Class 12 Macroeconomics - Government Budget PDF

Revision Notes Class 12 - Macroeconomics Chapter 5 - Government Budget and the Economy Budget: A budget is a year-long financial report that explains how future revenue and expenditure will be calculated item-wise. The budget details a country's revenue and...

Revision Notes Class 12 - Macroeconomics Chapter 5 - Government Budget and the Economy Budget: A budget is a year-long financial report that explains how future revenue and expenditure will be calculated item-wise. The budget details a country's revenue and expenditures. Main objectives of the budget are: Resource reallocation. Income and wealth redistribution Public-sector management Economic Stability Economic Development Employment Creation Two components of budget: 1. Revenue budget: The revenue budget is made up of the government of India's revenue receipts and the expenditures that are met with that revenue. 2. Capital budget: Capital receipts and payments are included in the capital budget. It also includes transactions from the Public Account. Budget Receipts 1. Revenue Receipts: Revenue receipts are those that do not result in a liability or a decrease in assets. The revenue is then split into two categories. Receipt from tax a. Direct tax: A taxpayer pays direct taxes in full to the government. It is also characterised as a tax in which the individual bears both the duty and the burden of payment. According to the type of tax charged, both the central government and state governments collect direct taxes. b. Indirect tax: The end-consumer of products and services is ultimately responsible for indirect taxes. It is impossible to avoid because taxes are levied Class XII Macroeconomics 1 on both products and services. It entails lower administrative costs as a result of convenient and regular collections. Receipt from non-tax: These include interest, commercial revenue, external grants, fines, penalties, and so on. 2. Capital Receipts: Capital receipts are government receipts that create liability or deplete financial assets. The main sources of capital receipts are loans from the public, also known as market borrowings, as well as borrowings from the Reserve Bank, commercial banks, and some other financial institutions through the sale of treasury bills, borrowings from foreign governments and international organisations, and loan recoveries. Small savings, provident funds, and net receipts from the sale of shares in Public Sector Undertakings are among the other items (PSUs). Budget Expenditure 1. Revenue expenditure: The nature of revenue expenditure is generally current or short-term. They are costs that the government must incur to carry out its daily operations. These costs are fully charged in the year they are incurred and are not depreciated over time. They might either be recurring or non-recurring. 2. Capital Expenditure: Capital expenditures are one-time investments of money or capital made by a government for the aim of expanding in various sectors and businesses in order to create profits. These funds are typically used to acquire fixed assets or assets with a longer lifespan. These include machinery, manufacturing equipment, and infrastructure-improvement equipment. These assets provide value to the government during their entire lifespan and may or may not have a salvage value. Budget Deficit: The amount by which a budget's expenditures exceed its revenue is referred to as a budget deficit. This deficit is a good indicator of the economy's financial health. Revenue deficit: Revenue deficit is defined as the difference between total revenue collected and total revenue expenditure. Only current income and current expenses are included in this deficit. A large deficit figure implies that the government should reduce its spending. The government may be able to boost revenue by raising tax revenue. Revenue deficit = Total revenue expenditure – Total revenue receipts Class XII Macroeconomics 2 Implications of Revenue Deficit are: A significant revenue shortfall indicates budgetary indiscipline. It indicates that the government is dissaving, i.e., the government is utilising savings from other sectors of the economy to pay its consumer expenditure. It indicates that the government is dissaving, i.e., the government is utilising savings from other sectors of the economy to pay its consumer expenditure. It demonstrates the government's excessive expenditures on administration. It lowers the government's assets owing to disinvestment. A significant revenue deficit sends a warning signal to the government to either cut spending or boost revenue. Fiscal Deficit: A fiscal deficit occurs when the government's total expenditures exceed its entire revenue produced. The government's borrowings, however, are not included. Fiscal deficit = Total expenditure – Total receipts excluding borrowings Implications of Fiscal Deficits are: A significant drawback or consequence of fiscal deficit is that it may result in a debt trap. It causes inflationary pressures. It stifles future advancement. It increases reliance on foreign resources. It raises the government's obligation. Primary Deficit: It is derived by subtracting interest payments from the fiscal deficit. Primary deficit = Fiscal deficit – Interest payments on previous loans Implications of Primary Deficit: It reflects how much of the government's borrowings will be used to cover costs other than interest payments. Measures to correct different deficits: Government subsidy cuts will aid in reducing the deficit. Class XII Macroeconomics 3  Where assets are not being used efficiently, disinvestment should be carried out. Increased emphasis on tax-based revenues, as well as necessary steps to prevent tax evasion. Borrowing from both domestic and international sources. A broader tax base could also aid in the reduction of the government's deficit. Fiscal Policy: Keynesian economics, a theory developed by economist John Maynard Keynes, serves as the foundation for fiscal policy. It is the system by which a government makes changes to its planned expenditure and tax rates in order to monitor and influence the performance of a country's economy. It is implemented in tandem with monetary policy, by which the central bank of the country impacts the country's money supply. This policy influence aids in containing inflation, increasing employment, and, most significantly, maintaining a healthy currency value. Debt: A quantity of the money borrowed by one entity, the borrower, from another entity, the lenders, is referred to as debt. Governments borrow money to cover their deficits, which allows them to fund regular operations as well as large capital expenditures. This debt might be in the form of a loan or bond issuance. Class XII Macroeconomics 4  Revision Notes Class 12 - Economics Chapter 1 - Macroeconomics Macro Economics: The term macro is derived from the Greek word ‘makro’, which means “large”. It is a branch of economics concerned with the description and explanation of economic processes involving aggregates. An aggregate is a collection of economic subjects that have some characteristics in common. Macroeconomics emerged after the publication of John Maynard Keynes' book, ‘The Theory of Employment, Interest, and Money’ in 1936. This branch investigates the economic relationships or issues that affect an economy as a whole, such as saving and total consumption. It investigates the principles, problems, and policies associated with attaining full employment and expanding production capacity. Economic Agents: Individuals or institutions making economic decisions are referred to as economic units or economic agents. They could be manufacturers or service providers who decide what and how much to produce. They could be entities such as the government, corporations, or banks that make economic decisions such as how much to spend, what interest rate to charge on credit, how much to tax, and so on. Great Depression: The Great Depression is widely regarded as the worst and longest economic downturn or recession in modern history. It all started in the United States. It then had a cascading effect on the world's economies. The Great Depression is said to have begun with the October 1929 stock market crash in the United States. To be more specific, the stock market crashed on October 24, 1929, which became known as Black Thursday in American history. The stock market crash caused panic among Wall Street investors, causing the stock market to lose nearly billions of dollars. This resulted in the failure of major financial institutions, such as banks. The depression was caused by an overabundance of food grains in the market, which resulted in a drop in agricultural prices. Class XII Economics 1  During the war, Canada, Australia, and the United States emerged as new alternate wheat-producing centres. Stocks of finished goods began to pile up because of underconsumption and excessive investment, resulting in low prices and, as a result, low-profit margins. Money in the economy was converted into unsold finished goods, resulting in a sharp drop in employment and, as a result, income levels fell drastically. The economy's demand for goods was so low that production was reduced, resulting in unemployment. In the United States, the unemployment rate rose from 3% to 25%. The Great Depression has its own set of implications and significance in economics since it leads to the collapse of the classical economic approach. Those who believed in the market dynamics of demand and supply, created the ground for the Keynesian approach to emerge. This occurrence supplied economists with enough evidence to identify macroeconomics as a distinct field of economics. This flow chart summarizes the cause-and-effect relationship of the Great Depression: Low demand → Overinvestment → Low level of employment → Low level of output → Low income → Low Demand Capitalist Country/Economy: In a capitalist country, capitalist enterprises perform a majority of the production activity. A typical capitalist enterprise has one or more entrepreneurs. They may provide the capital required to run the enterprise themselves or borrow it. According to Ralph Waldo Emerson – “Doing well is the result of doing good. That's what capitalism is all about.” In this type of economy the means of production is privately owned. It is primarily governed by the price mechanism, with no intervention from the government. The government's role is solely to maintain law and order. Profit is the driving force behind these means of production. This economic structure is also referred to as a free-market economy or laissez-faire. Capitalist economies include Hong Kong, Singapore, Canada, the United Arab Emirates, Ireland, and others. Important characteristics of the capitalist economy Private property No government interference Profit motive Class XII Economics 2  Freedom of enterprise Freedom of ownership Flexibility in labour markets Consumer sovereignty Price mechanism Revenue: Revenue is the amount of money earned from normal business operations and is calculated by multiplying the average sales price by the number of units sold. Investment Expenditure: Investment expenditure is defined as any expense incurred by an individual, a business, or the government for the development of new capital assets such as machinery, buildings, and so on. Wage Rate: The wage rate is the price charged for the sale and purchase of labour services. Wage Labour: Wage labour is defined as labour that is sold or purchased in exchange for a wage rate. Entrepreneurs: An entrepreneur is an individual who takes the risk of starting their own business based on an idea or a product they developed, assuming most of the risks and earning most of the gains. Main Objectives of Macro Economic Policies: Macroeconomic policies are implemented by the government or statutory bodies such as the Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI), and other similar organisations. 1. Sustainability 2. Price stability 3. Full employment 4. External balance 5. Social objectives Four Major Sectors of Economy from Macro Economic Point of View: The Household Sector, the Business Sector, the Government Sector, and the Foreign Sector are the four aggregate macroeconomic sectors that serve as the framework for macroeconomic analysis. Class XII Economics 3 The Household Sector, the Business Sector, the Government Sector, and the Foreign Sector are the four aggregate macroeconomic sectors that serve as the foundation for macroeconomic analysis. These four functions oversee four expenditures on Gross Domestic Product (GDP). i) Household Sector: This sector covers everyone, consumers, individuals, and every member of society. The household sector purchases products and services for consumption while also supplying producing inputs such as land, labour, capital, and entrepreneurs. This sector oversees the consumption expenditures component of GDP. In a nutshell, a household is defined as a single or group of people who make independent decisions about their economic activities, such as consumption and production. ii) Firms: People in the household sector work as workers in firms and make a living. Firms are economic units that produce goods and services. They utilise and organise production factors and carry out production processes for the purpose of profit. This comprises sole proprietorships, partnerships, and corporations. This sector oversees the GDP's investment expenditure. iii) Government Sector: A government preserves law and order, promotes growth and stability, and administers government services. This sector is in charge of the government's purchase involvement in GDP. A government's primary goal is to levy taxes to fund development projects such as dams, roads, and heavy industries, which typically have extended gestation periods. The government also invests in education and health sectors and delivers these services at a low cost. Examples include the Department of Transportation and the Environmental Protection Agency. iv) Foreign/ External Sector: This sector deals with the export and import of products and services. Export occurs when domestically produced goods and services are sold to the rest of the world. When goods and services are purchased from the rest of the world, this is referred to as import. Apart from the export and import of goods, there can be an inflow of goods, i.e., a country welcoming capital from other countries, and an outflow of foreign capital, i.e., investing in foreign countries. Net exports(Exports minus Imports) are the foreign sector's expenditure on GDP. Class XII Economics 4  Revision Notes Class - 12 Macro Economics Chapter 3 - Money and Banking Money: Money is the most often used means of exchange. There can be no exchange of commodities and thus no role for money in an economy consisting of only one person. Barter Exchange: It is a trade in which one product or service is exchanged for another. It is the oldest form of commerce. Individuals and businesses exchange goods and services based on equivalent prices and good estimates. Disadvantages of barter exchange: 1. A lack of a standardised means of measuring value. 2. There is a lack of desire for duplication. 3. A scarcity of common value measures. 4. Inadequate store of value. 5. Deferred payment standards are lacking. 6. Inability to divide. Functions of Money: The functions of money are broadly classified as 1. Primary functions. i. A mode of exchange. ii. A common measure of value or a common unit of value. 2. Secondary functions: i. Value storage. ii. Value transfer. iii. Deferred payment standard. Class XII Macro Economics 1 Demand of Money: It is referred to as an individual's liquidity preference, which is the decision of holding money in liquid form, i.e., cash, in order to earn interest or as a precaution. i. Transaction Motive: The drive to hold cash amounts is referred to as the transaction's motive. ii. Speculative Motive: It refers to funds retained by investors in order to capitalise on potential investment opportunities in the economy. Aggregate Money Demand: In an economy, the entire demand for money is made up of transaction demand and speculative demand. The former is proportionate to real GDP and the price level, whereas the latter is inversely related to the market interest rate. Md = M + M Where, Md = Money demand M = Transaction money demand M = Speculative money demand Fiat money: It is the currency that a government declares to be legal tender but is not backed by a physical asset. The value of fiat money is determined by the connection between supply and demand rather than the worth of the commodity used to make the money. Supply of Money: It refers to the total money held by the public at a particular point in time in an economy. The supply of money does not include the cash balances held by the national and state governments, as well as the stock of money held by the country's banking system, because these are not in active circulation in the country. Measures of Money Supply: i. M1: It is the first and basic measure of the money supply. It includes currency held by the public, demand deposits of commercial banks, and other deposits with the Reserve Bank of India (RBI). M1= Currency and coins with public (C) + Demand deposits of the public with the banks (DD) + Other deposits (OD) Class XII Macro Economics 2 ii. M2: It is also known as narrow money along with M1. It includes Savings deposits with Post Office saving banks. M2= M1 + Savings deposits with Post Office saving banks iii. M3: It also includes time deposits with a commercial bank and is known as broad money. M3= M1 + Net time deposits with commercial banks iv. M4: It includes the total deposits excluding National Saving Certificates and is also known as broad money along with M3. M4= M3 + Total post office deposits excluding National Saving Certificates (NSC) Banking Systems: 1. Commercial Bank: A commercial bank is a type of financial organisation that handles all transactions involving the deposit and withdrawal of money for the public, as well as the provision of loans for investment purposes and other similar activities. These banks are profit-making enterprises that conduct business only for the purpose of making a profit. State Bank of India, Canara Bank are some examples. 2. Central Bank: In the banking system, the central bank is recognised as the highest financial institution. It is seen as an essential component of a country's economic and financial system. The central bank is an independent authority in charge of supervising, regulating, and stabilising the country's monetary and banking structures. Money creation by Banks: If the value of any of its constituents, such as CU, DD, or Time Deposits, changes, the money supply will alter. The public's preference for maintaining cash balances as opposed to bank deposits has an impact on the money supply. The following major ratios summarise these influences on the money supply. 1. The Currency Deposit Ratio: The currency deposit ratio (cdr) depicts the amount of currency held by individuals as a percentage of total deposits. For instance, cdr rises over the holiday season as people convert deposits to cash balances in order to cover extra expenses. cdr = CU/DD Class XII Macro Economics 3 2. The Reserve Deposit Ratio: Banks keep a portion of the money customers keep in their bank accounts as reserve money and lend the rest to various investment initiatives. Reserve money is made up of two components: vault cash in banks and commercial bank deposits with the RBI. Banks use this reserve to meet account holders’ need for cash. The reserve deposit ratio (rdr) is the percentage of total deposits that commercial banks retain as reserves. Measures to bring forth a healthy Reserve deposit ratio: I. Qualitative Measures 1. Cash Reserve Ratio (CRR): It is a portion of a bank's total deposits that the Reserve Bank of India requires to be kept with the latter as liquid cash reserves. 2. Statutory Liquidity Ratio (SLS): It is essentially the reserve requirement that banks must maintain before extending credit to customers. It is essentially the reserve requirement that banks must maintain before extending credit to customers. Bank Rate: A bank rate is the interest rate charged by a nation’s central bank to its domestic banks in order for them to borrow money. The interest rates charged by central banks are meant to stabilise the economy. High Powered Money: It is the money created by the RBI and the government, in which the public holds the currency, and the banks hold the cash reserves. It differs from money for that money consists of demand deposits, whereas cash reserves serve as a foundation for creating demand deposits. II. Qualitative Measures 1. Open Market Operation: It refers to the central bank's selling and purchase of securities on the open market to and from commercial banks or the general public. 2. Bank Rate Policy: It refers to the central bank's manipulation of the discount rate in order to influence the economy's credit condition. 3. Sterilisation by RBI: The RBI's market-based strategy in neutralising a portion or whole of the monetary impact of foreign inflows is known as sterilising. Class XII Macro Economics 4  Revision Notes Class - 12 Macroeconomics Chapter 2- National Income Accounting IMPORTANT TERMINOLOGY Goods: In economics, goods are products and resources that meet people's needs and demands. A good can be a physical object, a man-made object, a service, or a mix of the three that can command a market price. Types of goods: a. Consumption Goods: Consumption goods are items that are utilised directly to satisfy human demands. Consumption goods support the core goal of an economy, which is to sustain the consumption of the economy's entire population. These are not used in the manufacturing of other goods. Consumption products, often known as final goods, are intended for final consumption. For instance, a television, a pen, or a pair of shoes. b. Capital Goods: Capital goods are goods used by one business to assist another in the production of consumer goods. Capital goods can not be easily transformed into cash. They are long-lasting and do not degrade easily. Class XII Macro Economics 1  Equipment, machinery, buildings, computers, are some common examples of capital goods. c. Final Goods: Final goods are commodities produced by a corporation for subsequent consumption by the consumer. These commodities satisfy a consumer's demands or desires. d. Intermediate Goods: Intermediate goods are utilised in the production of finished goods or consumer goods. They can also be considered to act as inputs in other commodities and to comprise the final goods as ingredients. Investment: An investment is an asset or object purchased with the intention of earning income or increasing in value. When a person buys a good as an investment, the intention is not to consume the good but rather to use it to build wealth in the future. Gross Investment: A company's capital investment before depreciation is referred to as its gross investment or gross capital investment. The absolute investment value made by the company in purchasing assets each year is shown by gross investment. Net investment: Class XII Macro Economics 2  It is defined as gross investment minus depreciation on existing capital. Net investment, in a nutshell, is the increase in productive stock. Net investment = Gross Investment – Depreciation Depreciation: Depreciation, in economic terms, is a way of dividing the cost of a tangible or physical asset over its usable life or life expectancy. Depreciation is a measurement of how much of the value of an asset has been diminished. Capital formation: Capital formation is the process of gradually increasing the stock of capital over time. Factor Cost: These are the earnings obtained by the owners of factors of production in exchange for providing factor services to the producer. Basic Prices: The basic price is the amount a producer receives from a purchaser for a unit of a thing or service provided as output, less any tax due and any subsidy due on that unit as a result of its production or sale. Basic price = Factor cost + Production taxes – Production subsidy Market Prices: The market price of a commodity is the price at which it is sold on the open market. It comprises the costs of production such as wages, rent, interest, input prices, profit, and so on. Class XII Macro Economics 3  It also includes government-imposed levies and government-provided producer subsidies. Market price = Basic price + Product taxes – Product subsidy Transfer Payments: Transfer payment refers to payment received without the provision of any service or goods in exchange. These are one-time payments with no expectation of a return. These are unearned incomes for recipients. These are given to you for free, with no need to make any current or future payments in exchange. Transfer payments are essentially government welfare expenditures. Stock Variable: A stock variable is a variable that is measured at a certain point in time. Stock does not have a temporal dimension. It influences the flow. Wealth, capital, etc are examples. Flow Variable: A flow is a quantity that is measured over a specific timeframe. Flows are thus described in terms of a given period, such as hours, days, weeks, months, or years. It has a time dimension to it. Leakage: Class XII Macro Economics 4  In the context of a circular flow of income model, leakage is an economic term that characterizes capital or money that escapes an economy or system. It lowers aggregate demand and income levels. For example, taxes, savings, and imports. Injection: When funds are added to an economy from sources other than people and enterprises, this is referred to as an injection. It raises aggregate demand as well as income levels. Injections can come from a variety of sources, including government spending, investment, and exports. Consumer Price Index: The consumer price index (CPI) reflects variations in the overall level of prices of products and services that a reference population obtains, consumes, or pays for consumption across time. Wholesale Price Index: A wholesale price index (WPI) is an indicator that monitors and tracks changes in the price of products before they reach the retail level. CIRCULAR FLOW OF INCOME The continual flow of commodities and services, revenue, and expenditure in an economy is referred to as the circular flow. Class XII Macro Economics 5  It depicts the circular redistribution of revenue between the manufacturing unit and households. ECONOMIC TERRITORY The geographical territory managed by a government constitutes a country's economic territory. People, goods, and capital may freely circulate inside this zone. The economic territory encompasses not just land but also national air space, territorial waters, and natural oil and gas resources in international waters. Scope of Economic Territory: Territorial seas and airspace are examples of political boundaries. Residents' ships and aircraft that travel between two or more countries. Embassies, consulates, military bases, and other international institutions. Residents operating fishing vessels, oil and gas rigs in foreign waters. Class XII Macro Economics 6 NORMAL RESIDENTS OF A COUNTRY A person or entity that regularly dwells in a country and has its centre of economic interest in that country is referred to as a normal resident of that country. Exceptions for Normal Residents of a country: Diplomats and embassy officials from other countries. People who work for international organisations such as WHO, IMF, UNESCO, and others are treated as normal citizens of the country to which they belong. Commercial travellers, tourists, students, and so on. AGGREGATES OF NATIONAL INCOME 1. Gross Domestic Product at Market Price (GDPMP) It is the market value of all final products and services generated by all manufacturing units located on a country's domestic territory within an accounting year. Gross domestic product at market prices equals the sum of all resident producers' gross values added at market prices plus taxes and fewer import subsidies. ( ) GDPMP = Net domestic product at Factor Cos NDPFC + Depreciation + Net Indirect Tax or, GDP = C + I + G + (X-M) 2. Gross Domestic Product at Factor Cost (GDPFC) Class XII Macro Economics 7  It is the total worth of all final goods and services produced within a country's domestic territory excluding net indirect taxation. GDPFC = GDPMP - Indirect tax + Subsidy, or GDPFC = GDPMP - NIT or GDPFC= Compensation of Employees + Rent + Interest + Profit + Depreciation 3. Net Domestic Product at Market Price (NDPMP) It is the depreciation-free market value of final goods and services produced in the country's domestic area within a year. Hence, it is the monetary worth of all final goods and services produced within a country's domestic territory within an accounting year, excluding depreciation. NDPMP = GDPMP - Depreciation 4. Net Domestic Product at Factor Cost (NDPFC)/ Domestic Income: It is the factor income received by owners of factors of production for providing factor services in domestic territory throughout a fiscal year. It is the total worth of all finished goods and services excluding depreciation and net indirect tax. Thus, it is equivalent to the sum of all factor incomes (compensation of employees, rent, interest, profit, and mixed income of self-employed) created in the country's domestic area. NDPFC = GDPMP n Depreciation n Indirect tax + Subsidy or NDPFC= Compensation of Employees + Rent + Interest + Profit 5. Net National Product at Factor Cost or National Income (NNPFC)/ National Income: Class XII Macro Economics 8  It is the aggregate of all factor earnings earned by ordinary people of a country in the form of wages. During an accounting year, rent, interest, and profit are calculated. It is the sum of all factor incomes earned by ordinary citizens of a nation throughout an accounting year, including employee pay, rent, interest, and profit. NNPFC = NDPFC + Factor income earned by normal residents from abroad nFactor payments made to abroad.ORNNPFC = NDPFC + NFIA = National Income 6. Gross National Product at Market Price (GNPMP) It is the market value of all finished goods and services generated by a country's normal citizens (both domestically and overseas) throughout an accounting year. GNPMP (MNPFC ) = GDPMP + NFIA Or GNPMP = NNPFC + Dep + NIT 7. Net National Product at Market Price (NNPMP) It is the sum of the factor incomes earned by normal citizens of a country throughout an accounting year, including net indirect taxes. NNPMP = NNPFC + Indirect tax - Subsidy Or NNPMP = NDPMP + Net factor income from;abroad 8. Gross National Product at Factor Cost (GNPFC) It is the sum of a country's normal people's factor earnings over the course of an accounting year, plus depreciation. GNPFC = NNPFC + Depreciation, or\\GNPFC = GDPFC + NFIA 9. National Income at Current Prices: Class XII Macro Economics 9  When products and services generated by ordinary inhabitants within and outside of a country in a year are evaluated at the current year’s values, i.e., current prices, this is referred to as national income at current prices. I It is also referred to as nominal national income. Y=QxP Here, Y = National income at current prices. Q = Quantity of goods and services produced in an accounting year. P = Prices of goods and services during the current accounting year. 10. National Income at Constant Prices: National Income at Constant Prices refers to the worth of products and services produced by ordinary inhabitants within and outside of a country in a given year at a constant price, i.e., the base year’s price. It is also referred to as actual national income. Y’ = Q x P’ Here, Y’ = National income at constant prices. Q = Quantity of goods and services produced during an accounting year. P’ = Prices of goods and services prevailing during the base year. 11. GVA at Market Prices: Production and product taxes are included in GVA at market prices, whereas production and product subsidies are excluded. GVA at market price = GDP at market prices 12. GVA at basic prices: Class XII Macro Economics 10  GVA at basic prices will exclude production subsidies available on the commodity and incorporate production taxes. GVA at basic prices = GVAMP - Net Production Taxes 13. GVA at factor cost: GVA at factor cost does not contain any taxes or subsidies. GVA at factor cost = GVA at basic prices - Net Production Taxes GDP AND WELFARE: GDP: It is a measure of the economic value of all final goods and services produced within a specific time period, which is typically annually or quarterly. A greater GDP suggests that more products and services are produced. It indicates the increased availability of goods and services, but this does not always imply that people were better off throughout the year. GDP is classified into two categories- Real GDP: Real gross domestic product (real GDP) is an inflation-adjusted estimate of the value of all goods and services generated by an economy each year. It is also known as "constant-price" or "inflation-corrected" or "GDP at constant prices". It is exclusively affected by changes in physical output, not by changes in the price level. It's referred to as a true indication of economic advancement. Nominal GDP Real GDP Deflator Nominal GDP: The products and services produced by all producing units in a country's domestic territory during an accounting year and valued at the current year's Class XII Macro Economics 11  prices or current prices are referred to as nominal GDP or GDP at current prices. Changes in both physical output and the price level have an impact on it. It is not regarded as a reliable indicator of economic advancement. Nominal GDP = Real GDP x GDP Deflator Conversion of Nominal GDP into Real GDP Nominal GDP Real GDP = x 100 Price Index GDP Deflator: The nominal-to-real GDP ratio is a well-known price index. This is known as the GDP Deflator. Thus, If GDP denotes nominal GDP and gdp denotes real GDP, then; GDP GDP Deflator = gdp The deflator is also expressed in percentage terms. In this scenario, GDP x GDP Deflator = 100 gdp Welfare: People's material well-being is referred to as welfare. It is determined by a variety of economic elements such as national income, consumption level, Class XII Macro Economics 12  product quality, etc, as well as non-economic factors such as environmental pollution, law, and order, and so on. Economic welfare refers to welfare that is dependent on economic variables, whereas non-economic welfare refers to welfare that is dependent on non- economic elements. Social welfare is defined as the sum of economic and non- economic well-being. Thus, GDP and welfare are directly associated, however, this relationship is incomplete because of the following limitation: Some limitation of per capita real GDP as an indicator of economic welfare: The exclusion of non-market transactions Externalities are not included in GDP but have an impact on wellbeing. GDP does not accurately reflect the quality of economic development. Not all products make contributions to economic welfare. Some products may have a detrimental impact. Inflation may create the impression of a decline. METHODS OF CALCULATING NATIONAL INCOME a. Product Method/ Value Added Method: It refers to a firm's production activities that add value to raw materials (intermediate goods). Alternatively, value added is defined as an enterprise's contribution to the present flow of products and services. To put it another way, the term "value added" is used to describe a company's net contribution. As a result, Value added of a firm = Value of Output– Value of intermediate goods used by the firm. Here, Value of output: Class XII Macro Economics 13  An enterprise's output is the commodities and services it produces during an accounting year. The market worth of all goods and services generated by a firm throughout an accounting year is referred to as the value of output. Value of Output = Quantity of output x Price Or Value of output = Sales + Stock Change in stock It is calculated as; Stock = Closing Stock - Opening Stock Intermediate Consumption: It refers to the value of non-factor inputs or raw material which is used in the process of production. b. Expenditure Method: It is believed that the value of domestic income is equal to the total sum of expenditures on the purchase of final products and services produced throughout an accounting year within an economy. Consumption Expenditure: The expenditure by households, individuals, etc on final goods and services. Government Expenditure: The expenditure by the government on final goods and services. Investment Expenditure: The expenditure on the purchase of the goods that would be used for further production. It includes fixed investment (on plant, machinery etc) and inventory investment (includes change in stock). Net exports: The difference between exports(X) and imports(M). Class XII Macro Economics 14 Formula GDPMp = C + I + G + (X – M) Here, C = consumer spending on different goods and services, I = investments made by businesses, and on capital goods, G = government’s spending on goods and services provided to the public, X = exports, and M = imports. c. Income Method: The income method is a real estate estimating methodology that divides the capitalization tariff or price by the net operating income of the rental payments. This calculation is used by investors to evaluate assets depending on their profitability. It is also called factor payment method, as in this the calculation of national income is through factor incomes. Classification of Factor Incomes Compensation of Employees: It comprises salary and wages earned in return for the services and talents you give in the production of goods and services. Travel allowances, bonuses, lodging allowances, and medical expenses are also included. It includes, ○ Wages and salaries ○ Payment in kind ○ Pension ○ Employers contribution Operating Surplus: It includes. Class XII Macro Economics 15 ○ Rent is the amount of money paid for the use of land. When determining income, rent only relates to the money obtained from the use of any land. Rent paid for the use of machinery and other equipment is not included in the calculation of rent. ○ Interest is the cost one pays for borrowing money. This now covers the interest paid when a business obtains a loan for an investment. ○ Profit, it includes dividends, profit tax, undistributed profits. Mixed Income: The income of self-employed professionals, farming units, and sole proprietorships is referred to as mixed income. Formula National Income (NNPFC) = Net Domestic Product at Factor Cost (NDPFC) + Net Factor Note: NDPFC = Rent + Compensation + Interest + Profit + Mixed income. Problem of Double Counting: When computing national income, the problem of double counting arises. The national income estimates become muddled when double accounting occurs in the calculation of national income. Methods to avoid the problem of double counting: Only the value of finished goods should be counted (final output method). Only the value added that equals the value of output less intermediary consumption should be counted (Value added method). Private Income: Private income is the estimated income of all factors and transfers to the private sector, both within and outside the country. Class XII Macro Economics 16 Private Income = Factor income from net domestic product accruing to the private sector + National debt interest + Net factor income from abroad + Current transfers from government + Other net transfers from the rest of the world. Personal Income: The term "personal income" refers to the sum of money received by all people or households in a certain country. Personal income comprises remuneration from a variety of sources, such as salaries, wages, and so on. Personal income (PI) NI n Undistributed profits n Net interest payments made by households nCorporate tax Transfer payments to the households from the government and firms Note: NI stands for National Income Personal Disposable Income: Disposable income, also known as personal disposable income, is the amount of money available for household consumption, savings, and spending after deducting income taxes. Personal Disposable Income (PDI) PI n Personal tax payments. n Non tax payments Class XII Macro Economics 17  Revision Notes Class 12 Macroeconomics Chapter 6 – Open Economy Macroeconomics Open Economy: It is one that conducts business with other countries in a range of methods. The majority of modern economies are open. Balance of Payment (BOP): It is a record of all transactions that occurred between firms in a particular country and the rest of the world over a certain time period, such as a quarter or a year. Accounts of Balance of payment: 1. Current Account: It is the record of goods and services traded as well as transfer payments. It encompasses a country's most important activities, such as capital markets and services. Two components of the Current Account: Balance of Trade (BOT): It is the difference between the value of a country’s exports and imports of goods over a specified timeframe. The export of products is recorded as a credit in the BOT, whereas the import of goods is recorded as a debit. It is also referred to as the Trade Balance. Balance of Invisibles: The difference between a country’s exports and imports of invisible over a certain time frame is known as the balance of invisible. Services, transfers, and income movements between countries are all examples of invisible. 2. Capital Account: All overseas asset transactions are recorded in the Capital Account. An asset is any type of wealth that may be held, such as money, stocks, bonds, government debt, and so on. The purchase of assets is recorded as a debit item on the capital account. Components of Capital Account: Investments: a. Direct Investment: Equity Capital, FDI, Reinvested Earning, and other Direct Capital Flows. b. Portfolio Investment: Offshore Funds, FII. Class XII Micro Economics 1  External Borrowings: Includes Short-term Debt, External Commercial Borrowings. External Assistance: Multilateral and Bilateral Loans, Government Aid, Inter- governmental Aid. Deficit of Balance of Payment Account: When a country has a balance of payments deficit, it imports more goods, capital, and services than it exports. It must take from other countries in order to pay for its imports. A deficit in the balance of payment happens when total payment surpasses total receipts; ergo BOP = Credit < Debit. A deficit of the balance of payment can be amended through an official reserve deal which signifies the sale of foreign exchange by the Reserve Bank. Autonomous Transactions: When international economic transactions are made for reasons other than bridging the balance of payments gap, they are referred to as autonomous transactions. One reason might be to make money. In the balance of payment, these items are referred to as “above the line” items. This type of transactions are free of the condition of the balance of payment account. Autonomous items allude to those international economic exchanges, which happen because of some economic intention, for example, profit maximisation. Accommodating Transactions: The gap in the balance of payments, or whether there is a deficit or surplus in the balance of payments, determines accommodating transactions, also known as “below the line” items. In other words, the net consequences of autonomous transactions determine them. Accommodating transactions are repaying capital exchanges that are intended to address the disequilibrium in the balance of payments, i.e., the autonomous items. If the balance of payment has a surplus or deficit, accommodating transactions are carried out on purpose to balance the balance of payment's surplus or deficit. Errors and Omissions: It is difficult to keep accurate records of all international transactions. As a result, in addition to the current and capital accounts, there is a third element of the balance of payment called errors and omissions, which reflects this. The entries made under this head relate for the most part to leads and lags in the detailing of exchanges. Class XII Micro Economics 2  It is a balancing entry that is expected to counterbalance the exaggerated or underestimated components. Foreign Exchange Market: The foreign exchange market is the market where national currencies are exchanged for one another. Commercial banks, foreign exchange brokers, other authorised dealers, and monetary authorities are the main participants in the foreign exchange market. The foreign exchange markets are the first and most established financial markets and remain the premise whereupon the remainder of the financial edifice is built. It provides global liquidity, ideally with reasonable stability. Foreign Exchange rate: An exchange rate is the worth of a country's currency versus that of another nation or an economic zone, also termed as Forex rate. Most of the trade rates are free-floating and will rise or fall based on market interest on the lookout. A few monetary forms are not free-floating and have limitations. It connects different countries' currencies and allows for cost and price comparisons across territorial boundaries. 1. Demand for Foreign Exchange: People require foreign exchange because they want to buy goods and services from other countries, send gifts abroad, and buy financial assets from a specific country. The demand for foreign exchange falls as the flexible exchange rate rises and vice versa. 2. Supply of Foreign Exchange: Foreign currency flows into the home country for the following reasons - a country's exports lead to foreigners purchasing its domestic goods and services; foreigners send gifts or make transfers, and foreigners purchase a home country’s assets. The foreign exchange supply has a positive relationship with the foreign exchange rate. When the foreign exchange rate rises, so does the supply of foreign exchange, and vice versa. Flexible Exchange Rate: The market forces of demand and supply determine this exchange rate. It is also referred to as a floating exchange rate. An increase in the exchange rate indicates that the price of foreign currency (dollar) in terms of domestic currency (rupees) has risen. This is referred to as depreciation of the domestic currency (rupees) in terms of foreign currency (dollars). Appreciation of the domestic currency (rupees) in terms of foreign currency (dollars) occurs when the price of domestic currency (rupees) increases in relation to foreign currency (dollars) (dollars). Class XII Micro Economics 3 Merits of Flexible Exchange Rate: a. There is no need to keep foreign exchange reserves. b. As a result, the ‘balances of payments’ are automatically adjusted. c. To remove impediments to capital and trade transfers. d. Improves resource allocation efficiency. e. It eliminates the issue of currency undervaluation or overvaluation. f. It encourages foreign exchange-based venture capital. Demerits of Flexible Exchange Rate: a. Future exchange rate fluctuations. b. Is a deterrent to international trade and investment. c. Promotes speculation. d. It contributes to market uncertainty. Fixed Exchange Rate: The government fixes the exchange rate at a specific level in this exchange rate system. The goal of a fixed exchange rate system is to maintain the value of a currency within a narrow spectrum. Devaluation occurs in a fixed exchange rate system when a government action raises the exchange rate, causing the domestic currency to become cheaper. In a fixed exchange rate system, a revaluation occurs when the government lowers the exchange rate, making the domestic currency more expensive. Merits of Fixed Exchange Rate: a. Exchange rate stability. b. There is no room for speculation. c. Encourages capital mobility and international trade. d. Attracts foreign investment. e. It forces the government to keep inflation under control. Demerits of Fixed Exchange Rate: a. In relation to the balance of payments, there are no automatic adjustments i.e., it forestalls changes for monetary standards that become under-or over-esteemed. b. Requiring a huge pool of reserves to help the currency of a country in the event that it goes under pressure. c. It could lead to currency undervaluation or overvaluation. d. It undercuts the goal of free markets. Determination of Equilibrium Foreign Exchange Rate: The equilibrium foreign exchange rate is the rate at which demand and supply of foreign exchange are equitable. It is determined by market forces, i.e., demand for and supply of foreign exchange, in a free market situation. The demand for foreign exchange and the Class XII Micro Economics 4 exchange rate has an inverse relationship. There is a direct relationship between foreign exchange supply and exchange rate. Because of the aforementioned reasons, the demand curve is sloped downward, and the supply curve is sloped upward. The equilibrium foreign exchange rate is determined graphically by the intersection of the demand and supply curves. Managed Floating: It is a hybrid of a flexible exchange rate system, known as the float, and a fixed rate system, known as the managed part. This exchange rate system enables a country's central bank to intervene on a regular basis in foreign exchange markets to moderate exchange rate movements whenever such actions are deemed appropriate. ER D S E S D F.Ex. Class XII Micro Economics 5  Revision Notes Class - 12 Macroeconomics Chapter 4 – Determination of Income and Employment AGGREGATE DEMAND (AD) It refers to the total value of all final goods and services that are planned to be purchased by all sectors of the economy at a given level of income over a given time. AD denotes the total expenditure on goods and services in an economy over a given time. Components of Aggregate Demand in an Open Economy: Consumption expenditure by households (C). Investment expenditure (I). Government consumption expenditure (G). Net exports (X – M). Therefore, AD = C + I + G + (X – M) Class XII Macro Economics 1 Components of Aggregate Demand in Closed Economy: A three sector economy; AD = C + I + G A Two sector economy; AD = C + I Ex-ante aggregate demand: The term ex-ante refers to what has already been planned. So, it is planned aggregate demand. Ex-post aggregate demand: Actual consumer spending and business capital investment are included in ex- post aggregate demand. In other words, the ex-post describes what actually occurred. AGGREGATE SUPPLY (AS): It is the monetary value of all final goods and services purchasable by an economy over a specific period. It refers to the movement of goods and services in the economy. AS is nothing more than national income because the money value of final goods and services equals net value-added. AS = C + S The aggregate supply represents the country's national income. AS = Y (National Income) Class XII Macro Economics 2 CONSUMPTION FUNCTION: Household income is the most important determinant of consumption demand. The relationship between consumption and income is described by a consumption function. The most basic consumption function assumes that consumption changes at the same rate as income. Equation of Consumption Function C C cY C = Consumption C = Autonomous consumption cY= Induced consumption Y= Income The consumption curve starts from the Y axis because, even when the income is zero, there is some consumption. Autonomous Consumption: Autonomous consumption is denoted by C and represents consumption that is unaffected by income. Class XII Macro Economics 3  When consumption occurs even when income is zero, it is due to autonomous consumption. Hence this consumption is independent of income. Induced Consumption: The induced component of consumption, cY, demonstrates consumption's dependence based on earnings/ income. Hence, this consumption is dependent on income. PROPENSITY TO CONSUME Propensity to consume is of two types: a. Average Propensity to Consume (APC): It refers to consumption per unit of income. C It is denoted as Y Points to Remember about APC APC>1: APC is greater than one if consumption exceeds national income before the break-even point i.e., APC > 1. APC=1: When APC=1, consumption equals national income at the break-even point. APC MPC. SAVING FUNCTION: The functional relationship between saving and national income is referred to as the saving function. Equation of saving function S = f (y) Where, S = Saving Y = National Income f = Functional relationship. S a 1 b y Class XII Macro Economics 5 Here, 1-b = MPS Y= Income -a = Savings, when Y is 0 In the diagram, the S curve starts from below 0, as when income is zero, the savings are negative. PROPENSITY TO SAVE Propensity to Save is of two types: a. Average Propensity to Save (APS): It refers to the savings per unit of income. S It is denoted as Y Points to Remember About APS Savings can never be equal to or greater than income, so APS can never be one or more than one. At the break-even point, when C= Y, APS can be zero, as here S= 0. This is because when a person consumes equals to what he/she earns, there are no savings. Class XII Macro Economics 6  When consumption exceeds income at income levels lower than the break-even point, APS can be negative. With an increase in income, APS rises. Hence, APS and income are directly related. b. Marginal Propensity to Save (MPS): It is the change in savings per unit of income change. It is represented by s and equals 1-c. This is because 1 is the whole, and if we less consumption from it, we can get the savings. It follows that, S + C = 1, i.e, the total of savings and consumption equals one. ?S That is MPS= ?Y Points to Remember About MPS MPS ranges from 0 to 1. MPS is the saving curve's slope. In the short run, MPS remains constant. Relation between APC and APS The product of APC and APS equals one. It can be demonstrated as follows: APC + APS = 1. Y=C+S Dividing both side by Y, we get Y C S Y Y Y That is, Class XII Macro Economics 7 1= APC + APS C S As, APC , APS Y Y Therefore, APC + APS = 1 Relation between MPC and MPS We know MPC + MPS = 1 Also, Y = C +S Hence Y C S - (i) Where, C Change in consumption Y Change in income S Change in savings And, C MPC Y And, S MPS Y So dividing eq (i) with change in Y on both sides Y C (Y C) Y Y Y Class XII Macro Economics 8  C S 1 Y Y 1 = MPC + MPS INVESTMENT: An investment is an asset or item purchased with the intention of earning income or increasing in value. An increase in the value of an asset over time is referred to as appreciation. Two heads of investment: Induced Investment: It is defined as an investment that is based on profit expectations and is directly influenced by income level. Autonomous Investment: It is defined as an investment that is not affected by changes in income and is not motivated solely by a profit motive. Ex-ante Investment: Ex-ante investment refers to the investment made by firms in the economy during a specific period. The planning is done with future expectations in mind. Ex-post Investment: This refers to the actual investment made by all entrepreneurs in the economy during a given period. It is the outcome of actual investment. EQUILIBRIUM LEVEL OF INCOME The equilibrium level of income is only determined when AD = AS or S = I, i.e., when the flow of goods and services in the economy equals the demand for goods and services. Class XII Macro Economics 9  However, it cannot always be at full employment and may be less than full employment. SHORT RUN EQUILIBRIUM OUTPUT: The quantity of real GDP that will exist when AD intersects Short Run Aggregate Supply in a short-run macroeconomic equilibrium is the amount of aggregate output produced. Assumptions: Closed Economy: In the framework of a two-sector model (households and firms), the determination of equilibrium output will be investigated. It implies that there is no government or international sector. Such that AD=C+I Self contained Investment: It is assumed that investment expenditure is self- contained, i.e., investments are unaffected by income levels. Short-period analysis: This analysis is with reference to short period only. AD-AS APPROACH: The level of output where the Aggregate Demand equals Aggregate Supply (AD = AS) in an economy. It indicates that whatever the producers intended to manufacture during the year is exactly equal to what the buyers intended to purchase during the year. Here, AD = C + I (for a two- AS = C + S That is, AD = Aggregate Demand, AS = Aggregate Supply, C = Consumption, Class XII Macro Economics 10 I = Investment, S = Saving The diagram represents aggregate demand, and the situation of equilibrium at point K, where AD=AS, and the level of equilibrium output at point Y. Two different situations: AD > AS: In this case aggregate demand exceeds aggregate supply, and a situation of unfulfilled demand persists. To curb this situation, the producers will enhance the level of output and production such that AS could increase and become equal to AD, and the situation of equilibrium is restored. This is shown as point R in the diagram, where AD>AS. AD < AS: In this case aggregate demand is less than the aggregate supply, and a situation of unwanted stocks persists. To curb this situation, the producers will decrease the level of output and production such that AS could decrease and become equal to AD, and the situation of equilibrium is restored. This is shown as point S in the diagram, where AD I: At this point, some of the anticipated output remains unsold, forcing companies to keep unsold items on hand. In order to clear the stocks, producers will cut production, resulting in a decrease in output. As a result, the economy's income decreases. Less income means less savings, and this cycle will continue until saving equals investment. S > I: People spend more money than is necessary to purchase the projected output when S > I. This means that AD outnumbers AS in the economy. As a result, manufacturers will increase output to compensate for the situation. As a result, investment rises to the point where it equals investment. Equilibrium So, equilibrium is reached when: Class XII Macro Economics 12 AD = AS... (i) We already know that AD is the sum of Consumption (C) and Investment (I): AD = C + I... (ii) Additionally, AS is the sum of consumption (C) and saving (S): AS = C + S... (iii) When we substitute (ii) and (iii) into (i), we get: C + S = C + I, or S=I Note: It's important to remember that AD, AS, Savings, and Investment are all ex-ante variables. TYPES OF EMPLOYMENT Full employment: This occurs when all those who are able and willing to work at the prevailing wage rate are given the opportunity to do so. Voluntary unemployment: This occurs when a person is able to work but unwilling to work at the prevailing wage rate. Involuntary unemployment: This occurs when a worker is able and willing to work at the prevailing wage rate but is unable to find work. Under employment: It occurs when all those who can work at current wage rates are unable to find work. It refers to the economic situation in which AS= AD or S = I, but there is insufficient labour force utilisation. MULTIPLIER MECHANISM: The multiplier shows us what the eventual change in income will be as a result of a change in investment. Changes in investment lead to changes in income. The aggregate demand rises when the autonomous measures (A) rise. Class XII Macro Economics 13  As a result, output and income will rise in the next round, causing consumption and the AD to rise. This is referred to as the multiplier mechanism. It is represented symbolically by: I Y C Y The operation of a multiplier can be illustrated using the table below, which is 4 based on consumption, that is, K 1000 and MPC. 5 Working of multiplier: The process of income generation is shown below. Rounds I Y C 1 1000 1000 4 1000 = 800 5 2 - 800 4 800 = 640 5 3 - 640 4 640 = 512 5 4 - 512 4 512 = 409.6 5 Total 5000 Class XII Macro Economics 14  4 According to the above table, as MPC = , the initial increase in investment of 5 Rs 1000 results in a total increase in income of Rs 5000. From the whole increase in income, Rs. 4000 will be spent and Rs. 5000 will be saved. The derivation of the sum of total increase in income is shown below. () () 2 3 4 4 4 = 1000 + x 1000 x 1000 x 1000 +..........oo 5 5 5 [ () () [ 2 3 4 4 4 +..........oo = 1000 1 + + + 5 5 5 1 4 = 1000[ - ] 1 5 5 =1000 x 1 = Rs. 5000 crores. INVESTMENT MULTIPLIER: The investment multiplier (K) is the ratio of the change in income (Y) caused by the change in investment (I). The value of the investment multiplier ranges from one to infinity. Y 1 1 K= or K = or K = I 1 - MPC MPS EXCESS DEMAND: It occurs when aggregate demand exceeds aggregate supply, resulting in full employment. Reasons for excess demand: Class XII Macro Economics 15 ○ Rise in household consumption demand due to increased propensity to consume. ○ Rise in private investment demand because of higher provision and availability of credit facilities. ○ Higher public (government) expenditure. ○ Rise in demand for exports. ○ Rise in supply of money ○ Rise in disposable income. Impact of Excess demand on: ○ General Price Level: General price level increases as when aggregate demand exceeds aggregate supply at a full employment level, there is a situation of inflation in the economy ○ Output: It has no impact on output, as the economy is already at full employment level, thus no idle capacity exists. Hence, one cannot raise the output more than already. ○ Employment: No impact on employment level. The economy is already operating at full employment equilibrium. Class XII Macro Economics 16 DEFICIENT DEMAND: It occurs when AD falls short of AS at full employment. To put it another way, AD < AS is at full employment. It's referred to as deficient demand. Reasons for Deficient demand: ○ Fall in household consumption demand due to decreased propensity to consume. ○ Fall in private investment demand because of lesser provision and availability of credit facilities. ○ Reduced public (government) expenditure. ○ Fall in demand for exports. ○ Fall in supply of money ○ Fall in disposable income. Impact of Deficient demand on: ○ General Price Level: General price level falls as when aggregate demand is less than aggregate supply at a full employment level, there is a situation of deflation in the economy ○ Output: Low output levels, due to unemployment, and reduced investment. ○ Employment: Low employment levels, as there will be a case of involuntary unemployment. Diagram Class XII Macro Economics 17 INFLATIONARY GAP: The difference between actual aggregate demand and the level of aggregate demand required to achieve full employment is known as the inflation gap. It assesses the magnitude of excess demand. The area between FE represents the inflationary gap, as here aggregate supply, EM, is less than aggregate demand FM. As the output could not be increased beyond the full employment level, prices will rise, and there will be a situation of inflation in the economy. DEFLATIONARY GAP: Deflationary gap refers to the difference between the actual aggregate demand and the level of aggregate demand required to achieve full employment. It assesses the degree of deficient demand. The area between a and b shows deflationary gap, as here the Aggregate supply is greater than that of aggregate demand. Class XII Macro Economics 18 MECHANISM TO CONTROL EXCESS DEMAND OR DEFICIENT DEMAND: 1. Fiscal Policy: Fiscal policy refers to the general government's expenditure and income policies used to achieve its objectives. It includes: a. Change in taxation: Taxation is used to represent revenue policy. Excess Demand: During an inflationary period, the government raises taxes, resulting in a loss in people's purchasing power. This is due to the fact that in order to limit excess demand, the economy's liquidity must be reduced. Deficient Demand: In case of deficient demand, tax rates b. Change in public expense: The government must invest heavily in public works projects like roads, buildings, and irrigation systems. Excess Demand: During an inflationary period, the government should limit (lower) its expenditure on public works such as roads, buildings, and irrigation projects, therefore reducing people's money income and consumer requirements. Class XII Macro Economics 19  Deficient Demand: During deficient demand, the government should increase its expenditure on public works such as roads, buildings, and irrigation projects, therefore increasing people's money income and consumer requirements. c. A Shift in public borrowing: Excess Demand: This measure implies that the government should borrow money from the general population, which reduces people's purchasing power by leaving them with less money. As a result, during periods of high demand, the government should resort to increased public borrowing. Deficient Demand: This measure implies that the government should reduce the borrowings from the general population, which increased people's purchasing power. As a result, during periods of deficient demand, the government should resort to reduced public borrowing. 2. Monetary Policy: It is the policy of a country's central bank to control the amount of money in circulation and the availability of credit in the economy. A. Quantitative measures: These are the monetary policy instruments that influence the overall supply of money/credit in the economy. These instruments do not direct or restrict credit flow to specific sectors of the economy. a. Bank Rate: The bank rate is the interest rate at which a central bank lends money to commercial banks with no security. Excess Demand: Bank Rate should be increased in situations of excess demand, as due to this, the quantity of money accessible to banks decreases, and the commercial bank’s capacity to provide credit also falls. Hence the aggregate demand falls down with a low credit creation and supply of money in the economy. Deficient Demand: Bank Rate should be reduced in situations of deficient demand, as due to this, the quantity of money accessible to banks increases, Class XII Macro Economics 20  and the commercial bank’s capacity to provide credit also rises. Hence the aggregate demand increases as a result of high credit creation and supply of money in the economy. b. Cash Reserve Ratio (CRR): It is the minimum percentage of a bank's total deposits that it must keep with the central bank. As a matter of law, commercial banks must keep a certain percentage of their deposits with the central bank in the form of cash reserves. Excess Demand: CRR should be increased in situations of excess demand, as due to this, the quantity of money accessible to banks decreases, and the commercial bank’s capacity to provide credit also falls. Hence the aggregate demand falls down with a low credit creation and supply of money in the economy. Deficient Demand: CRR should be reduced in situations of deficient demand, as due to this, the quantity of money accessible to banks increases, and the commercial bank’s capacity to provide credit also rises. Hence the aggregate demand increases as a result of high credit creation and supply of money in the economy. c. Statutory Liquidity Ratio (SLR): It specifies the minimum proportion of net total demand and time obligations that commercial banks must retain with themselves. Excess Demand: SLR should be increased in situations of excess demand, as due to this, the quantity of money accessible to banks decreases, and the commercial bank’s capacity to provide credit also falls. Hence the aggregate demand falls down with a low credit creation and supply of money in the economy. Deficient Demand: SLR should be reduced in situations of deficient demand, as due to this, the quantity of money accessible to banks increases, and the commercial bank’s capacity to provide credit also rises. Hence the aggregate demand increases as a result of high credit creation and supply of money in the economy. d. Open Market Operations (OMO): Class XII Macro Economics 21 It consists of the central bank purchasing and selling government assets and bonds on the open market. Excess Demand: In situations of excess demand, the central bank should sell the government assets and bonds in the open market. This reduces the ability of commercial banks to provide loans, thus reducing the levels of aggregate demand. Deficient Demand: In situations of deficient demand, the central bank should buy the government assets and bonds in the open market. This increases the ability of commercial banks to provide loans, thus increasing the levels of aggregate demand, due to higher purchasing power in the hands of people.. B. Qualitative measures: a. Marginal requirement: Commercial banks extend loans to businesses and dealers in exchange for the security of their commodities. The bank will never grant credit equivalent to the entire amount of the security. It is never worth more than the security. Excess Demand: In situations of excess demand, the margin requirements are raised, as it discourages the borrowers because high margin required means less amount of loan provided to them. Deficient Demand: In situations of deficient demand, the margin requirements are reduced so as to encourage the borrowers to take loans, as low margin required means more amount of loan provided to them. b. Credit rationing: The central bank can use this approach to direct commercial banks not to lend for specific reasons or to lend more for specific objectives or priority sectors. c. Moral suasion: Moral suasion refers to the central bank's persuasion, request, informal suggestion, advice, and appeal to commercial banks to cooperate with the central bank's overall monetary policy. Excess Demand: In cases of excess demand, the central bank requests for contraction of credit. Class XII Macro Economics 22  Deficient Demand: In cases of deficient demand, the central bank requests for extension of credit. PARADOX OF THRIFT: It is defined as a situation in which people tend to save more money, and this increased saving leads to reduced consumption, resulting in a decrease in aggregate consumption. Such a savings system reduces employment levels, reduces total economic savings, and slows economic growth. This is regarded as a crucial component of Keynesian economics. Class XII Macro Economics 23