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Thursday, December 20, 2018

Class 12 Macroeconomics December 20, 2018

Class 12 Macroeconomics Chapter-10 Balance of Payment

Class 12 Macroeconomics

Chapter-10

Balance of Payment

Introduction
This chapter gives a detailed account of balance of payment of an economy, it structure and categorisation into current and capital account. Thereafter explaining balance of trade and its differences with the balance of payment, autonomous items, accommodating items and their differences, disequilibrium in balance of payment.
Balance Of Payment, Its Structure And Components
1. The balance of payments of a country is a systematic record of all economic transactions between its residents and residents of the foreign countries during a given period of time.
Note: Economic transactions are the transactions which cause transfer of value. In the context of foreign transactions value is transferred by the residents of one country to the residents of other country. Example: when exports of goods or services are made by country A to country B, value (= export receipts) is transferred by country B to country A. Between the countries, value is transferred in terms of foreign exchange (i.e. payments are received and made in terms of foreign exchange).
2. Structure of balance payment accounting
(a) Transactions are recorded in the balance of payments accounts in double-entry book keeping.
(b) Each international transaction undertaken by country will results in a credit entry and debit entry of equal size.
(c) As international transactions are recorded in double entry accounting, the BOP accounting must always balance i.e., total amount of debits must be equal to total amount of credits.
(d) The balancing item Errors and omissions must be added to “balance” the BOP accounts.
(e) By convension, debit items and credit items are entered with a minus sign and plus sign respectively.
(f) Transactions in BOP are classified into the following five major categories:
(i) Goods and services account (ii) Unilateral transfer account
(iii) Long-term capital account (iv) Short-term private capital account
(v) Short-term official capital account
For each of these given categories, specific types of transactions are shown as debits or credits. This is shown in below table:
balance-payment-cbse-notes-class-12-macro-economics-1

balance-payment-cbse-notes-class-12-macro-economics-1

balance-payment-cbse-notes-class-12-macro-economics-2

The above five categories are also divided into the following two major categories of accounts in the BOP account statement:
3. Current Account (Category-I, Category-II):
(a) Meaning: Current account records imports and exports of goods and services and unilateral transfers.
(b) Components of Current Account: The main components of Current Account are:
(i) Export and Import of Goods (Merchandise Transactions or Visible Trade):
A major part of transactions in foreign trade is in the form of export and import of goods (visible items). Payment for import of goods is written on the negative side (debit items) and receipt from exports is shown on the positive side (credit items). Balance of these visible exports and imports is known as balance of trade (or trade balance).
(ii) Export and Import of Services (Invisible Trade): It includes a large variety of non-factor services (known as invisible items) sold and purchased by the residents of a country, to and from the rest of the world. Payments are either received or made to the other countries for use of these services. Services are generally of three kinds: (a) Shipping, (b) Banking, and (c) Insurance. Payments for these services are recorded on the negative side and receipts on the positive side.
(iii) Unilateral or Unrequisted Transfers to and from abroad (One sided Trans¬actions): Unilateral transfers include gifts, donations, personal remittances and other ‘oneway’ transactions. These refer to those receipts and payments, which take place without any service in return. Receipt of unilateral transfers from rest of the world is shown on the credit side and unilateral transfers to rest of the world on the debit side.
(iv) Income receipts and payments to and from abroad: It includes investment income in the form of interest, rent and profits.
4. Capital Account (Category-Ill, Category-IV, Category-V):
(a) Meaning: Capital account is that account which records all such transactions between residents of a country and rest of the world which cause a change in the asset or liability status of the residents of a country or its government.
(b) Components of Capital Account: The main components of capital account are:
(i) Loans: Borrowing and lending of funds are divided into two transactions:
• Private Transactions
-> These are transactions that are affecting assets or liabilities by individuals, businesses, etc. and other non-government entities. The bulk of foreign investment is private.
-> For example, all transactions relating to borrowings from abroad by private sector and similarly repayment of loans by foreigners are recorded on the positive (credit) side.
-> All transactions of lending to abroad by private sector and similarly repayment of loans to abroad by private sector is recorded as negative or debit item.
• Official Transactions
-> Transactions affecting assets and liabilities by the government and its agencies.
-> For example, all transactions relating to borrowings from abroad by government sector and similarly repayment of loans by foreign government are recorded on the positive (credit) side.
-> All transactions of lending to abroad by government sector and similarly repayment of loans to abroad by government sector is recorded as negative or debit item.
Private and official transactions borrowing are of two components:
(i) Commercial borrowings, referring to borrowing by a country (including government and private sector) from international money market. This involves market rate of interest without considerations of any concession, (ii) Borrowings as External Assistance, referring to borrowing by a country with considerations of assistance. It involves lower rate of interest compared to that prevailing in open market.
(ii) Foreign Investment (Investments to and from abroad): It includes:
• Investments by rest of the world in shares of Indian companies, real estate in India, etc. Such investments from abroad are recorded on the positive (credit) side as they bring in foreign exchange.
• Investments by Indian residents in shares of foreign companies, real estate abroad, etc. Such investments to abroad are recorded on the negative (debit) side as they lead to outflow of foreign exchange.
‘Investments to and from abroad’ includes two types of investments:
-> Foreign Direct Investment (FDI)
It refers to purchase of an asset in rest of the world, such that it gives direct control to the purchaser over the asset.
For example, (i) acquisition of a firm in the domestic country by a foreign country’s firm (ii) transfer of funds from the parent company abroad to the subsidiary company in the domestic country.
-> Portfolio Investment
Portfolio Investment refers to the purchase of financial asset by the foreigners that does not give the purchaser control over the asset. A foreign Institutional Investment (FII) is also a part of portfolio investment.
For instance, purchase of shares of a foreign company, purchase of foreign government’s bonds, etc. are treated as portfolio investments.
(iii) Change in Foreign Exchange Reserves
• The foreign exchange reserves are the financial assets of the government held in
• central bank. A change in reserves serves as the financing item in India’s BOP.
• So, any withdrawal from the reserves is recorded on the positive (credit) side and any addition to these reserves is recorded on the negative (debit) side.
• It must be noted that ‘change in reserves’ is recorded in the BOP account and not ‘reserves’.
Balance Of Payments And Its Types
1. Balance: It means difference between the sum of credits and sum of debits. The BOP account records three balances:
(a) Balance of trade
(b) Balance on current account
(c) Balance on capital account
2. Balance of trade: The term “balance of trade” denotes the difference between the exports and imports of goods in a country. Balance of trade refers to the visible items only. It is the difference between the value of merchandise (goods) exports and imports.
Balance of Trade = Export of visible goods – Import of visible goods.
3. Balance on current account: It is the difference between sum of credits and sum of debits on current account.
Balance on Current Account = Sum of credits on current account – Sum of debits on current account
4. Balance on capital account: It is the difference between sum of credits and sum of debits on capital account.
Balance on capital account = Sum of credits on capital account – Sum of debits
on capital account
Autonomous And Accommodating Items, Deficit In Balance Of Payment And Disequilibrium In Balance Of Payment
1. Autonomous items
(a) Autonomous items refer to those international economic transactions in the
current account and capital account which take place due to some economic motive such as profit maximisation.
(b) These transactions are independent of the state of BOP account.
(c) These items are also known as ‘above the line items’.
(d) For example, if a foreign company is making investments in India with the aim of earning profit, then such a transaction is independent of the country’s BOP situation.
2. Accommodating items
(a) Accommodating items refer to the transactions that are undertaken to cover deficit or surplus in autonomous transactions, i.e., such transactions are determined by net consequences of autonomous transactions.
(h) These items are also known as ‘below the line items’.
(c) For example, if there is a current account deficit in BOP, then this deficit is settled by capital inflow from abroad. The sources used to meet a deficit in BOP, are: (i) Foreign exchange reserves; (ii) Borrowings from IMF or foreign monetary authorities.
3. Deficit in BOP
(a) The balance of payments of a country is a systematic record of all economic transactions between the residents of foreign countries during a given period of time.
(b) The transaction in the balance of payment account can be categorized as autonomous transactions and accommodating transactions.
(c) Autonomous transactions are transactions done for some economic consideration such as profit.
(d) When the total inflows on account of autonomous transactions are less than total outflows on account of such transactions, there is a deficit in the balance of payments account.
(e) Suppose, the autonomous inflow of foreign exchange during the year is $500, while the total outflow is $600. It means that there is a deficit of $100.
4. Disequilibrium in 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:
(a) Economic Factors
(i) Large scale development expenditure that may cause large imports.
(ii) Cyclical fluctuations in general business activity such as recession or depression.
(iii) High domestic prices may result in imports.
(b) Political Factors: Political factors instability may cause large capital outflows and hamper the inflows of foreign capital.
(c) Social Factors: Changes in tastes, preference and fashions of the people bring disequilibrium in BOP by inflowing imports and exports.
Words that Matter
1. Balance of payment: The balance of payments of a country is a systematic record of all economic transactions between its residents and residents of the foreign countries during a given period of time.
2. Current account: It records imports and exports of goods and services and unilateral transfers.
3. Capital account: Capital account is that account which records all such transactions between residents of a country and rest of the world which cause a change in the asset or liability status of the residents of a country or its government.
4. Foreign Direct Investment: It refers to purchase of an asset in rest of the world, such that it gives direct control to the purchaser over the asset.
5. Portfolio Investment: It refers to the purchase of financial asset by the foreigners that does not give the purchaser control over the asset.
6. Balance: It means difference between the sum of credits and sum of debits.
7. Balance of trade: The term “balance of trade” denotes the difference between the exports and imports of goods in a country. Balance of trade refers to the visible items only.
8. Balance on Current Account: It is the difference between sum of credits and sum of debits on current account.
Balance on Current Account = Sum of credits on current account – Sum of debits on current account
9. Balance on Capital Account: It is the difference between sum of credits and sum of debits on capital account.
Balance on capital account = Sum of credits on capital account – Sum of debits
on capital account
10. Autonomous items: It refer to those international economic transactions in the current account and capital account which take place due to some economic motive such as profit maximisation.
11. Accommodating items: It refer to the transactions that are undertaken to cover deficit or surplus in autonomous transactions, i.e., such transactions are determined by net consequences of autonomous transactions.
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NCERT TEXTBOOK QUESTIONS SOLVED

Question 1. Differentiate between Balance of Trade and Current Account Balance.
[3 Marks] Or
Distinguish between BOT and Balance on current account.[AI 2008, CBSE 2013, Sample Paper 2013]
Answer:
ncert-solutions-for-class-12-macro-economics-balance-of-payment-1

ncert-solutions-for-class-12-macro-economics-balance-of-payment-1

ncert-solutions-for-class-12-macro-economics-balance-of-payment-2

Question 2. Should a current account deficit be a cause for alarm? Explain.[1 Mark]
Answer: No, if deficit in current account is offset by the capital account, otherwise such deficit has to be met by following which is a cause for alarm.

Depleting Foreign Exchange reserves
Taking foreign Loans.

Value: Analytic.
Question 3. If inflation is higher in country A than in country B, and the exchange rate between the two countries is fixed. What is likely to happen to the trade balance between the two countries?[1 Mark]
Answer: The exports from country B to country A will go up in this situation resulting in improvement or surplus trade balance for B. But due to higher price in country A, its imports will increase for country B and it will lead to deficit in trade balance for country A.

Class 12 Macroeconomics Chapter-9 Foreign Exchange Rate

Class 12 Macroeconomics

Chapter-9

Foreign Exchange Rate

Introduction
This chapter defines the meaning of foreign exchange and related terms, how foreign exchange rate is determined, study of foreign exchange rate regimes (fixed and flexible exchange rate) and their differences; thereafter hybrid systems of exchange rate and operation of foreign exchange market.

Foreign Exchange And Its Related Concepts
1. Foreign exchange refers to all the currencies of the rest of the world other than the domestic currency of the country. For example, in India, US dollar is the foreign exchange.
2. The rate at which one currency is exchanged for another is called Foreign Exchange Rate.
In other words, the foreign exchange rate is the price of one currency stated in terms of another currency. For example, if one U.S dollar exchanges for 60 Indian rupees, then the rate of exchange is 1$ = Rs. 60 or 1 Rs = 1/60 or 0.0166 U.S. dollar.
3. Foreign exchange market is the market where the national currencies are converted, exchanged or traded for one another.
4. Functions of a foreign exchange market
(a) Transfer Function: Transfer function refers to transferring of purchasing power
among countries.
(b) Credit Function: It implies provision of credit in terms of foreign exchange for the export and import of goods and services across different countries of the world.
(c) Hedging Function: Hedging function pertains to protecting against foreign exchange risks. Where Hedging is an activity which is designed to minimize the risk of loss.
5. Sources of demand of foreign exchange:
The demand (or outflow) of foreign exchange comes from the people who need it to make payments in foreign currencies. It is demanded by the domestic residents for the following reasons:
(a) Imports of Goods and Services: When India imports goods and services, foreign exchange is demanded to make the payment for imports of goods and services.
(b) Tourism: Foreign exchange is demanded to meet expenditure incurred in foreign tours.
(c) Unilateral Transfers Sent Abroad: Foreign exchange is required for making unilateral transfers like sending gifts to other countries.
(d) Purchase of Assets in Foreign Countries: It is demanded to make payment for purchase of assets, like land, shares, bonds, etc. in foreign countries.
(e) Repayment of loans to Foreigners: As and when we have to pay interest and repay the loans to foreign lenders, we require foreign exchange.
(d) Speculation: Demand for foreign exchange arises when people want to make gains from appreciation of currency.
6. Reasons for ‘Rise in Demand’ for Foreign Currency:
The demand for foreign currency rises in the following situations:
(a) When price of a foreign currency falls, imports from that foreign country become cheaper. So, imports increase and hence, the demand for foreign currency rises. For example, if price of 1 US dollar falls from Rs. 60 to Rs. 55, then imports from the USA will increase as American goods will become relatively cheaper. It will raise the demand for US dollar.
(b) When a foreign currency becomes cheaper in terms of the domestic currency, it promotes tourism to that country. As a result, demand for foreign currency rises.
(c) When price of a foreign currency falls, its demand rises as more people want to make gains from speculative activities.
7. Demand curve of foreign exchange is downward sloping:
foreign-exchange-rate-cbse-notes-class-12-macro-economics-1

foreign-exchange-rate-cbse-notes-class-12-macro-economics-1

(a) Demand curve of foreign exchange slopes downwards due to inverse relationship between demand for foreign exchange and foreign exchange rate.
(b) In figure, demand for foreign exchange (US dollar) and rate of foreign exchange are shown on the horizontal axis and vertical axis respectively.
(c) The demand curve [US$] is downward sloping. It means that less foreign exchange is demanded as the exchange rate increase
(d) This is due to the fact that rise in the price of foreign exchange increases the rupee cost of foreign goods, which make them more expensive. As a result, imports decline. Thus, the demand for foreign exchange also decreases.
8. Sources of supply of foreign exchange: The supply (inflow) of foreign exchange comes from the people who receive it due to the following reasons.
(a) Exports of Goods and Services: Supply of foreign exchange comes through exports of goods and services.
(b) Tourism: The amount, which foreigners spend in the home country, increases the supply of foreign exchange.
(c) Remittances (unilateral transfers) from Abroad: Supply of foreign exchange increases in the form of gifts and other remittances from abroad.
(d) Loan from Rest of the world: It refers to borrowing from abroad. A loan from U.S. means flow of U.S. $ from U.S. to India, which will increase supply of Foreign exchange.
(e) Foreign Investment: The amount, which foreigners invest in our home country, increases the supply of foreign exchange.
(f) Speculation: Supply of foreign exchange comes from those who want to speculate on the value of foreign exchange.
9. Reasons of‘rise in supply’ of foreign currency: The supply of foreign currency rises in the following situations:
(a) When price of a foreign currency rises, domestic goods become relatively cheaper. It induces the foreign country to increase their imports from the domestic country. As a result, supply of foreign currency rises. For example, if price of 1 US dollar rises from Rs. 60 to Rs. 65, then exports to USA will increase as Indian goods will become relatively cheaper. It will raise the supply of US dollars.
(b) When price of a foreign currency rises, foreign direct investment (FDI). from rest of the world increases, which will increase the supply for foreign exchange.
(c) When price of a foreign currency rises, supply of foreign currency also rises as people want to make gains from speculative activities.
10. Supply curve of foreign exchange is upward sloping:
foreign-exchange-rate-cbse-notes-class-12-macro-economics-2

foreign-exchange-rate-cbse-notes-class-12-macro-economics-2

(a) Supply curve of foreign exchange slopes upwards due to positive relationship between supply for foreign exchange and foreign exchange rate, which means that supply of foreign exchange increases as the exchange rate increases.
(b) This makes home country’s goods become cheaper to foreigners since rupee is depreciating in value. The demand for our exports should therefore increase as the exchange rate increases.
(c) The increased demand for our exports will translate into greater supply of foreign exchange.
Thus, the supply of foreign exchange increases as the exchange rate increases.
How Foreign Exchange Is Determine, Disequilibrium Conditions Under Exchange Rate
1. Determination of foreign exchange rate:
(a) Exchange rate in a free exchange market is determined at a point, where demand for foreign exchange is equal to the supply of foreign exchange.
(b) Let us assume that there are two countries – India and U.S.A – and the exchange rate of their currencies i.e., rupee and dollar is to be determined. Presently, there is floating or flexible exchange regime in both India and U.S.A. Therefore, the value of currency of each country in terms of the other currency depends upon the demand for and supply of their currencies.
(c) In the above diagram, the price on the vertical axis is stated in terms of domestic currency (that is, how many rupees for one US dollar). The horizontal axis measures the quantity demanded or supplied.
(d) In the above diagram, the demand curve [D$] is downward sloping. This means that less foreign exchange is demanded as the exchange rate increases. This is due to the fact that the rise in price of foreign exchange increases the rupee cost of foreign goods, which make them more expensive. As a result, imports decline. Thus, the demand for foreign exchange also decreases.
(e) The supply curve [S$] is upward sloping which means that supply of foreign exchange increases as the exchange rate increases.
foreign-exchange-rate-cbse-notes-class-12-macro-economics-3

foreign-exchange-rate-cbse-notes-class-12-macro-economics-3

This makes home country’s goods become cheaper to foreigners since rupee is depreciating in value. The demand for our exports should therefore increase as the exchange rate increases.
The increased demand for our exports translates into greater supply of foreign exchange. Thus, the supply of foreign exchange increases as the exchange rate increases.
2. Disequilibrium conditions under equilibriun exchange rate:
(a)Change in demand:
(i) Increase in demand for dollar: An increase in the demand for US dollar in India will cause the demand curve to shift to D₁$ and the exchange rate rises to P₁$. Note that increase in the exchange rate means that more rupees are required to buy one US dollar. When this occurs, Indian rupee is said to be depreciating.
foreign-exchange-rate-cbse-notes-class-12-macro-economics-4

foreign-exchange-rate-cbse-notes-class-12-macro-economics-4

(b) Change in Supply
(i) Increase in supply for dollar: An increase in the supply of US dollar causes the supply curve to shift to S₁$ and exchange rate falls to P₁$. In this case, rupee cost of US dollar is decreasing and the Indian rupee is said to be appreciating.
foreign-exchange-rate-cbse-notes-class-12-macro-economics-5

foreign-exchange-rate-cbse-notes-class-12-macro-economics-5

(ii) Decrease in demand for dollar: A decrease in the demand for US dollar in India will cause the demand curve to shift to D₁$ and the exchange rate falls to P₁$. Note that decrease in the exchange rate means that less rupees are required to buy one US dollar. When this occurs, Indian rupee is said to be appreciating.
foreign-exchange-rate-cbse-notes-class-12-macro-economics-6

foreign-exchange-rate-cbse-notes-class-12-macro-economics-6

(ii) Decrease in supply of dollar: A decrease in the supply of US dollar causes the supply curve to shift to S₁$ and exchange rate rises to P₁$. In this case, rupee cost of US dollar is increasing and the Indian rupee is said to be depreciating.
foreign-exchange-rate-cbse-notes-class-12-macro-economics-7

foreign-exchange-rate-cbse-notes-class-12-macro-economics-7

Exchange Rate Regimes (Fixed, Flexible And Managed Floating Exchange Rate And Their Merits And Demerits)
Types of exchange rate regimes:
1. Fixed exchange rate system (Pegged exchange rate system):
(a) Meaning:
(i) The system of exchange rate in which exchange rate is officially declared and fixed by the government is called fixed exchange rate system.
(ii) When domestic currency is tied to the value of foreign currency, it is known as
pegging.
(iii) To maintain stability in fixed exchange rate system, government buy foreign currency when exchange rate appreciates and sell foreign currency when exchange rate depreciate. This process is called Pegging operation, i.e., all efforts made by the central bank to keep the rate of exchange stable.
Note:
(i) Fixed exchange rate is not determined by the forces of demand and supply in the market. Such a rate of exchange has been associated with Gold Standard System during 1880-1914.
(ii) According to this system, value of every currency is determined in terms of gold. Accordingly, ratio between gold value of the two countries was fixed as exchange rate between those currencies.
(iii) For example, Value of one dollar = 100 gms of gold.
Value of a rupee = 5 gms of gold
Then, 1 dollar = 100/5 = Rs. 20
(b) Merits of fixed exchange rate system:
(i) Stability: It ensures stability, in the international money market/exchange market. Day to day fluctuations are avoided. It helps formulation of long term economic policies, particularly relating to exports and imports.
(ii) Encourages international trade: Fixed exchange rate system implies low risk and low uncertainty of future payments. It encourages international trade.
(iii) Co-ordination of macro policies: Fixed exchange rate helps co-ordination of macro policies across different countries of the world. Long term economic policies can be drawn in the area of international trade and bilateral trade agreements.
(c) Demerits of fixed exchange rate system:
(i) Huge international reserves: Fixed exchange rate system is often supported with huge international reserves of gold. This is because different currencies are directly or indirectly convertible into gold.
(ii) Restricted movement of capital: Fixed exchange rate restricts the movement
of capital across different parts of the world. Accordingly, international growth process suffers. .v
(iii) Discourages venture capital: Venture capital in the international money market refers to investments in the purchase of foreign exchange in the international money market with a view to earn profits. Fixed exchange rate system discourages such investments. Fixed exchange rate discourages venture capital in the international money market.
(d) Devaluation of currency: Devaluation refers to decrease in the value of domestic
currency in terms of foreign currency by the government. It is a part of fixed
exchange rate.
(e) Revaluation of currency: Revaluation refers to increase in the value of domestic
currency by the central government. It is a part of fixed exchange rate.
2. Flexible exchange rate (floating exchange rate system):
(a) Meaning:
(i) The system of exchange rate in which value of a currency is allowed to float freely as determined by demand for and supply of foreign exchange is called flexible exchange rate system.
(ii) Under this system, the central banks, without intervention, allow the exchange rate to adjust to equate the supply and demand for foreign currency.
(iii) The foreign exchange market is busy at all times by changes in the exchange rates.
(b) Merits of flexible exchange rate system:
(i) No need for international reserves: Flexible exchange rate system is not to be supported with international reserves.
(ii) International capital movements: Flexible exchange rate system enhances movement of capital across different countries of the world. This is due to the fact that member countries are no longer required to keep huge international reserves.
(iii) Venture capital: Flexible exchange rate promotes venture capital in foreign exchange market. Trading in international currencies itself becomes an important economic activity.
(c) Demerits of flexible exchange rate system:
(i) Instability: It causes instability in the international money market. Exchange rate tends to fluctuate like price of goods in the commodity market.
(ii) International trade: Instability in foreign exchange market causes instability in the area of international trade. It becomes difficult to draw long period policies of exports and imports.
(iii) Macro policies: While fixed exchange rate helps coordination of macro policies, flexible exchange rate makes it a difficult proposition. Day to day fluctuations in exchange rate makes bilateral trade agreements a difficult exercise.
(d) Currency depreciation:
(i) Currency depreciation refers to decrease in the value of domestic currency in terms of foreign currency. It makes the domestic currency less valuable and more of it is required to buy a foreign currency. It is a part of flexible exchange rate.
(ii) For example, rupee is said to be depreciating if price of $1 rises from ? 60 to Rs. 65.
(iii) Effect of depreciation of domestic currency on exports: Depreciation of domestic currency means a fall in the price of domestic currency (say, rupee) in terms of a foreign currency (say, $). It means, with the same amount of dollars, more goods can be purchased from India, i.e., exports to USA will increase as they will become relatively cheaper.
(e) Currency appreciation:
(i) Currency appreciation refers to increase in the value of domestic currency in terms of foreign currency. The domestic currency becomes more valuable and less of it is required to buy a-foreign currency. It is a part of flexible exchange rate.
(ii) For example, Indian rupee appreciates when price of $1 falls from Rs. 60 to Rs. 55.
(iii) Effect of appreciation of domestic currency on imports: Appreciation of domestic currency means a rise in the price of domestic currency (say, rupee) in terms of a foreign currency (say, $). Now, one rupee can be exchanged for more $, i.e., with the same amount of money, more goods can be purchased from the USA. It leads to increase in imports from the USA as American goods will become relatively cheaper.
3. Managed floating rate system:
(a) Managed floating exchange rate is a mixture of a flexible exchange rate (the float part) and a fixed exchange rate (the Managed part).
(b) In other words, it refers to a system in which foreign exchange is determined by free market forces (demand and supply forces), which can be influenced by the intervention of the central bank in foreign exchange market.
(c) Under this system, also called Dirty floating, central banks intervene to buy or sell foreign currencies in an attempt to stabilize exchange rate movements in case of extreme appreciation or depreciation.
Kinds Of Foreign Exchange Rate (Spot And Forward Market)
1. Spot market for foreign exchange:
(a) If the operation is of daily nature, it is called spot market or current market.
(b) The exchange rate that prevails in the spots market for foreign exchange is called spot rate.
(c) In other words, spot rate of exchange refers to the rate at which foreign currency is available on the spot.
2. Forward market for foreign exchange:
(a) A market for foreign exchange for future delivery is known as forward market.
(b) Exchange rate that prevails in a forward contract for purchase or sale of foreign exchange is called forward rate.
(c) Thus, forward rate is the rate at which a future contract for foreign currency is bought and sold.
Other Types Of Exchange Rate System
1. Wider band System:
(a) It is a system that allows wider adjustment in the fixed exchange rate system.
(b) It allows adjustment upto 10% around the “parity” between any two currencies in the internationahmoney market.
(c) For example, if one US dollar is fixed as equal to fifty Indian rupees, 10% revision (upward or downward) is to be allowed in this exchange rate of 1: 50. Exchange rate may be revised as,
1: 60 + 10% = 1: 66 or as 1: 60 – 10% = 1 : 54
2. Crawling peg system:
(a) It allows “small” but regular adjustments in the exchange rate for different currencies.
(b) Not more than (+) 1% adjustment is allowed at a time. Indeed, it is a small adjustment.
(c) But it can crawl, i.e., it can be repeated at regular intervals.
Some Important Terms
1. Nominal exchange rate (NER): The number of units of domestic currency required to purchase a unit of foreign currency is called nominal exchange rate. Thus, $1 = Rs. 60. It may move to $1 = Rs. 65, and so on.
2. Nominal effective exchange rate (NEER):
(a) The concept is useful for an aggregative analysis. A nation has to deal with a number of countries, and hence a number of currencies.
(b) For example, during a period Indian rupee may be losing value against the American dollar, but it may be gaining value against Euro.
(c) Therefore, we would be interested in knowing what is happening in aggregate to our rupee i.e., is it gaining or losing.
(d) For this purpose, we prepare a basket of all the currencies which we are interested in, and find out the average of the changes in these currencies in a given period. This gives us the nominal effective exchange rate (NEER).
(e) So, finally NEER is the measure of average relative strength of a given currency with respect to other currencies without eliminating the effect of change in price.
3. Real exchange rate (RER): RER is the exchange rate which is calculated after eliminating the effects of price change. Therefore, RER is based on constant prices.
4. Real effective exchange rate (REER): REER is the measure of average relative strength of a given currency with respect to other currencies after eliminating the effects of price change.
5. Parity value: In the context of exchange rate in foreign exchange market, parity value refers to the value of one currency in terms of the other for a given basket of goods and services. If a U.S. dollar buys 50 times the goods and services in India, compared to a rupee, the parity value of a US dollar should be 50 : 1. Accordingly, the exchange rate between rupee and a US dollar ought to be Rs. 50 : 1$. Any change in the parity value would imply a corresponding change in exchange rate.
Words that Matter
1. Foreign exchange: It refers to all the currencies of the rest of the world other than the domestic currency of the country. For example, in India, US dollar is the foreign exchange.
2. Foreign Exchange Rate: The rate at which one currency is exchanged for another is called Foreign Exchange Rate.
3. Foreign exchange market: It is the market where the national currencies are converted, exchanged or traded for one another.
4. Hedging function: Hedging function pertains to protecting against foreign exchange risks, where Hedging is an activity which is designed to minimize the risk of loss.
5. Fixed exchange rate system: The system of exchange rate in which exchange rate is officially declared and fixed by the government is called fixed exchange rate system.
6. Pegging: When domestic currency is tied to the value of foreign currency, it is known as pegging.
7. Pegging operations: It refers to all efforts made by the central government to keep the rate of exchange stable.
8. Venture capital: Venture capital in the international money market refers to investments in the purchase of foreign exchange in the international money market with a view to earn profits.
9. Devaluation: It refers to decrease in the value of domestic currency in terms of foreign currency by the government. It is a part of fixed exchange rate.
10. Revaluation: It refers to increase in the value of domestic currency by the central government. It is a part of fixed exchange rate.
11. Flexible Exchange Rate: The system of exchange rate in which value of a currency is allowed to float freely as determined by demand for and supply of foreign exchange is called flexible exchange rate system.
12. Currency depreciation: It refers to decrease in the value of domestic currency in terms of foreign currency. It makes the domestic currency less valuable and more of it is required to buy a foreign currency. It is a part of flexible exchange rate.
13. Currency appreciation: It refers to increase in the value of domestic currency in terms of foreign currency. The domestic currency becomes more valuable and less of it is required to buy a foreign currency. It is a part of flexible exchange rate.
14. Managed floating exchange rate: It is a mixture of a flexible exchange rate (the float part) and a fixed exchange rate) the Managed part).
15.Spot Rate: If the operation is of daily nature, it is called spot market or current market.
16. Forward Rate: A market for foreign exchange for future delivery is known as forward market.
17. Nominal Exchange Rate (NER): The number of units of domestic currency required to purchase a unit of foreign currency is called nominal exchange rate.
18. Nominal Effective Exchange Rate (NEER): It is the measure of average relative strength of a given currency with respect to other currencies without eliminating the effect of change in price.
19. Real Exchange Rate (RER): It is the exchange rate which is calculated after eliminating the effects of price change. Therefore, RER is based on constant prices.
20. Real Effective Exchange Rate (REER): It is the measure of average relative strength of a given currency with respect to other currencies after eliminating the effects of price changes.
21. Parity value: It refers to the value of one currency in terms of the other for a given basket of goods and services.-
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NCERT TEXTBOOK QUESTIONS SOLVED

Question 1. How is exchange rate determined under a flexible exchange rate regime? [6 Marks]
Or
How is foreign exchange rate determined? Explain with diagram.
Or [AI 2004; CBSE 06 q How is exchange rate determined in a foreign exchange market? Explain.[AI 2013 (Set 1)]
Answer:

Exchange rate in a free exchange market is determined at a point, where demand for foreign exchange is equal to the supply of foreign exchange.
Let us assume that there are two countries – India and U.S.A – and the exchange rate of their currencies i.e., rupee and dollar is to be determined.
Presently, there is floating or flexible exchange regime in both India and U.S.A. Therefore, the value of currency of each country in terms of the other currency depends upon the demand for and supply of their currencies.
In the above diagram, the price on the vertical axis is stated in terms of domestic currency (that is, how many rupees for one US dollar). The horizontal axis measures the quantity demanded or supplied.
In the above diagram, the demand curve [D$] is downward sloping. This means that less foreign exchange is demanded as the exchange rate increases. This is due to the fact that the rise in price of foreign exchange increases the rupee cost of foreign goods, which make them more expensive. As a result, imports decline. Thus, the demand for foreign exchange also decreases.
The supply curve [S$] is upward sloping which means that supply of foreign exchange increases as the exchange rate increases. This makes home country’s goods become cheaper to foreigners since rupee is depreciating in value. The demand for our exports should therefore increase as the exchange rate increases. The increased demand for our exports translates into greater supply of foreign exchange. Thus, the supply of foreign exchange increases as the exchange rate increases.
The intersection of the supply and demand curves determine equilibrium exchange rate (OP$) and equilibrium quantity [OQ$] of foreign currency i.e., US [$].

Question 2. Differentiate between devaluation and depreciation. [3 Marks]
Answer:
ncert-solutions-class-12-macro-economics-foreign-exchange-rate-2

ncert-solutions-class-12-macro-economics-foreign-exchange-rate-2

ncert-solutions-class-12-macro-economics-foreign-exchange-rate-3

Question 3. Are the concepts of demand for domestic goods and domestic demand for goods the same? [3 Marks]
Answer:

Demand for domestic goods and domestic demand for goods are two different concepts.
Demand for domestic goods is a demand for goods made by both domestic and foreign countries.
Domestic demand for goods is a demand for goods by our own country for goods ..which may be produced in foreign countries.

Question 4. Would the central bank need tointervene in a managed floating system? Explain why? [3 Marks]
Answer:

In a managed floating system a central bank of a country has freedom to bring change in the exchange rate within certain limits.
A country is allowed after information to the IMF to bring a certain limited amount of change in the rate of exchange.
A central bank cannot bring change in its exchange rate by more than 10%. For it, permission of IMF is necessary.

Class 12 Macroeconomics Chapter-8 Government Budget and the Economy

Class 12 Macroeconomics

Chapter-8

Government Budget and the Economy

Introduction
This is a descriptive chapter on government budget of Indian economy, wherein its objectives, importance, types, components, budget deficits and its types (Revenue, Fiscal, Primary Deficit) and their implications are studied.
Chapter at a Glance
Government Budget And Its Related Concepts
1. A government budget is an annual financial statement showing item wise estimates of
expected revenue and anticipated expenditure during a fiscal year.
2. Budget has two parts:
(a) Receipts; and (b) Expenditure.
3. Objectives of budget:
(a) Activities to secure a reallocation of resources:
(i) Private enterprises always desire to allocate resources to those areas of production where profits are high.
(ii) However, it is possible that such areas of production (like production of alcohol) may not promote social welfare.
(iii) Through its budgetary policy the government of a country directs the allocation of resources in a manner such that there is a balance between the goals of profit maximisation and social welfare.
(iv) Production of goods which are injurious to health (like cigarettes and whisky) is discouraged through heavy taxation.
(v) On the other hand, production of “socially useful goods” (like electricity, ‘Khadi’) is encouraged through subsidies.
(vi) So, finally government has to reallocate resources in accordance to social and economic considerations in case the free market fails to do or does so inefficiently.
(b) Redistributive activities:
(i) Budget of a government shows its comprehensive exercise on the taxation and subsidies.
(ii) A government uses fiscal instruments of taxation and subsidies with a view of improving the distribution of income and wealth in the economy.
(iii) A government reduces the inequality in the distribution of income and wealth by imposing taxes on the rich and giving subsidies to the poor, or spending more on welfare of the poor.
(iv) It reduces income of the rich and raises the living standard of the poor, thus, leads to equitable distribution of income.
(v) Expenditure on special anti poverty and employment schemes will be increased to bring more people above poverty line.
(vi) Public distribution system should be inferred so that only the poor could get foodgrains and other essential items at subsidised prices.
(vii) So finally, Equitable distribution of income and wealth is a sign of social justice which is the principal objective of any welfare state in India.
(c) Stabilising activities:
(i) Free play of market forces (or the forces of supply and demand) are bound to generate trade cycles, also called business cycles.
(ii) These refer to the phases of recession, depression, recovery and boom in the economy. (Hi) The government of a country is always committed to save the economy from
business cycles. Budget is used as an important policy instrument to combat(solve) the situations of deflation and inflation.
(iv) By doing it the government tries to achieve the state of economic stability.
(v) Economic stability leads to more investment and increases the rate of growth and development.
(d) Management of public enterprises:
(i) A government undertakes commercial activities that are of the nature of natural monopolies; and which are established and managed for social welfare of the public.
(ii) A natural monopoly is a situation where there are economies of scale over a large range of output.
(iii) Industries which are potential natural monopolies are railways etc.
4. Importance of a budget:
(a) Today every country aims at its economic growth to improve living standard of its people. Besides, there are many other problems such as poverty, unemployment, inequalities in incomes and wealth etc. Government strives hard to solve these problems through budgetary measures.
(b) The budget shows the fiscal policy. Itemwise estimates of expenditure discloses how much and on what items, the government is going to spend. Similarly, itemwise details of government receipts indicate the sources from where the government intends to get money to finance the expenditure.
In this way budget is the most important instrument in hands of governments to achieve their objectives and there lies the importance of the government budget. Note: Fiscal year is the year in which country’s budgets are prepared. Its duration is from 1st April to 31st March.
5. Types of budget: It may be of two types:
(a) Balanced Budget (b) Unbalanced Budget
Let us discuss them in detail:
(a) Balanced Budget: If the government revenue is just equal to the government expenditure made by the general government, then it is known as balanced budget.
government-budget-economy-cbse-notes-class-12-macro-economics-1

(b) Unbalanced Budget: If the government expenditure is either more or less than a government receipts, the budget is known as Unbalanced budget.
It may be of two types:
(i) Surplus budget (ii) Deficit budget
Let us discuss them in detail:
(i) Surplus Budget: If the revenue received by the general government is more in comparison to expenditure, it is known as surplus budget.
In other words, surplus budget implies a situation where government income is in excess of government expenditure.
government-budget-economy-cbse-notes-class-12-macro-economics-2

(ii) Deficit Budget: If the expenditure made by the general government is more than the revenue received, then it is known as deficit budget.
In other words, in deficit budget, government expenditure is in excess of government income.
government-budget-economy-cbse-notes-class-12-macro-economics-3

Components Of Government Budget, Budget Receipts Its Types
1. Components of a government budget: Government budget, comprises of two parts—
(a) Revenue Budget and (b) Capital Budget.
(a) Revenue Budget: Revenue Budget contains both types of the revenue receipts of the government, i.e., Tax revenue and Non tax revenue ; and the Revenue expenditure.
(i) Revenue Receipts: These are the receipts that neither create any liability nor reduction in assets of the government. It includes tax revenues like income tax, corporation tax and non-tax revenue like fines and penalties, special assessment, escheat etc.
(ii) Revenue Expenditure: An expenditure that neither creates any assets nor cause reduction of liability is called revenue expenditure.
(b) Capital Budget: Capital budget contains capital receipts and capital expenditure of the government.
(i) Capital Receipts: Government receipts that either creates liabilities (of payment of loan) or reduce assets (on disinvestment) are called capital receipts. Capital receipts include items, which are non-repetitive and non-routine in nature.
(ii) Capital Expenditure: This expenditure of the government either creates physical or financial assets or reduction of its liability. Acquisition of assets like land, machinery, equipment, its loans and advances to state governments etc. are its examples.
2. Budget receipts (government receipt): Budget receipt refers to the estimated receipts of the government from various sources during a fiscal year. It shows the sources from where the government intends to get money to finance the expenditure. Budget receipts are of two types:
government-budget-economy-cbse-notes-class-12-macro-economics-4

government-budget-economy-cbse-notes-class-12-macro-economics-4

(a) Revenue receipts
(i) Meaning:
• Government receipts, which
-> Neither create any liabilities for the government; and
-> Nor cause any reduction in assets of the government, are called revenue receipts.
In revenue receipts both the conditions should be satisfied.
• Revenue receipts include items which are Repetitive and routine in nature.
(ii) Revenue receipts are further classified into:
• Tax Revenue:
-> Tax revenue refers to receipts from all kinds of taxes such as income tax, corporate tax, excise duty etc.
-> A tax is a legally compulsory payment imposed by the government on income and profit of persons and companies without reference to any benefit. Taxes are of two types: Direct taxes and Indirect taxes.
• Non-Tax Revenue:
-> Non-tax revenue refers to government revenue from all sources other than taxes.
-> These are incomes, which the government gets by way of sale of goods and services rendered by different government departments.
-> Components of Non-Tax Revenue:
♦ Commercial Revenue (Profit and interest):
♦ It is the revenue received by the government by selling the goods and services produced by the government agencies.
♦ For example, profit of public sector undertakings like Railways, BHEL, LIC etc.
♦ Government gives loan to State Government, union territories, private enterprises and to general public and earns interest receipts from these loans.
♦ It also includes interest and dividends on investments made by the government.
♦ Administrative Revenue: The revenue that arises on account of the administrative function of the government. This includes:
♦ Fee: Fee refers to a payment made to the government for the services that it renders to the citizens. Such services are generally in public interest and fees are paid by those, who receive such services. For example, passport fees, court fees, school fees in government schools.
♦ License Fee: License fee is a payment to grant a permission by a government authority. For example, registration fee for an automobile.
♦ Fines and penalties for an infringement of a law, i.e., they are imposed on law breakers.
♦ Special Assessment: Sometimes government undertakes developmental activities by which value of nearby property appreciates, which leads to increase in wealth. So, it is the payment made by owners of those properties whose value has appreciated. For example, if value of a property near a metro station has increased, then a part of developmental expenditure made by government is recovered from owners of such property. This is the value of special assessment.
♦ Forfeitures are in the form of penalties imposed by courts that a person needs to pay in the court of law for failing to comply with court orders.
♦ Escheat refers to the claim of the government on the property of a person who dies without having any legal heir or without leaving a will.
♦ External grants: Government receives financial help in the form of grants, gifts from foreign governments and international organisations (IMF, World Bank). Such grants and gifts are received during national crisis such as earthquakes, flood, war etc.
(b) Capital receipts:
(i) Meaning:
• Government receipts, that either creates liabilities (of payment of loan) or reduce assets (on disinvestment) are called capital receipts.
In capital receipts any one of the conditions must be satisfied.
• Capital receipts include items which are non-repetitive and non-routine in nature,
(ii) Components:
• Borrowing (Domestic and External): Borrowings are made to meet the financial requirement of the country. A government may borrow money:
-> Domestically: General Public (By issuing government bonds in the open market). Reserve Bank of India.
-> Externally: Rest of the world (foreign government and international institutions)
• Recovery of Loans and Advances: Loans offered to others are assets of the government. It includes recovery of loans granted by the central government to state and union territory governments. It is a capital receipt because it reduces financial assets of the government. For example, The Government of India may give Rs. 1000 crore as a loan to The Government of Delhi. Here the value of asset is Rs. 1000 crore. When The Government of Delhi repaid Rs. 100 crore, the value of The Government of India assets reduces to Rs. 900 crore. Since, recovery of loan reduces the value of assets, it is termed as a capital receipts.
• Disinvestment: A government raises funds from disinvestment also. Disinvestment means selling whole or a part of the shares (i.e., equity) of selected public sector enterprises held by government. As a result, government assets are reduced.
Types Of Taxes:
1. Direct Taxes: When (a) liability to pay a tax (Impact of Tax), and (b) the burden of that tax (Incidence of tax), falls on the same person, it is termed as direct tax. A direct tax is paid directly by the same person on whom it has been levied. It means a tax in which impact and incidence of tax falls on the same persons, then it is termed as direct tax. In other words, burden of a direct tax is borne by the person on whom it is imposed which means the burden cannot be shifted to others. Alternatively, the person from whom the tax is collected is also the person who bears the ultimate burden of the tax. Income tax and corporate (profit) tax are most appropriate examples of direct tax.
2. Indirect Tax: When (a) liability to pay a tax (Impact of tax) is on one person; and
(b) the burden of that tax (Incidence of tax), falls on the other person, it is termed as indirect tax. It means a tax in which impact and incidence of tax lie on two different persons, then it is termed as indirect tax. In other words, indirect taxes are the taxes of whose burden can be shifted to others. In case of an indirect tax, person first pays the tax but he is able to transfer the burden of the tax to others. For instance, sales tax is an indirect tax because indirect tax is collected by government from the seller of the commodity who in turn realizes the tax amount from the buyer by including it in the price of the commodity. Other examples of indirect taxes are excise duty, custom duty, entertainment tax, service tax etc.
3. Progressive Tax: A tax the rate of which increases with the increase in income and decreases with the fall in income is called a progressive tax. The higher is the income of a taxpayer, the higher is proportionate tax he pays. For example, in India income tax is considered a progressive tax because its rate goes on increasing with the increase in annual income. For example, presently (2012-2013) there is no tax up to annual income of Rs. 2,00,000 but the.rate of income tax increases with the increase in incomes. It is 10% on incomes between Rs. 2,00,000 and Rs. 5,00,000; 20% on incomes between Rs. 5,00,000 and Rs.10,00,000 and 30% on incomes above Rs. 10,00,000.
4. Proportional Taxation: A tax is called proportional when the rate of taxation remains constant as the income of the taxpayer increases.
Example: If tax rate is 10% and the annual income of a person is Rs. 2,00,000, then he will have to pay Rs. 20,000 per year as tax. If income rises to Rs. 3,00,000 per annum, then the tax liability will rise to Rs. 30,000 per year. In this case, burden of tax is more on the poor section as compared to rich section.
5. Regressive Tax: In a regressive tax system, the rate of tax falls as the tax base increases.
government-budget-economy-cbse-notes-class-12-macro-economics-5

government-budget-economy-cbse-notes-class-12-macro-economics-5

In this case, we find that (a) the amount of tax to be paid increases, and (b) the rate at which tax is to be paid falls.
Budget Expenditure & Its Related Concepts
1. Meaning: Budget expenditure refers to the estimated expenditure of the government on its “development and non-development programmes or “plan and non-plan programmes during the fiscal year.
2. Types:
(a) Plan and non-plan expenditure
(b) Revenue and capital expenditure
(c) Developmental and non-developmental Expenditure
government-budget-economy-cbse-notes-class-12-macro-economics-6

government-budget-economy-cbse-notes-class-12-macro-economics-6

(a) Plan and non-plan expenditure:
(i) Plan Expenditure: Plan expenditure refers to that expenditure which is incurred by the government to fulfill its planned development programmes. This includes both consumption and investment expenditure by the government or Planning Commission of a country. Expenditure on agriculture, industry, public utilities, health and education etc. are examples of plan expenditure.
(ii) Non-Plan Expenditure: This refers to all such government expenditures which are beyond the scope of its planned development programmes. For instance, no government can escape from its basic function of protecting the lives and properties of the people. For this government has to spend on police, judiciary, military etc. In short, expenditure other than expenditure related to current Five-year plan is treated as non-plan expenditure.
(b) Revenue and capital expenditure:
(i) Revenue Expenditure: An expenditure that (a) Neither creates any assets (b) nor causes any reduction of liability.
In revenue expenditure both the conditions should be satisfied.
Examples of revenue expenditure are: salaries of government employees, interest : payment on loans taken by the government, pensions etc.
(ii) Capital Expenditure: An expenditure that either create assets for the government [equity or shares) of the domestic, or multinational corporations purchased by the government), or cause reduction in liabilities of the government, [repayment of loans reduces liability of the government).
In capital expenditure any one of the above conditions must be satisfied.
Thus, it refers to expenditure that leads to creation of assets and reduction in liabilities. Such expenditure is incurred on long period development.
Conclusion: A basic difference between capital expenditure and revenue expenditure is that the capital expenditure is incurred on creation or acquisition of assets, whereas, the revenue expenditure is incurred on rendering services.
For example: Expenditure on construction of a hospital building is capital expenditure, but expenditure on medicines, salaries of doctors etc. for rendering services by the hospital is revenue expenditure.
(c) Developmental and non-developmental Expenditure:
(i) Developmental Expenditure: Developmental expenditure is the expenditure on activities which are directly related to economic and social development of the country. This includes expenditure on education, health, agriculture, transport, roads, rural development etc. This also includes loans given by the government to enterprises like Sahara for the purpose of development.
(ii) Non-developmental Expenditure: Non-developmental expenditure of the
government is the expenditure on the essential general services of the government. This includes expenditure on defence, payment of old age pension, collection of taxes, interest on loans, subsidies etc.
Deficits And Implications Of These Deficits
1. Budget deficit:
(a) Meaning:
(i) Budgetary deficit refers to the excess of total budgeted expenditure (both revenue expenditure and capital expenditure) over total budgetary receipts (both revenue receipt and capital receipt).
(ii) In other words, when sum of revenue receipts and capital receipts fall short of the sum of revenue expenditure and capital expenditure, budgetary deficit is said to occur. Symbolically,
Budgetary Deficit = Total Expenditure – Total Receipts
(b) Types:
(i) Revenue deficit, (ii) Fiscal deficit and (iii) Primary deficit
2. Revenue deficit:
(a) Meaning:
(i) Revenue deficit refers to the excess of revenue expenditure of the government over its revenue receipts. Symbolically,
Revenue Deficit = Total Revenue Expenditure – Total Revenue Receipts
(ii) The government of India budget for the year 2012-2013, total expenditure is Rs. 12,42,263 crore against total revenue receipts of Rs. 8,78,804 crore. As a result there is revenue deficit of Rs. 3,63,459 (12,42,263-8,78,804) crore, which is 3.6% of GDP.
(b) Implications of revenue deficit:
(i) Revenue deficit indicates dis-savings on government account because the government has to make up uncovered gap.
(ii) Revenue deficit implies that the government has to cover this uncovered gap by drawing upon capital receipts either through borrowing or through sale of its assets.
(iii) Since government is using capital receipts to generally meet consumption expenditure of the government, it leads to an inflationary situation in the economy.
(c) Measures to reduce revenue deficit are:
(i) Government should reduce its unproductive or unnecessary expenditure.
(ii) Government should increase its receipts from various sources of tax and non-tax revenue.
3. Fiscal deficit:
(a) Meaning:
(i) Fiscal deficit is defined as excess of total expenditure over total receipts (revenue and capital receipts) excluding borrowing. In the form of an equation:
government-budget-economy-cbse-notes-class-12-macro-economics-7

government-budget-economy-cbse-notes-class-12-macro-economics-7

(ii) Fiscal deficit is a measure of total borrowings required by the government.
(iii) Fiscal deficit indicates capacity of a country to borrow in relation to what it produces. In other words, it shows the extent of government dependence on borrowing to meet its budget expenditure.
(iv) Another point to be noted here is that as the government borrowing increases, its liability in future to repay loan with interest also increases leading to a higher revenue deficit. Therefore, fiscal deficit should be as low as possible.
(v) Fiscal deficit for the year 2012-2013 is 4,89,890 crore which is 4.9% of GDP.
(b) Implications of fiscal deficit:
(i) Causes Inflation: An important component of government borrowing includes borrowing from the Reserve Bank of India. This invariably implies deficit financing or meeting deficit requirements of the government by way of printing more currency. This is a dangerous practice, though very convenient for the government. It increases circulation of money and causes inflation.
(ii) Increase in Foreign Dependence: Government also borrows from rest of the world. It increases our dependence on other countries. Foreign borrowing is often associated with economic and political interference by the lender countries. It increases our economic slavery.
(iii) Financial Burden for Future Generation: Borrowing implies accumulation of financial burdens for the future generations. It is for future generations to repay loans as well as the mounting interest thereon.
(iv) Deficits Multiply Borrowings: Payment of interest increases revenue expenditure of the government, causing an increase in its revenue deficit. Thus, a vicious circle is set wherein the government takes more loans to repay earlier loans, which is called Debt Trap.
4. Primary deficit:
(a) Meaning:
(i) Primary deficit is defined as fiscal deficit minus interest payments.
Primary Deficit = Fiscal Deficit – Interest Payments
(ii) The government of India budget for the year 2012-2013, fiscal deficit is 4,89,890 crore and Interest Payment is 3,11,996 crore. As a result, primary deficit is 1,77,894 crore, which is 1.8% of GDP.
(b) Implications of primary deficit: While fiscal deficit shows borrowing requirement of the government for financing the expenditure inclusive of interest payments, primary deficit reflects the borrowing requirements of the government for meeting expenditures other than interest payments on earlier loans.
Words that Matter
1. Government Budget: A government budget is an annual financial statement showing itemwise estimates of expected revenue and anticipated expenditure during a fiscal year.
2. Balanced Budget: If the government revenue is just equal to the government expenditure made by the general government, then it is known as balanced budget.
3. Unbalanced budget: If the government expenditure is either more or less than a government receipts, the budget is known as Unbalanced budget.
4. Surplus Budget: If the revenue received by the general government is more in comparison to expenditure, it is known as surplus budget.
5. Deficit Budget: If the expenditure made by the general government is more than the revenue received, then it is known as deficit budget.
6. Budget receipt: It refers to the estimated receipts of the government from various sources during a fiscal year.
7. Budget expenditure: It refers to the estimated expenditure of the government on its “development and non-development programmes or “plan and non-plan programmes during the fiscal year.
8. Revenue Budget: Revenue Budget contains both types of the revenue receipts of the government, i.e., Tax revenue and Non tax revenue ; and the Revenue expenditure.
9. Revenue Receipts: Government receipts, which
(a) Neither create any liabilities for the government; and
(b) Nor cause any reduction in assets of the government, are called revenue receipts.
10. Tax Revenue: Tax revenue refers to receipts from all kinds of taxes such as income tax, corporate tax, excise duty etc.
11. Tax: A tax is a legally compulsory payment imposed by the government on income and
profit of persons and companies without reference to any benefit.
12. Non-tax revenue: It refers to government revenue from all sources other than taxes called non-tax revenue.
13. Revenue Expenditure: An expenditure that (a) Neither creates any assets (b) nor causes any reduction of liability.
14. Capital Budget: Capital budget contains capital receipts and capital expenditure of the government.
15. Capital Receipts: Government receipts that either creates liabilities (of payment of loan) or reduce assets (on disinvestment) are called capital receipts.
16. Capital Expenditure: Government expenditure of the government which either creates physical or financial assets or reduction of its liability.
17. Direct Tax: When (a) liability to pay a tax (Impact of Tax), and (b) the burden of that tax (Incidence of tax), falls on the same person, it is termed as direct tax.
18. Indirect Tax: When (a) liability to pay a tax (Impact of tax) is on one person; and (b) the burden of that tax (Incidence of tax), falls on the other person, it is termed as indirect tax.
19. Progressive Tax: A tax the rate of which increases with the increase in income and decreases with the fall in income is called a progressive tax.
20. Proportional Taxation: A tax is called proportional when the rate of taxation remains constant as the income of the taxpayer increases.
21. Regressive Tax: In a regressive tax system, the rate of tax falls as the tax base increases.
22. Plan expenditure: It refers to that expenditure which is incurred by the government to fulfill its planned development programmes.
23. Non-Plan Expenditure: This refers to all such government expenditures which are beyond the scope of its planned development programmes.
24. Developmental Expenditure: Developmental expenditure is the expenditure on activities which are directly related to economic and social development of the country.
25. Non-developmental expenditure: Non-developmental expenditure of the government is the expenditure on the essential general services of the government.
26. Budgetary deficit: It refers to the excess of total budgeted expenditure (both revenue
expenditure and capital expenditure) over total budgetary receipts (both revenue receipt and capital receipt).
27. Revenue Deficit: Revenue deficit refers to the excess of revenue expenditure of the government over its revenue receipts.
28. Fiscal deficit: It is defined as excess of total expenditure over total receipts (revenue and capital receipts) excluding borrowing. Fiscal deficit indicates capacity of a country to borrow in relation to what it produces. In other words, it shows the extent of government dependence on borrowing to meet its budget expenditure.
29. Debt Trap: A vicious circle set wherein the government takes more loans to repay earlier loans, which is called Debt Trap.
30. Primary deficit: It is defined as fiscal deficit minus interest payments.
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NCERT TEXTBOOK QUESTIONS SOLVED

Question 1. Explain why public goods must be provided by the government? [3-4 Marks]
Answer:

Public goods are those goods and services for which consumption by some individuals does not reduce the amount available to others.
For example parks,roads,water,bridges,national defense etc..
these goods are non-rival and non-excludable ones.
people receives benefits from public goods but do not pay for them.Such a goods can only prepared by government.

Question 2. Distinguish between revenvu expenditure and capital expenditure .
State the basis of classifying government expenditure into revenue and capital expenditure. Give an example of each.
Answer:
ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-1

ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-1

Question 3. The fiscal deficit gives the borrowing requirement of the government Elucidate. [3-4 Marks]
Answer:

Fiscal deficit is defined as excess of total expenditure over total receipts (revenue and capital receipts) excluding borrowing. In the form of an equation:
Fiscal Deficit = Total Budget Expenditure – Total Budget Receipts (Net of borrowing)
= Total Expenditure (Revenue
Expenditure + Capital Expenditure) – Revenue Receipts (Tax Revenue + Non-Tax Revenue) – Non-Debt Capital Receipts (Recovery of Loans + Dis-investment Proceeds)
= Revenue Deficit + Capital Deficit (excluding Borrowing)- Borrowing
= Net borrowing at home + Borrowing from RBI + Borrowing from abroad
Fiscal deficit shows total borrowing requirements of the government from all sources.
As the government borrowing increases, its liability in future to repay loan with interest also increases leading to a higher revenue deficit. Therefore, fiscal deficit should be as low as possible.

Question 4. Give the relationship between revenue deficit and fiscal deficit. [3-4 Marks]
Answer:

Fiscal deficit is always a wider concept than revenue deficit.
Revenue deficit is defined as the excess of government’s revenue expenditure over revenue receipts. In terms of formula:
Revenue Deficit = Revenue Expenditures (RE) – Revenue Receipts (RR)
In short, there will be revenue deficit in a government budget when revenue expenditure exceeds revenue receipts.
Fiscal deficit is defined as the excess for all expenditure over total receipts net of borrowings.
Initially, Fiscal deficit does not take into account all types of receipts. It does not take into account borrowings. But finally they have to depend on borrowing to met fiscal deficit.
Fiscal Deficit = Revenue Deficit + Capital Deficit (Excluding Borrowing)- Borrowing
= Net borrowing at home + Borrowing from RBI + Borrowing from abroad

Question 5. Does public (government) debt impose a burden? Explain. [3-4 Marks]
Answer: Public debt is not always a blessing. Excessive use of it creates a lot of crisis in an economy; such as,

Hampers Economic Development of a Country: Loans are easily borrowed but it is very difficult to repay them.Generally, government imposes more taxes. It brings instability and is an obstacle in the economic development of a country.
Poses Threat to Political Freedom: Foreign loans and assistance lead to deep conflict among countries. The friction among countries challenges the political freedom.
Proves a Burden on Common Man: Loans taken for unproductive purposes, like war and armaments, are a burden on common man in the form of higher taxes.
Leads to Extravagant Spending: Public debt leads to unplanned spending. This provides incentive to the government to implement the schemes that require excessive expenditure.
Results in Drain of National Wealth: Repayment of foreign loans results in drain of wealth out of the country.

Question 6. Are fiscal deficits necessarily inflationary? [3-4 Marks]
Or
“Governments across nations are too much worried about the term fiscal deficit”. Do you think that fiscal deficit is necessarily inflationary in nature? Support your answer with valid reasons.
Answer:

Fiscal deficits are not necessarily inflationary.
As we know fiscal deficit shows borrowing requirement of the government.
If we borrow when there is a situation of underemployment in an economy i.e., in a situation of deficient demand, then it is not inflationary because in a situation of deficient demand output is held back because of lack of demand.
A high fiscal deficit (borrowing) is accompanied by higher demand and greater output which is not inflationary.
On the other hand, if we borrow at the full employment level, then it is inflationary in nature.
A high fiscal deficit (borrowing) is accompanied by higher prices because aggregate demand is greater than aggregate supply at the full employment level which is always inflationary.

Question 7. Discuss the issue of deficit reduction.[3-4 Marks]
Answer: The deficit in a government budget can be reduced by the following steps:

Taxes should be increased. Government can make a plan for rising direct taxes to increase its receipts can also be raised by increasing rates of taxes or by imposing new taxes.
Reduction in Government Expenditures: It can be done through making government activities more efficient through better planning of programmes and better administration.
The government can raise Receipts through the sale of shares in PSUs (Public Sector Undertaking).
Changing the scope and role of government by withdrawing from same areas where it operated before.

MORE QUESTIONS SOLVED

I. Very Short Answer Type Questions (1 Mark)
Question 1. Define government budget.
Answer: A government budget is an annual financial statement showing itemwise estimates of expected revenue and anticipated expenditure during a fiscal year.
Question 2. State any one obj ective of a government budget.
Answer: Activities to secure a reallocation of resources
Question 3. Define a tax.
Answer: A tax is a legally compulsory payment imposed by the government on income and profit of persons and companies without reference to any benefit. Tax is of two types: Direct tax and Indirect tax.
Question 4. Why is service tax an indirect tax?
Answer: Its impact and incidence lie on different persons.
Question 5. State any two sources of non-tax revenue receipts.
Answer:

Commercial revenue (profit and interest)
Administrative revenueffees, fines and penalties, escheats etc)

Question 6. Is borrowing by the government a revenue receipt?
Answer: No, it is not so because it creates a liability (for the government) of repayment.
Question 7. Why is tax not a capital receipt?
Answer: Tax is not a capital receipt because it leads neither to creation of liability nor to reduction in assets.
Question 8. Why is interest termed as a revenue receipt?
Answer: Interest is a revenue receipt because it creates neither any liability nor causes a reduction in the assets of the government.
Question 9. Why are borrowings a capital receipt?
Answer: They create a liability (in terms of repayment).
Question 10. Why are subsidies treated as revenue expenditure?
Answer: Subsidies are treated as revenue expenditure because they create neither any asset nor cause a reduction in any liability of the government.
Question 11. Why is repayment of loan a capital expenditure?
Answer: It reduces the liabilities of the government.
Question 12. Why is recovery of loans treated as a capital receipt?[CBSE All India 2005]
Answer: Recovery of loans is treated as a capital receipt because it reduces assets of the government.
Question 13. Why are receipts from taxes categorised as revenue receipts?
Answer: Receipts from taxes are categorised as revenue receipts because they create neither any liability nor cause a reduction in the assets of the government.
Question 14. What is meant by revenue deficit?
Answer: Revenue deficit refers to the excess of revenue expenditure of the government over its revenue receipts. Revenue Deficit = Revenue Expenditure- Revenue Receipts
Question 15. If the revenue receipts are Rs. 1,000 crore and revenue expenditure is Rs. 1,200 crore, how much will be the revenue deficit?
Answer: Revenue Deficit = Revenue Expenditure – Revenue Receipts = 1,200 – 1,000 = Rs. 200 crore.
Question 16. Define fiscal deficit.
Answer: Fiscal deficit is defined as excess of total expenditure over total receipts (revenue and capital receipts) excluding borrowing.
Question 17. What is the meaning of primary deficit?
Answer: Primary deficit refers to the difference between fiscal deficit of the current year and interest payments on the previous borrowings.
Question 18. How is primary deficit calculated?
Answer: Primary Deficit = Fiscal Deficit – Interest Payments
Question 19. What does zero primary deficit mean?
Answer: If primary deficit is zero, fiscal deficit= interest payments. It means the government has to borrow only for its interest commitments on earlier loans.
II. Multiple Choice Questions (1 Mark)
Question 1. Budget is placed before:
(a) Lok Sabha
(b) Rajya Sabha
(c) Both Lok Sabha and Rajya Sabha
(d) Parliament
Answer: (c)
Question 2. Budget is a:
(a) Financial statement
(b) Monetary statement
(c) Political statement
(d) All of them
Answer: (a)
Question 3. Which article of the Constitution takes about the budget?
(a) Article 110 (b) Article 111
(c) Article 112 (d) Article 113
Answer: (c)
Question 4. One year period from 1 April to 31 March of next year is called a:
(a) Monetary year (b) Fiscal year
(c) Plan year (d) Tax year
Answer: (b)
Question 5. Capital receipts may come from:
(a) Market borrowings
(b) Provident funds
(c) Recoveries of loans
(d) All of them
Answer: (d)
Question 6. Find direct tax among the following taxes:
(a) Personal income tax
(b) Excise duty
(c) Sales tax
(d) Service tax
Answer: (a)
Question 7. Among the following types of taxes, find the indirect one.
(a) Gift tax
(b) Corporate income tax
(c) VAT
(d) Wealth tax
Answer: (c)
Question 8. If budgetary deficit is nil and borrowings and other liabilities are 70 crore, what is the amount of fiscal deficit?
(a) Nil (b) 30 crore
(c) Can’t say (d) 70 crore
Answer: (d)
Question 9. When the government tries to,meet the gap of public expenditure and public revenue through borrowing from the banking system, it is called
(a) deficit financing
(b) debt financing
(c) credit financing
(d) none of them
Answer: (a)
Question 10. ……….is the difference between
total receipts and total expenditure.
(a) Fiscal deficit
(b) Budget deficit
(c) Revenue deficit
(d) Capital deficit
Answer: (b)
Question 11. If borrowings and other liabilities are added to the budget deficit, we get
(a) revenue deficit
(b) capital deficit
(c) primary deficit
(d) fiscal deficit
Answer: (d)
Question 12. Payment of interest is _
(a) revenue expenditure.
(b) capital expenditure
(c) primary deficit.
(d) fiscal deficit
Answer: (a)
Question 13. If the total receipts are Rs.1000 crore and total expenditure is ?1500 crore, how much will be the budgetary deficit?
(a) 500 crore (b) 1500 crore
(c) 1000 crore (d) -500 crore
Answer: (a)
Question 14. A government shows a primary deficit of ?4400 crore. The revenue expenditure on interest payment is Rs.400
crore. How much is the fiscal deficit?
(a) 4000 crore (b) 4800 crore
(c) 4400 crore (d) -400 crore
Answer: (b)
Question 15. A government shows a primary deficit of Rs 10,000 crore. The revenue expenditure on interest payment is Rs 8000 crore. How much is the fiscal deficit?
(a) 18000 crore (b) 10000 crore
(c) 8000 crore (d)-8000 crore
Answer: (a)
Question 16. In a government budget, revenue deficit is Rs,50,000 crore and borrowings are Rs.75,000 crore. How much is the fiscal deficit?
(a) 50000 crore (b) 75000 crore (c) 25000 crore (d) -25000 crore
Answer: (b)
Question 17. Borrowing in government budget is: (Choose the correct alternative)[CBSE 2015]
(a) Revenue deficit
(b) Fiscal deficit
(c) Primary deficit
(d) Deficit in taxes
Answer: (b)
Question 18. The non – tax revenue in the following is: (Choose the correct alternative
(a) Export duty (b) Import duty (c) Dividends (d) Excise
Answer: (c)
Question 19. Primary deficit in a government budget is: (Choose the correct alternative)
(a) Revenue expenditure – Revenue receipts
(b) Total expenditure – Total receipts
(c) Revenue deficit – Interest payments
(d) Fiscal deficit – Interest payments
Answer: (d)
Question 20. Direct tax is called direct because it is collected directly from: (Choose the correct alternative)
(a) The producers on goods produced
(b) The sellers on goods sold
(c) The buyers of goods
(d) The income earners
Answer: (d)
Question 21. The government budget has a revenue deficit. This gets financed by:
(A) Borrowing
(B) Disinvestment
(C) Tax revenue
(D) Indirect taxes
(a) A and D (b) C and D
(c) A and B (d) C and D
Answer: (c)
Question 22. Which of the following statement is not true for fiscal deficit?
A fiscal deficit:
(a) represents the borrowing of the government.
(b) is the difference between total expenditure and total receipts of the government.
(c) is the difference between total expenditure and total receipts other than borrowing.
(d) increases the future liability of the government
Answer: (b)
Question 23. The government budget of a hypothetical economy presents the following information, which of the following value represents Budgetary Deficit, (all fig. in ? crores)
1. Revenue Expenditure = 25,000
2. Capital Receipts = 30,000
3. Capital Expenditure = 35,000
4. Revenue Receipts = 20,000
5. Interest Payments = 10,000
6. Borrowings = 20,000
(a) Rs. 12,000
(b) Rs. 10,000
(c) Rs. 20,000
(d) None of the above.
Answer: (b)
Question 24. Which of the following statement is true?
(a) Loans from IMF is a Revenue Receipt.
(b) Higher revenue deficit necessarily leads to higher fiscal deficit.
(c) Borrowing by a government represents a situation of fiscal deficit.
(d) Revenue deficit is the excess of capital receipts over the revenue receipts.
Answer: (c)
III. Short Answer Type Questions (3-4 Marks)
Question 1. Explain objective of stability of prices of government budget. [CBSE, (F) 2010] Or
Explain the ‘economic stability’ objective of a government budget. [CBSE, AI2011] Or
Explain stabilising activities function of budget.
Answer:

Free play of market forces (or the forces of supply and demand) are bound to generate trade cycles, also called business cycles.
These refer to the phases of recession, depression, recovery and boom in the economy.
The government of a country is always committed to save the economy from business cycles. Budget is used as an important policy instrument to combat(solve) the situations of deflation and inflation.
By doing it the government tries to achieve the state of economic stability.
Economic stability leads to more investment and increases the rate of growth and development.

Question 2. Name two sources each of non-tax revenue receipts. [CBSE 2004]
Answer: Non-tax revenue refers to government revenue from all sources other than taxes called non-tax revenue. These are incomes, which the government gets by way of sale of goods and services rendered by different government departments. Its two sources are:

Commercial Revenue (Profit and interest): It is the revenue received by the government by selling the goods and services produced by the government agencies. For example, profit of public sector undertakings like Railways, BHEL, LIC etc. Government gives loan to State Government, union territories, private enterprises and to general public and earns interest receipts from these loans. It also includes interest and dividends on investments made by the government.
Administrative Revenue: The revenue that arises on account of the administrative function of the government. This includes:
(i) Fee: Fee refers to a payment made to the government for the services that it renders to the citizens. Such services are generally in public interest and fees are paid by those, who receive such services. For example, passport fees, court fees, school fees in government schools,
(ii) License Fee: License fee is a payment to grant a permission by a government authority. For example, registration fee for an automobile.

Question 3. Distinguish between: Revenue receipts and capital receipts. [CBSE 2005, 10]
Or
Distinguish between ‘revenue receipt’ and ‘capital receipt’ and give two examples of each. [CBSE 2007]
Answer:
ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-2

ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-2

ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-3

Question 4. Distinguish between Direct tax and indirect tax.
Answer:
ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-4

ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-4

Question 5. Differentiate between Revenue Budget and Capital Budget.
Answer:
ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-5

ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-5

Question 6. Differentiate between Developmental and Non-Developmental Expenditure.
Answer:
ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-6

ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-6

Question 7. What are the implications of a large revenue deficit? Give two measures to reduce this deficit. [CBSE Sample Paper 2010]
Answer:

Revenue deficit indicates dis¬savings on government account because the government has to make up uncovered gap.
Revenue deficit implies that the government has to cover’this uncovered gap by drawing upon capital receipts either through borrowing or through sale of its assets.
Since government is using capital receipts to meet generally consumption expenditure of the government which leads to an inflationary situation in the economy.

Two measures to reduced revenue deficit are :

Government should reduce its unproductive or unnecessary expenditure.
Government should increase its receipts from various sources of tax and non-tax revenue.

Question 8. What are implications of fiscal deficit? [A/2005; CBSE 06C, 07]
Answer:

Causes Inflation: An important component of government borrowing includes borrowing from the Reserve Bank of India. This invariably implies deficit financing or meeting deficit requirements of the government by way of printing more notes. This is a dangerous practice, though very convenient for the government. It increases circulation of money and causes inflation.
Increase in Foreign Dependence:Government also borrows from rest of the world. It increases our dependence on other countries. Foreign borrowing is often associated with economic and political interference by the lender countries. It increases our economic slavery.
Financial Burden for Future Generation: Borrowing implies accumulation of financial burdens for the future generations. It is for future generations to repay loans as well as the mounting interest thereon.
Deficits Multiply Borrowings:Payments of interest increases revenue expenditure of the government, causing an increase in its revenue deficit. Thus, a vicious circle set wherein deficits multiply borrowings.

IV. True Or False
Are the following statements true or false? Give reasons.
Question 1. Government budget is a statement of actual receipts and payments of the government.
Answer: False.
Reason: It is a statement of “Estimated’ (and not actual) receipts and payments of the government.
Question 2. Rise in revenue deficit will always lead to higher fiscal deficit.
Answer: False.
Reason: Fiscal deficit leads to rise in revenue deficit.
Question 3. Service tax is a indirect tax as its impact and incidence is on the same individual.
Answer: False.
Reason: Its burden can be shifted to others.
Question 4. Direct tax are generally ‘Proportional’ in nature.
Answer: False.
Reason: Direct taxes are generally ‘progressive’ in nature.
Question 5. Primary deficit is the difference between capital deficit and interest payments.
Answer: False.
Reason: Primary deficit is the difference between fiscal deficit and interest payments.
Question 6. Non-debt capital receipts only includes disinvestment.
Answer: False.
Reason: It also includes the recovery of loan.
Question 7. Fiscal deficit is non-inflationary.
Answer: False.
Reason: Fiscal deficit can be inflationaiy when we are at full employment level.
It is so because large fiscal deficits creates excess money supply that creates inflation.
Question 8. Expenditure made on the development of a railway line is a capital expenditure.
Answer: True.
Reason: This expenditure creates an asset for the railway and government.
Note: As per CBSE guidelines, no marks will be given if reason to the answer is not explained.
Note: As per CBSE guidelines, no marks will be given if reason to the answer is not explained.
V. Long Answer Type Questions (6 Marks)
Question 1 . Explain the role the government can play through the budget in influencing allocation of resources. [CBSE 2015] OR .
Explain the ‘allocation of resources’ objective of government budget.[CBSE 2011] OR
Explain the allocation function of agovernment budget. [CBSE AI2010]OR
Explain how government can influence allocation of resources through government budget.
Answer:

Private enterprises always desire to allocate resources to those areas of production where profits are high.
However, it is possible that such areas of production (like production of alcohol) may not promote social welfare.
Through its budgetary policy the government of a country directs ‘ the allocation of resources in a manner such that there is a balance between the goals of profit maximisation and social welfare.
Production of goods which are injurious to health (like cigarettes and whisky) is discouraged through heavy taxation.
On the other hand, production of “socially useful goods” (like electricity, ‘Khadij is encouraged through subsidies.
So, finally government has to reallocate resources in accordance to social and economic considerations in case the free market fails to do or does so inefficiently.

Question 2. Explain how the government can use the budgetary policy in reducing inequalities of incomes. [AI 2015] OR
How can a government budget help in reducing inequalities of income? Explain. [CBSE 2009]OR
How can a government budget be helpful in altering distribution of income in an economy? Explain.[CBSE 2010] OR
Explain ‘redistribution of income’ objective of government budget. [CBSE2011, A/2011] OR
Reduction in income inequalities raises welfare of the people. How can government help, through government budget, in this regard? Explain? [A/2013, C (Set /)]
Answer:

Budget of a government shows its comprehensive exercise on the taxation and subsidies.
A government uses fiscal instruments of taxation and subsidies with a view of improving the distribution of income and wealth in the economy.
A government reduces the inequality in the distribution of income and wealth by imposing taxes on the rich and giving subsidies to the poor, or spending more on welfare of the poor.
It will reduce income of the rich and raises the living standard of the poor, thus, leads to equitable distribution of income.
Expenditure on special anti poverty and employment schemes will be increased to bring more people above poverty line.
Public distribution system should be inferred so that only the poor could get foodgrains and other essential items at subsidised prices.
Equitable distribution of income and wealth is a sign of social justice which is as the principal objective of any welfare state in India.

Categorize the following items into Revenue and Capital Receipts
Question 1. Statement—Loan from the Australian government. [CBSE Delhi 2006]
Answer: Capital receipt.
Reason: It creates liability for the government.
Question 2. Statement—Corporation tax. [CBSE Delhi 2006, Sample Paper 10] OR
Statement—Income tax received by government.
Answer:  Revenue receipt.
Reason: It creates neither any liability nor reduces any asset of the government.
Question 3. Statement—Grants received from International Monetary Fund
Answer: Revenue receipt.
Reason: It creates neither any liability nor reduces any asset of the government.
Question 4. Statement—Profits of public sector undertakings. [ CBSE Sample Paper 2010]
Answer: Revenue receipt.
Reason: It creates neither any liability nor reduces any asset of the government.
Question 5. Statement—Sale of a public sector undertaking. [CBSE Delhi 2006]OR
Statement—Receipts from sale of shares of a public sector undertaking. [CBSE Sample Paper 2010]
Answer: Capital receipt.
Reason: It reduces assets of the government.
Question 6. Statement—Foreign aid against earthquake victims.
Answer: Revenue receipt.
Reason: It creates neither any liability nor reduces any asset of the government.
Question 7. Statement—Dividends on investments made by government.[CBSE Delhi 2006]
Answer: Revenue receipt.
Reason: It creates neither any liability nor reduces any asset of the government.
Question 8. Statement—Borrowings from public.
Answer: Capital receipt.
Reason: It creates liability for the government.
Question 9. Statement—Fees of a Government College.
Answer: Revenue receipt.
Reason: It creates neither any liability nor reduces any asset of the government.
Question 10. Statement—Recovery of loans. [CBSE Delhi 2006]
Answer: Capital receipt.
Reason: It reduces assets of the government.
Question 11. Statement—Loans recovered from public sector enterprises.
Answer: Capital receipt.
Reason: It reduces assets of the government.
Question 12. Statement—License and court fees received by the government in the year 2012-13
Answer: Revenue receipt.
Reason: It creates neither any liability nor reduces any asset of the government.
Question 13. Statement—Loan taken from the USA for the infrastructural developments.
Answer:  Capital receipt.
Reason: It creates liability for the government.
Question 14. Statement—Sale of shares held by Government in a PSU.
Answer: Capital receipt.
Reason: It reduces assets of the government.
Question 15. Statement—Financial help from microsoft for the victims of flood affected areas.
Answer: Revenue receipt.
Reason: It creates neither any liability nor reduces any asset of the government
Question 16. Statement—Amount borrowed from Japan for construction of Metro.
Answer: Capital receipt.
Reason: It creates liability for the government.
Question 17. Statement—Dividend received by government from a company.
Answer: Revenue receipt.
Reason: It creates neither any liability nor reduces any asset of the
government.
Question 18. Statement—Funds raised from public in the form of National Saving Certificates and Kisan Vikas Patras.
Answer: Capital receipt.
Reason: It creates liability for the government.
Question 19. Statement—Sale of 40% shares of a public sector undertaking to a private enterprise.
Answer: Capital receipt.
Reason: It reduces assets of the L government.
Question 20. Statement—Profits of LIC, a public enterprise.
Answer: Revenue receipt.
Reason: It creates neither any s liability nor reduces any asset of the government.
Categorize the following items intoDirect and Indirect Taxes
Question 1. Statement—Corporation tax. [CBSE Foreign 2006]
Answer:  Direct tax.
Reason: Its impact and incidence lie on the same person.
Question 2. Statement—Value Added tax. [ CBSE Delhi 2010]
Answer:  Indirect tax.
Reason: Its impact and incidence lie on different persons.
Question 3. Statement—Service tax. [CBSE Foreign 2006]
Answer:  Indirect tax.
Reason: Its impact and incidence lie on different persons.
Question 4. Statement—Wealth tax. [CBSE Foreign 2006, Delhi 2010]
Answer: Direct tax.
Reason: Its impact and incidence lie on the same person.
Question 5. Statement—Indirect tax. [CBSE Foreign 2006]
Answer: Indirect tax.
Reason: Its impact and incidence lie on different persons.
Question 6. Statement—Income tax.
Answer: Direct tax.
Reason: Its impact and incidence lie on the same person.
Question 7. Statement—Entertainment tax.
Answer: Indirect tax.
Reason: Its impact and incidence lie on different persons.
Question 8. Statement—Corporate tax.
Answer: Direct tax.
Reason: Its impact and incidence lie on the same person.
Question 9. Statement—Excise duty.
Answer: Indirect tax.
Reason: Its impact and incidence lie on different persons.
Question 10. Statement—Custom duty.
Answer: Indirect tax.
Reason: Its impact and incidence lie on different persons.
Question 11. Statement—Capital Gains Tax.
Answer: Direct tax.
Reason: Its impact and incidence lie on the same person.
Categorize the following items into Revenue and Capital Expenditure
Question 1. Statement—Subsidies. [CBSE AI 2006]
Answer: Revenue expenditure.
Reason: It creates neither any asset nor reduces any liability of the government.
Question 2. Statement—Defence capital equipments purchased from Germany.
Answer:  Capital expenditure.
Reason: It increases asset of the government.
Question 3. Statement—Grants given to State Governments. [CBSE AI 2006]
Answer: Revenue expenditure.
Reason: It creates neither any asset nor reduces any liability of the government.
Question 4. Statement—Construction of school building. [CBSE AI 2006]
Answer: Capital expenditure.
Reason: It increases asset of the government.
Question 5. Statement—Expenditure incurred on administrative and defence services.
Answer: Revenue expenditure.
Reason: It creates neither any asset nor reduces any liability of the government.
Question 6. Statement—Repayment of loan. [CBSE AI 2006]
Answer: Capital expenditure.
Reason: It reduces the liability of the government.
Question 7. Statement—Amount spent on construction of Bridges
Answer: Capital expenditure.
Reason: It increases asset of the government.
Question 8. Statement—Payment of salaries to staff of government hospitals.
Answer: Revenue expenditure.
Reason: It creates neither any asset nor reduces any liability of the government.
Question 9. Statement—Purchase of 20 cranes for the construction of flyovers
Answer: Capital expenditure.
Reason: It increases asset of the government.
Question 10. Statement—Amount borrowed from USA repaid.
Answer: Capital expenditure.
Reason: It reduces the liability of the government.
Question 11. Statement—Salary paid to Army officers.
Answer: Revenue expenditure.
Reason: It creates neither any asset nor reduces any liability of the government.
Question 12. Statement—Purchase of Metro coaches from Japan.
Answer: Capital expenditure.
Reason: It increases asset of the government.
Question 13. Statement—Repayment of Loan taken from the World Bank.
Answer: Capital expenditure.
Reason: It reduces the liability of the government.
Question 14. Statement—Grants given by central government to state government.
Answer: Revenue Expenditure.
Reason: It creates neither any asset nor reduces any liability of the government.
Question 15. Statement—Loan given to Union Territories
Answer: Capital expenditure.
Reason: It increases asset of the government.
Question 16. Statement—Interest paid on National Debt.
Answer: Revenue expenditure.
Reason: It creates neither any asset nor reduces any liability of the government.
Question 17. Statement — Expenditure on construction of Metro.
Answer: Capital expenditure.
Reason: It increases asset of the government.
Question 18. Statement—Pension paid to retired government employees.
Answer: Revenue expenditure.
Reason: It creates neither any asset nor reduces any liability of the government.
Question 19. 10% shares purchased by the government in a private company.
Answer: Capital expenditure.
Reason: It increases asset of the government.
VI. Higher Order Thinking Skills
Question 1. Define debt trap. [1 Mark]
Answer: It is a vicious circle set wherein the government takes more loans to repay earlier loans.
Question 2. Distinguish between revenue deficit and fiscal deficit. [CBSE 2009, 13] [3 Marks]
Answer:
ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-7

ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-7

Question 3. Difference between primary deficit and fiscal deficit. [Delhi 2013] [3 Marks]
Answer:
ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-8

ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-8

Question 4. How can a deficit be financed? [3 Marks]
Answer: A deficit can be financed in two ways:

Monetary Expansion: It means printing new notes to the extent of deficit. It involves government borrowings from the Central bank (Reserve Bank of India) through the issue of the treasury bills to the Central Bank. The Central Bank purchases the treasury bills in return for cash (procured by printing new notes). The government use this cash to finance the deficit.
The second method of financing the deficit is borrowing by the government from the public through market loans etc.
By borrowing from abroad (rest of the world).

Question 5. Can there be a fiscal deficit in a government budget without a revenue deficit? Explain. [CBSE Sample Paper 2008] [3-4 Marks]
Answer:

Yes, there can be a fiscal deficit in government budget without any revenue deficit.
Revenue deficit is a position where total revenue expenditure of the government exceeds its total revenue receipts.
Fiscal deficit is a position where total expenditure of the government exceeds sum total of its revenue receipts and non-debt capital receipts.
Hence, there can be a fiscal deficit without revenue deficit in following situations:
(i) When capital budget shows a deficit and revenue budget is balanced.
(ii) When deficit in capital budget is greater than surplus in revenue budget.

Question 6. Revenue deficit is the real deficit and not the fiscal deficit. How? [3 Marks]
Answer:

Fiscal deficit is defined as excess of total expenditure over total receipts (revenue and capital receipts) excluding borrowing.
In other words, it is equal to borrowings and borrowings are just an act of the government which may be finance interest payments of the government also.
While revenue deficit exclusively takes into account current interest payment obligations of the government not connected with the actual activities.
Thus, revenue deficit is more important than fiscal deficit.

Question 7. From the following data about a government budget find: (a) revenue deficit, (b) fiscal deficit and (c) primary deficit: [CBSE, All India 2011] [3 Marks]
ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-9

ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-9

Answer: (a) Revenue deficit = Revenue expenditure – Revenue receipts (Tax revenue + Non-tax Revenue)
= 80 – (47+10) = Rs. 23 Arab
(b) Fiscal deficit = Total expenditure (Revenue expenditure + Capital expenditure) – Revenue receipts(Tax revenue + Non-tax revenue) – Non-debt Capital ReceiptfCapital receipts – borrowings)
= (80 + 0) – (47 + 10) – (34 – 32)
= 80 – 57 – 2 = Rs. 21 Arab
(c) Primary deficit = Fiscal deficit – Interest payments
= 21 – 20 = Rs. 1 Arab
8. Find (a) fiscal deficit and (b) primary deficit from the following items: [CBSE Sample Paper 2013] [3 Marks]
ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-10

ncert-solutions-for-class-12-macro-economics-government-budget-and-the-economy-10

Answer: (a) Fiscal deficit = Borrowings = Rs. 15000 crore.
(b) Primary deficit = Fiscal deficit – Interest payments = 15000 – 25% of (70000 – 50000) = 15000 – 25% of 20000 = 15000 – 5000 = Rs. 10000 crore.
VII. Value Based Questions
Question 1. There has been consistent rise in prices of fruits and vegetables in Delhi for sometimes. Which measures of budget will you support to reduce the prices of these commodities? [ 1 Mark]
Answer: Prices of fruits and vegetables can be reduced by providing subsidies to the producer of fruits & Vegetables and the government should also provide fruits and vegetables at subsidised rates to the consumers through public distribution system.
Value : Problem solving
Question 2. Budget deficit creates disequilibrium in every economy, but in developing countries like India, why does government depend on it? [ 1 Mark]
Answer: Per capital income in developing countries like India is comparatively low so the tax receipts of the government are not sufficient, but on the other hand government has to incur heavy public expenditure for the development of economy so a government is compelled on budget deficit.
Value : Economic awareness
Question 3. In India a majority of population is lying below poverty line due to inequality of ‘Income and Wealth’. How can budget be helpful in solving this problem? [1 Mark]
Answer: In Indian budget progressive tax system can be a good measure to remove the inequality of ‘income and wealth’ and government should provide social facilities like education, health and food grain to the poor at subsidized rates.
Value : Problem solving.
Question 4. Classify the following items into revenue expenditure and capital expenditure. Give reason for your answer. [3-4 Marks]
(a) Free supply of stationary to the students by the government.
(b) Economic assistance given according to Ladli scheme.
(c) Expenditure on the construction of computer lab in school by the government.
(d) Expenditure on Mid Day Meal given to students by the government.
Answer: (a), (b) and (d) are revenue expenditures because they neither create assets nor cause reduction in assets.
(c) is capital expenditure because it increases assets of the government. Value : Analytic
Question 5. In India, for the last several years, there has been deficit in the revenue account. How is it met or financed? [1 Mark]
Answer: Two measures to reduce revenue : deficit:

Government should reduce revenue expenditure.
To increase taxes, both direct and ; indirect.

Value : Analytic
Question 6. If you were to be appointed as the Finance Minister of India, which taxes would you prefer: direct taxes or indirect taxes and why? [3-4 Marks]
Answer: As we know, direct tax and indirect tax are complimentary to each other i.e., they are not substitutes to each other. There is really nothing to choose between direct taxes and indirect taxes as such. Both of them have their relative merits and demerits.
They differ from each other as:

Indirect taxes reach all the sections of the society; whereas direct taxes cannot reach all the sections.
Direct taxes can be highly progressive; whereas Indirect taxes are generally proportional.
Indirect taxes can be easily used to influence the consumption of specific commodities; whereas direct taxes cannot be used thus. In short, it is necessary to strike a balance between direct taxes and indirect taxes as a source of tax revenue.

Question 7. Should we rely exclusively on direct taxes for mobilizing tax revenue because indirect taxes are inequitable? Comment. [3 Marks]
Answer:

We cannot depend solely on direct taxes because they are progressive in nature and there is possibility of tax evasion.
But as against it indirect taxes are proportional in nature and are generally imposed on commodities (necessity goods etc.) which each and every individual purchase.
So, direct and indirect tax are important for providing funds for investment and for other social welfare considerations.

Question 8. Levy of taxes on all commodities without caring for their impact on the common man is not desirable. Comment. [3 Marks]
Answer:

Indirect taxes such as sales tax and excise duty fall heavily on the shoulders of a common man.
This means they are inequitable.
Therefore, in such a situation, tax basket should be a mixture of direct and indirect taxes both.

Question 9. It is not only difficult but impossible to tax all those who should be taxed, in India. Why? [ 1 Mark]
Answer: Due to lack of necessary information and disclosures required, tendency of the people to avoid taxes and lack of efficient implementation machinery, it is not possible to tax all those who should be taxed.
Question 10. In the government of India budget for the year 2013-14 the Finance Minister proposed to raise the excise duty on cigarettes. He also proposed to increase income tax on individuals earning more than ? One crore per annum.
Identify and explain the types of taxes proposed by the finance minister. Was the government’s objective only to earn revenue themselves? What possible welfare objective could the government be considering? Explain. [6 Marks] [CBSE Sample Paper 2014]
Answer: (a) Excise Duty: Indirect Tax When (a) liability to pay a tax (Impact of tax) is on one person; and(b) the burden of that tax (Incidence of tax), falls on the other person, it is termed as indirect tax.(b) Income Tax: Direct Tax When (a) liability to pay a tax (Impact of Tax), and (b) the burden of that tax (Incidence of tax), falls on the same person, it is termed as direct tax.(c) Besides the objective of raising more revenue, the proposals also serve some welfare objectives.

First, raising excise duty on cigarettes makes cigarettes costlier and discourages smoking. Less smoking have positive influence on health and raises welfare of the people,
Secondly, raising income tax on incomes above ? one crore will help in reducing inequalities in income.
Thirdly, the extra revenue is raised from these proposals, and if spent on health and education of the poor it will do the welfare of the poor.

Question 11. Regulation of prices in the case of agricultural products is not only desirable but necessary. Explain. [3 Marks]
Answer:

As we know that agricultural production depends upon natural factors like rainfall, climate etc. these natural factors creates a situation of drought or surplus production.
Therefore, in such a situation for helping farmers in case of drought the government should fix a price lower than the market price (which is also known as price ceiling) and in case of the surplus production the government should fix a price higher than the market price (which is also known as price floor).
Surplus or shortages should be met by the government from its buffer stock operations through Public Distribution System (PDS) such as ration shops or fair price shops.

Question 12. We should try to regulate interest rates prevailing among farmers, weaker sections of society and poor villagers. How can we control it? [3-4 Marks]
Answer:

A government and monetary authorities fix the rate of interest which is based on bank rate fixed by the RBI and consequent interest rates are charged by the commercial banks.
In this regard we have regional rural banks being set up in rural areas to benefit the rural artisans, small and marginal labourers and weaker sections of the society.
They provide credit assistance at concessional lending rates.
However, weaker sections of society including poor farmers and villagers pay very high rate of interest which they pay to the moneylenders or zamindars.
Therefore, for reducing rate of interest for such people, some necessary steps should be taken such as promoting cooperative societies etc.

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