equilibrium for this monetary authoritywill have to provide more dollars to the market to remove excess demand. Excess demand Q13. a) What will happen to Equilibrium foreign exchange rate if The number Of tourists going abroad from India increases. OR b) What will happen to Equilibrium foreign exchange rate if More Indians go abroad for education? OR c) What will happen to Equilibrium foreign exchange rate if More Indians going abroad for medical treatment. OR d) What will happen to Equilibrium foreign exchange rate if More Indians invest abroad in financial assets or property. OR e) What will happen to Equilibrium foreign exchange rate if Imports of India in increase. OR Ans demand for foreign exchange increased 75 So demand curve for foreign exchange ($) rises upwards to the right from D1 to D2 At original Equilibrium foreign exchange rate. (Rs./$) S 60Rs./$ e2 Rs.55/$ P e1 A Excess Demand D2 D1 O Q1 Q2 Quantity Demanded & Supplied of foreign exchange Now Quantity Demanded of $=PA Quantity supplied of $ = Pe1 So Excess demand for $ =e1 A is created. Hence $ will appreciate due to which Quantity supplied of $ will increase & Quantity Demanded of $ will decrease till new Equilibrium foreign exchange is reached at point e2 Where Quantity Demanded of $ = Quantity supplied of $ =OQ2, at rupees 60/$ Q14. a) What will happen to equilibrium foreign exchange rate if number of foreign tourist coming to India decrease? b) What will happen to equilibrium foreign exchange rate if number of foreign medical tourists coming to India decrease? 76 c) What will happen to equilibrium foreign exchange rate if Foreigners visiting India decreases. d) What will happen to equilibrium foreign exchange rate if foreign exports of India decrease? NOTE: ANSWER to all questions above will be same Ans Supply for foreign exchange decreases. So supply curve for foreign exchange rises upwards to left form S1 to S2. S2 (Rs./$) 60Rs./$ Rs.55/$P e2 A S1 e1 Excess Demand D O Q2 Q1 Quantity Demanded & Supplied of foreign exchange At original Equilibrium foreign exchange rate rupees 55/$ Now Quantity Demanded of $=Pe1 Quantity supplied of $ = PA So excess demand of $ = Ae1 created. Hence $ will appreciate, due to which Quantity supplied $ will increase 77 Quantity Demanded of $ will decrease this process will continue till new Equilibrium foreign exchange rate is reached at E2, where Qd of $= Qs of $= OQ2. Q15. Why does demand for foreign exchange ($) decreases when its price decreases? Give Reasons. OR why does demand for $ decrease when $ appreciate? Give Reasons. OR Why does demand for foreign exchange ($) decreases when domestic currency i.e rupees depreciates? Give Reasons. Ans when dollar appreciate (i.e. rupee depreciates) for c.g from rupees 55/$ to rupees 60/$ So $ becomes costly for Indians, so demand for dollar decreases due to following reasons Going abroad by Indians for education becomes costly so they demand less dollars. Going abroad by Indian for medical treatment becomes costly. So they demand less dollars. Import of foreign goods by Indians becomes costly So demand for $ decreases. Investing abroad becomes costly so Indians buy less physical financial asset from abroad so demand for $ falls. Q16. Why does supply for foreign exchange ($) increase when in price increases? Give Reasons. OR Why does supply for $ increase when $ appreciates? Give Reasons. OR Why does supply for $ increase when domestic currency i.e rupees depreciates? Give Reasons. Ans When $ appreciates for eg from rupees 55/$ to rupees 60/$ (i.e. rupee depreciates),. Now with one Dollar ($) foreigners can buy more Rupees’. So Indian goods become cheaper for foreigners. The reason why supply of $ increases are:Export of Indian goods increases as Indian goods are cheaper for foreigners so supply of $ rises. 78 Foreign tourist coming to India rises as it becomes cheaper to visit India supply of $ rises. Medical treatment in India for foreigners becomes cheaper. So they come for medical treatment. Education in India becomes cheaper for foreigners, so they come to India for education $ supply rises. Foreign invest more money in India as it is cheaper to buy physical & financial assets in India , so $ supply rises Q17. Why does supply of $ decrease when $ depreciates rupee appreciates? Ans. Hint mention Sources of supply of $ which Cause decrease in $ supply Q18. Why does demand for $ increases when $ depreciates Rupee appreciates? Ans . Hint: Mention Sources of Demand for $ that cause increase in demand for $. Excess supply Q19. a) What will happen to foreign exchange rate if The no. of tourists coming to India increases. b) What will happen to foreign exchange rate if the exports of India increase? c) What will happen to foreign exchange rate if tourists coming to India increases? d)what will happen to foreign exchange rate if Medical tourists from foreign countries coming to India increases . e) what will happen to foreign exchange rate if More foreigners invest in India. NOTE: ANSWER to all questions above will be same except first sentence Ans It the number of tourists coming to India increases them the supply of foreign currency ($) increases, Supply curve, Of $ shifts downwards to right from S1 toS2 , Supply for foreign exchange (i.e. dollar $) is equal. 79 S1 (Rs./$) Excess Supply 60Rs./$ A e1 Rs.55/$ B S2 e2 D Q1 Q2 O Quantity Demanded & Supplied of foreign exchange At original Equilibrium foreign exchange rate of OA (ruppees55/$) Now Quantity Demanded of $=Ae1 Quantity supplied of $ = AB So excess Supply of $ = e 1 Bcreated. Hence $ will depreciate, due to which Quantity supplied $ will decrease Quantity demanded of $ will increase this process will continue till new Equilibrium foreign exchange rate is reached at E2, where Qd of $= Qs of $=OQ2. Q20. The market price of US Dollar has increased considerably leading to rise in prices of imports of essential goods. What can the Central bank do to ease the situation? Ans: The Central bank can start selling US dollars from its reserves. Q21. a)what will happen to Equilibrium foreign exchange rate if The number Of tourists going abroad from India decreases. OR 80 b)what will happen to Equilibrium foreign exchange rate if less Indians go abroad for education. OR c) what will happen to Equilibrium foreign exchange rate if less Indians going abroad for medical treatment. OR d) What will happen to Equilibrium foreign exchange rate if less Indians invest abroad in financial assets or property. OR e) What will happen to Equilibrium foreign exchange rate if Imports of India in decrease NOTE: ANSWER to all questions above will be same except first sentence Ans It the number of Indian Tourists going to Abroad decreases then, Demand for foreign Currency decreases Demand curve of $ Shifts downwards to left from D1 to D2 (Rs./$) Excess Supply 60Rs./$ B Rs.55/$ P A S e1 e2 D1 D2 O Q2 Q1 Quantity Demanded & Supplied of foreign exchange 81 At original Equilibrium foreign exchange rate of OB (ruppees55/$) Now Quantity Demanded of $=BA Quantity supplied of $ = B e1 So excess Supply of $ = e 1 A is created. Hence $ will depreciate, due to which Quantity supplied $ will decrease Quantity Demanded of $ will increase this process will continue till new Equilibrium foreign exchange rate is reached at E2, where Qd of $= Qs of $. Chapter: Balance of Payment Balance of payment Account 1.Balance of Payment (BOP)-It records all the transactions during a financial year between residents a of country and rest of the world which leads to inflow and outflow of foreign exchange. 2.Components of or Items of BOP Autonomous Transactions or items OR Independent Transactions or items OR Above the line items (It includes- I. Current Account (a)Trade of goods. (tangible item or visible trade)-Export & import of goods. (b)Trade of services (intangible items or invisible trade) )-Export & import of services (i)Factor services like income I Current Account from entrepreneurship i.e profit or payment II Non reserve Items of Capital account) for capital i.e. interest. (ii)Non-factor services - banking , shipping insurance (iii)unilateral transfer – gifts, donation remmittances. 82 II. Capital A/c (Short term and long them borrowings ,sale and purchase of physical & financial assets) Banking capital Private capital Government or public borrowing or capital Accommodating Transactions or items OR Errors and omissions. Official reserve transactions – changes in gold, SDR’s , foreign Exchange reserves. Below the line items Current Account- It records all the exports and imports of goods and services. These transactions do not affect asset and liability position of a country. Exports and all receipts of foriegtn exchange from unilateral transfers are recorded on the credit side with(+) sign. The main components of Current Account are: i) Export and import of goods ie. Visible trade or trade of Tangible items ii) Export and import of Services i.e. Invisible trade or trade of intangible items: a)Non factor services like shipping, banking, insurance etc. b)Factor services like income capital i.e. interest. from entrepreneurship i.e profit or payment for iii) Unilateral or Transfer payments: These refer to those receipts and payments, which take place without any service in return. It includes gifts, donations, Personal remittances etc.. 83 Capital Account- Any transaction between resident of a country and rest of the world whichresults in change in asset and liability position of a country with rest of the world is recorded in capital A/c it includes long term & short term borrowings; sale & purchase of physical and financial assets, changes in the official reserves of foreign exchange, gold, SDR’s with the monetary authorities The main components of Capital Account are A)Banking capital B)Private capital C)Government or public borrowing or capital D) Errors and omissions. E) Official reserve transactions – changes in gold, SDR’s , foreign Exchange reserves. Note in other words you can write components of Capital Account as given below Components of Capital account i) Private capital transactions: Capital transactions undertaken by the private sector of the country in the form of short-term and long-term foreign loans. ii) Government capital transactions: It includes the transactions undertaken by the government with the rest of the world. For example, govt. borrows from IMF. iii) Banking capital: It refers to capital movements and investment by foreign branches of banks. iv) Foreign direct investment: It refers to purchase of assets in the rest of the world such that it gives direct control over the asset. For example, acquisition of foreign firm by an Indian firm. 84 v) Portfolio Investment: It refers to purchase of assets in the rest of the world such that it does not give direct control over the asset. For example, purchase of shares of a foreign firm by an Indian firm. vi) errors and Omissions and vii)official reserve transactions- These include transactions by monetary authority i.e Central bank which causes changes in reserves of gold, SDR’s , foreign Exchange etc. with central bank. 3. Autonomous items or transactions Accommodating items or transactions Or Independent Or Below the line Or above the line Items/ Transactions Items / Transactions These include Current Account items, I.e These include official reserves of gold SDR’s, export import of goods services &Non Foreign Exchange etc. reserve Items of Capital account These transactions are done by all the These transactions are done only by the sectors in economy i.e. household, firm, monetary officials (RBI) govt, etc. those international economic transactions that take place due to some economic motive such as profit maximization. These transactions are done to balance the BOP i.e. to bring Equilibrium in balance of payment in accounting terms to correct disequilibrium created by autonomous items in the BOP .like government financing, borrowings from IMF etc. 4. 85 Balance of Trade Balance of Payments (BOT) (BOP) It is the difference b/w exports and imports It includes of Goods only Current A/c, i.e export import of goods as BOT = (Exports – Imports )of goods only well as services. Capital A/c (non-reserve items of Capital A/c ) It is unfavourable when imports are more In accounting terms BOP is always in than exports. equilibrium. It is favourable when imports are less than But in economic terms there can be exports. disequilibrium. & BOP can have deficit or surplus. 5. The balance of trade shows a deficit of Rs. 600 crores, the value of exports is Rs.1000 crores. 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. 1600. 6.’ There can be disequibrium in BOP’. comment.how can it be corrected? OR BOP is always in equilibrium comment. or BOP always balances comment. 86 AnsIn accounting terms BOP always balancesbecauses it is based on double-entry book keeping system and the sum of credit side is always equal to sum of debit side items. The individual items in BoP may not balance but the total credits of the country must be equal to total debits. A deficit or surplus in current account is balanced by surplus or deficit in capital account. If there is difference between the autonomous items, it would be settled by accommodating items which are intended to balance the BoP. Hence Balance of payment always balances. Disequilibrium occurs in BOP in economic terms. When sum of credit side of autonomous items is more than sum of debit side then there is surplus in BOP Correction of surplus in BOP in done by monetary authority by increasing reserves of gold, foreign exchange with RBI and increasing SDRS held with the IMF (International monetary fund) When Debit Side of autonomous items is more than credit side, deficit in BOP Occurs. Correction of deficit in BOP in done by monetary authority by decreasing foreign exchange reserves, reducing SD R,s held with the IMF. 7. What is the balance of visible items in the balance of payments account called? Ans:- Balance of trade. 8. CAUSES of DISEQUILIBRIUM in 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. 87 II Political factors: Political instability may cause large capital outflows and hamper the inflows of foreign capital. III Social factors: exports. Changes in tastes, preferences and fashions may affect imports and 88 UNIT 1 – INTRODUCTION 4marks 1. Opportunity cost:- Opportunity cost refers to value of a factor in its next best (or second best) alternative use.in other wordsIt is the cost of next best alternative foregone. 2.Production possibility curve/ Production possibility frontier or boundary ortransformation line or transformation curve:- The production possibility curve shows all the possible combination of two goods that can be produced with the help of given resources and technology. 3.MARGINAL OPPORTUNITY COST: MOC of a particular good along PPC is the amount of other good which is sacrificed for production of additional unit of another good. 4.MARGINAL RATE OF TRANSFORMATION: MRT is the ratio of units of one good sacrificed to produce one more unit of other good. Unit of one good sacrificed ∆y MRT = --------------------------------------------- = ---More unit of other good produced ∆x 5.How is the growth of an economy be presented through PPC ? Ans:- Rightward shift of PPC. 6.State the economic problems relating to the allocation of resources. Ans:-The problems related to allocation of resources has three aspects: (i) What to produce? (ii) How to produce? (iii) For whom to produce? (i) What to produce ?:-As we know resources are scares, we can not produceseverything in whatever quantity we wish to. We are bound to face the problem of what to produce and how much. The economy has to decide what goods and services are to be produced. For instance which of the consumer goods like sugar, cloth, wheat, ghee, etc. are to be produced and which of the capital goods like machines, tractors etc,. are to be produced. Similarly choice has also to be made between the production of war time goods like rifles, guns, tanks and peace time goods like bread and butter. (ii) How to produce ?:- How to produce means how to organise production this problem is concerned with the choice of technique of production. For example, production of cloth is possible either by handlooms or by modern machines this problem is to concerned with the efficient use of resources. There are two technique of production:(a) Labour intensive technique:- Under this technique, labour is used more than capital. (b) Capital intensive technique:- Under this technique, capital is used more than labour. (iii) For whom to produce ?:- It is a problem relating to choice of user of the goods and services, should we produce for those who can pay high price ? If yes is the answer, we shall 89 end up producing goods and services for a respectively richer section of society or even for a richer section of the world commodity. There quality of life would improve, but that of the poor would stagnate or deteriorate further. As such, the gulf between the rich and the poor would keep on widening. On the other hand if goods are produced for the poor only, they may not afford to buy, reducing profits of the producers. Accordingly, level of output may remain low, and the process of growth will suffer. Hence the problem of choice related to the final users of goods and services. 7.Differentiate between positive and normative economics :- SNo Positive Economics Normative Economics 1 It deals with what is what was. It deals with what ought to be. 2 It is based on cause and effect of It is based on ethics. facts. 3 It can be verified with actual data 4 In this value of judgments are not In this value of judgments are given. given. It cannot be verified with actual data. 8. What is production possibility curve? state its features & give a brief discussion Ans:- Production possibility curve shows different combinations of two goods which can be produce with the given resources on the assumptions that (i) Resources are fully and efficiently utilised (ii) Technique of production remains constant. Features of PPC:(i) Production possibility curve slopes downward:-production possibility curve slopes downward from left to right. It is because in a situation of fuller utilisation of the given resources, production of both the goods cannot be increased. More of a good-X can be produced only only by giving up the production of another goodsY. (ii) Production possibility curve is concave to the point of origin:-PPC is concave to the origin because of increasing marginal opportunity cost. It is because to produce each additional unit of good-X, more and more units of good-Y will have to be sacrificed than before. Opportunity cost of producing every additional unit of goodX tends to increase in terms of the loss of production of good-Y. 90 (Production Possibility Schedule) Production possibilities Goods A B C D E Wheat 100 90 70 40 0 Gun 0 10 20 30 40 Production possibility curve 9.How is the growth of a country shown with the help of production possibility curve? Growth of resources:-Overtime an economy may generate more resources. Gulf countries, for example, have acquired additional sources of oil. By selling oil these countries have acquired more capital goods. They have enhanced their production capacity. Accordingly, their PPC has shifted to the right. Fig. shows shift in PPC to the right when availability of resources increases. 91 Owing to increase in resources, (which generally happens in every economy overtime) PPC shifts to the right. It shows higher level of output of both the goods. Thus, PP shows higher level of output thanAD. 10 Microeconomics Macroeconomics 1-Microeconomics studies economics issues or economic problems at thlevel of an individual-an individual firm, an individual household or individual consumer. 1. macro economics studies economic issues or economic problems at the level of the economy as a whole. 2-Allocation of resources to different uses is the central issue in microeconomics. 2. Raising the level of output and growth is the central issue in macro economics. 3. Examples:- consumer’s demand, market price of commodity, firm’s output. 3. Examples:aggregate demand, general price level in the economy, aggregate supply in the economy. 11. Market economy In a market economy decisions relating to what, how and for whom to produce are governed by the market forces of supply and demand. The government does not interfere the process of decision making. Planned economy It is an economy inwhichdecisions relating to what, how and for whom to produce are taken by some central authority appointed by the government. It is an economic system, in which all material means of production are owned and operated by the private sector with profit motive. In this economy all material means of production are owned by the government or by a centrally planned authority. Economic decisions are taken for social welfare. 12. Draw a production possibility curve and mark the following situations: a) underutilization of resources b) full employment of resources 92 c) scarcity of resources Ans. Every point on PP curve like ABCDEF indicates full employment and efficient uses of resources. Any point below or inside PP curve like G underutilization of resources. Any point above PP curves like H indicates Scarcity of resources. Wheat 14 12 P A B H (scarcity of resources) 10 C Full employment of resources 8 6 *G E 4 2 0 Under utilizationof resources F 1 2 3 4 5 Cloth 13.Production Possibility Curve And Opportunity Cost It refers to a curve which shows the various production possibilities that can be produced with given resources and technology. 93 1. Production Possibilities Production Commodity A Possibility Commodity Marginal opportunity B cost of commodity A A 0 15 - B 1 14 15-14=1 C 2 12 14-12=2 D 3 09 12-9=3 E 4 05 9-5=4 F 5 0 5-0=5 Commodity A If the economy devotes all its resources to the production of commodity B, it can produce 15 units but then the production of commodity A will be zero. There can be a number of production possibilities of commodity A & B If we want to produce more commodities B, we have to reduce the output of commodity A &vise versa. 14. (1) causes of Upward shiftin PP curve (a) When there is improvement in technology. (b) Increase in resources. 94 y o x (2) Down ward shift When Resources depletes y X O 15..Distinguish between a centrally planned economy and a market economy. SNo Planned Economy Market Economy 1 All the materials means of production All the materials means of production are are owned by government. owned by private individuals. 2 Main objectives of production is social Main objectives of welfare maximization of profit. 3 Ownership of property government control. 4 All the economic problems are solved as All the economic problems are solved through per direction of the planning price mechanism i.e., demand and supply. commission. is production are under There is no limit to private ownership of property. 95 16. From the following PP schedule calculate MRT of good x. Production possibilities A B C D E Production of good x units 0 1 2 3 4 Production of good y units 14 13 11 8 4 Production of good X Production of good units Y units MRT = ∆y / ∆x 0 14 - 1 13 1:1 2 11 2:1 3 8 3:1 4 4 4:1 96