P4 - Economics - FT - Books @CAFoundationLegends

CA FOUNDATION - ECONOMICS
INDEX
1 INTRODUCTION OF BUSINESS
ECONOMICS 1-4
2 THEORY OF DEMAND AND SUPPLY 5-12
3 THEORY OF PRODUCTION AND COST 13-18
4 PRICE DETERMINATION IN
DIFFERENT MARKETS
19-24
5 BUSINESS CYCLES 25-26
6 DETERMINATION OF NATIONAL
INCOME 27-121
7 PUBLIC FINANCE 122-222
8 MONEY MARKET 223-273
9 INTERNATIONAL TRADE 274-375
10 INDIAN ECONOMY 376-417

r
Chapte
INTRODUCTION OF
1 BUSINESS ECONOMICS
1. The origin of economics can be traced to Adam Smith book An Inquiry into the Nature
and Causes of Wealth of Nations published in the year 1776. Adam Smith is the
father of Economics. At its birth it was called 'Political Economy’.
2. Economics has been defined in four different ways:

 Wealth Definition: Adam Smith, defined economics as a science of wealth-which
means production and consumption of wealth.
 Welfare Definition: Marshall defined the welfare aspect of economics as
attainment and use of material things. He defined economics in its normative
aspect.
 Scarcity Definition: Robbins emphasizes that economics is a study of human
behaviour, where there is a relationship between ends and scarce means and
that the scarce means have alternative uses. He said economics is neutral
between ends. He defined economics in its positive aspect.
 Growth Definition: Samuelson's definition of economics is most comprehensive,
relevant and accepted. The definition includes both the aspects of economics,
i.e., distribution of limited resources and problem of economic development.
3. Economics as a Science: Economics is a science where various facts are systematically

collected, classified and analyzed. Economics is a social science whose subject matter
is man who cannot be controlled and predicted. Physics, Chemistry and Biology are
pure sciences where experiments can be conducted in a laboratory under controlled
conditions.
4. Economics as an Art: Economics is an art as it has several branches which give

practical direction to some economic problems of the society.
5. Economics is a science having both positive and normative sides. The role of an
economist is not only to explain and explore but also to admire and condemn.
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This role of an economist is essential for healthy and rapid growth of an economy.
Positive economics deals with what is, and normative economics deals with what
ought to be. Positive economics deals with facts and normative economics deals
with ethics.
6. Microeconomics deals with behavior of individual decision making units such as

consumers, resource owners, etc. It is also called Price Theory. Macroeconomics
deals with aggregates such as national income, aggregate consumption, etc. It is
also called Theory of Income and Employment. Both micro and macro economics
are complementary and should be fully utilized for proper understanding of an
economy.
7. There are two methods of constructing an economic theory (a) Deductive method
(b) Inductive method.
(a) In the deductive method, the process of reasoning goes from general assumptions
to particular predictions. It was adopted by classical economists and is simple.
The method is more suitable when facts and data are not available. This method
is called abstract or priori method.
(b) In the inductive method, the process of reasoning goes from particular facts to
general theory. It was popular among modern economists and is more precise,
realistic and scientific. The method is more suitable when facts and data are
available.
Deductive and inductive methods are not alternative of each other. Both the methods
are needed for constructing an economic theory.
8. Business Economics integrates economic theory with business practice and relies on
economic analysis in the formulation of business policies.
9. While Business Economics is basically concerned with Micro Economics, Macro

economics analysis has got an important role to play. Macroeconomics analysis the
environment in which the business has to function.
10. Business Economics is a normative science which is interdisciplinary and pragmatic in

approach.
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11. There are two categories of business issues to which economic theories can be directly
applied, namely: Microeconomics applied to operational or internal issues and
Macroeconomics applied to environmental or external issues.
12. Business Economics makes use of microeconomic analysis such as, demand analysis
and forecasting, production and cost Analysis inventory management, market
structure and pricing policies, resource allocation, theory of capital and investment
decisions, profit analysis and risk and uncertainty analysis.
13. Business Economics also considers Macroeconomics related to economic systems,

business cycles, national income, employment, prices, saving and investment,
Government’s economic policies and working of financial sector and capital market.
14. The central problem is the problem of choice or the problem of economizing. The
main causes of central problems are:
 unlimited human wants
 limited economic resources
 alternative uses of resources
The central problems are:-

1. What to produce and how much to produce.
2. How to produce
3. For whom to produce
4. Economic growth
15. All point on Production Possibility curve (PPC) solves the first two problems and
points on a higher PPC solves the problem of economic growth. PPC cannot solve the
problem of 'For whom to produce.
 PPC shows various alternative combinations of goods and services that an
economy can produce when the resources are fully and efficiently employed.
The slope of PPC measures opportunity cost of the commodity in terms of alternative
opportunity given up. Since the opportunity cost is increasing therefore PPC is concave
to the origin and scarcity of resources gives downward slope to PPC. [Opportunity
cost is cost of alternative opportunity given up.]
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16. There are three forms of economic organization:

(a) Capitalistic economy or free economy
(b) Socialistitc economy or Controlled economy
(c) Mixed economy.
 Capitalism is the system that advocates price mechanism to solve the central
economic problems. In a capitalistic economy, prices are determined by the market
forces of demand and supply. The only aim is profit maximization and the consumers
are free to consume whatever they like. It has faith in liesez fair policy i.e least
interference by the government.
 Socialism is the system where government or public sector owns the factors of
production (land, labor, capital and enterprise) and the central planning authority
solves central economic problems. The aim is to maximize welfare of the society and
the consumers can consume only those goods which are produced by the government.
 In a mixed economy, public and private sectors exist side by side. Both price mechanism
and central planning authority solves central economic problems. India is a mixed
economy.
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r
Chapte
THEORY OF DEMAND
2 AND SUPPLY
Theory of Demand
1. Meaning of Demand: Demand for a commodity refers to the quantity of a commodity

which a consumer is willing and able to purchase at a certain price during any
particular period of time.
2. In economics, demand means effective desire which means there should be desire to
own the good, sufficient money to buy it and willingness to spend the money.
3. The determinants of demand are (i) price of the good (ii) price of related goods (iii) income
of the consumers (iv) tastes and preferences of the consumers and (v) other factors such
as size of population, composition of population, distribution of income etc.
4. The law of demand states that there is an inverse relationship between price of a
commodity and its quantity demanded, ceteris paribus. The assumptions of the law
of demand are that Pr, Y, T and D are constant.
 The demand schedule is a tabular or numerical representation of law of demand.
It is of two types-:
 Individual demand schedule shows the quantity demanded on the part of a single
consumer at various prices per unit of time.
 Market demand schedule shows the aggregate of the quantity demanded by all
the consumers at various prices per unit of time.
 Demand curve is a graphical or geometric representation of law of demand. It is
of two types-:
 Individual demand curve is graphical representation of quantity demanded by a
single consumer at different prices.
 Market demand curve is constructed by horizontally or laterally summing all the
individual demand curves at each and every price.
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5. The demand curve slopes downward because of (i) law of diminishing marginal utility
(ii) income effect, (iii) substitution effect, (iv) new consumers creating demand and (v) several
uses of a commodity.
6. Exception to the law of demand are found in the following cases (i) Giffen goods,
(ii) Conspicuous goods or goods of status, (iii) Expectation of a price rise in future,
(iv) Demonstration effect, (v) conspicuous necessities, (vi) impulsive purchase and
(vii) Ignorance effect and (viii) Emergency.
7. Movement along a demand curve (change in quantity demanded) occurs due to change
in the price of the good itself other factors remaining constant.
8. Shift of the demand curve (change in demand) occurs due to change in (i) price of
other good (ii) income of the consumers (iii) tastes of the consumers etc. price of the
commodity remains constant.
 Movement on demand curve can be expansion or contraction of demand whereas
change in demand can be increase or decrease in demand.
9. Price Elasticity of Demand (Ep) measures percentage change in quantity demanded of

a good due a percentage change in its price Therefore, Ep can be calculated as:
Percentage change in quatity demanded
Ep =
Percentage change in price
∆Q P
or, = – ×
∆P Q
10. The major determinants of price elasticity of demand are:

(i) Nature of the commodity
(ii) Availability of substitutes
(iii) Several uses of the commodity
(iv) Share of a commodity in consumers budget
(v) Time – period
(vi) Habit of the consumer.
(vii) Tied demand.
(viii) Price range.
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11. There are five degrees of ep. Check List

(i) Perfectly inelastic demand (ep = 0)  Inelastic demand  Elastic Demand
demand curve will be vertical line  Elastic Demand  Luxurious goods
parallel to y-axis.  Substitute not  Substitute avail-

available able
(ii) Inelastic demand (0 < ep < 1) demand
 Single or limited  Multiple uses of
curve will be relatively stipper. no.of use of com- the commodity
modity
(iii) Unitary elastic demand (ep = 1)
 Low share in con-  High share in
demand curve will be like rectangular sumer’s budget consumer’s bud-
get
hyperbola.
 Short period  Long period
(iv) Elastic demand (1 < ep < ∞) demand  Habitual  Non–habitual
curve will be relatively flatter. consumer consumer
(v) Perfectly elastic demand (Ep = ∞)s.  Tied demand  Independent

demand
demand curve will be a horizontal  Low & high price  Medium price
line parallel to x-axis. range range
12. Measurement of Price Elasticity of Demand:-

i. Percentage or proportionate method
ii. Geometric (or point) method.
iii. Total outlay or expenditure method
iv. Arc or mid – value method.
(i) In the percentage method, Ep is calculated by the formula:
∆Q P
Ep = ×
∆P Q
(ii) In the geometric method, ep at a point on a linear (straight) demand curve

is calculated as:
Lower segment of the demand curve
ep =
Upper segment of demand curve
(iii) In the total outlay method, the ep is measured on the basis of change in
total expenditure (TE) or total revenue as a result of change in price of
commodity. If -
(a) price rises and TE/TR also rises and vice-versa then ep < 1
(b) price rises or falls TE/TR remains constant then ep = 1
(c) price rises and TE/TR falls and vice-versa then ep > 1
Q1 – Q2 P + P2
(iv) For arc elasticity, the formula is Ep = × 1
Q1 + Q2 P1 – P2
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13. Income Elasticity of Demand measures % ag changes in demand due to % ag change

in income of the consumer.
∆Q Y
Therefore, ey = ×
∆Y Q
(a) If value of ey is between 0 to1 then good is normal or essential.

(b) If ey > 1 then good is luxury and
(c) If ey is negative i.e. less than 0 then good is inferior.
14. Cross-Elasticity of Demand(ec): It measures% ag changes in the quantity demanded of

good x due to % ag change in price of good y. The formula for calculating ec is:
∆Qx ∆Py
ec = ×
∆Py ∆Qx
 When ec = + ∞, goods are perfect substitutes
 When ec = +ve goods are substitutes
 When ec = 0, goods are totally unrelated
 When ec = -ve, goods are complements.
15. Advertisement elasticity of sales or promotional elasticity of demand measures the

responsiveness of a good’s demand to changes in the firm’s spending on advertising.
Value of advertisement elasticity of demand is positive and various between 0 and 00.
16. Demand Distinctions

 Producer’s goods and Consumer’s goods
 Durable goods and Non-durable goods
 Derived demand and Autonomous demand
 Industry demand and Company demand
 Short-run demand and Long-run demand
17. Forecasting of demand is the art and science of predicting the probable demand for
a product or a service at some future date on the basis of certain past behaviour
patterns of some related events and the prevailing trends in the present.
18. Methods of Demand Forecasting

 Survey of Buyer’s Intentions
 Collective Opinion Method
 Expert Opinion Method
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 Barometric Method
 Statistical Methods such as:-
• Trend Projection Method
• Graphical Method
• Least Square Method
• Regression Analysis
• Controlled Experiments Method
• Laboratory Experiments Method
Theory of Consumer’s Behaviour

1. The logical basis of consumer behaviour has been explained by different theories.
Some of the most important theories of consumer behavior are:
(i) Marshall’s Marginal Utility Theory
(ii) Hicks and Allen's Indifference Curve Theory.
2. Marginal Utility Theory:

 The law of diminishing marginal utility states that as the consumer consumes
more and more units of a commodity, its marginal utility falls.
 Utility is expected satisfaction to a consumer when he is willing to spend money
on a stock of commodity which has the capacity to satisfy his want.
 Marginal utility (MU) is addition made to total utility (TU) as a result of consumption
of one more unit of the commodity.
 When MU is 0, TU is maximum. It is called saturation point.
 When MU is falling but positive TU is rising but with diminishing rate.
 When MU is negative, TU is falling.
 Assumption of the theory

(i) Rationality
(ii) Cardinality
(iii) Measurement in terms of money.
(iv) Constant marginal utility of money
(v) Independent utility
 Marshall's consumer surplus :-

The amount consumer is willing to pay - The amount he actually pays. =
Area between the MU curve and price of the commodity.
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3. Indifference Curve Theory

 Assumptions of the theory are:
(i) Rationality
(ii) Ordinarily
(iii) Diminishing marginal rate of substitution
(iv) Consistency and transitivity of choice
(v) More is better
Indifference curve shows different combinations of two goods that gives the same level
of satisfaction to the consumer.
A set of indifference curves is called an indifference map.
Features of indifference curve are:

(i) Downward sloping to the right
(ii) Convex to the origin
(iii) Two indifference curve can never intersect each - other.
(iv) Higher indifference curve represents higher level of satisfaction.
(v) Indifference curve can not touch either of the axis.
 Budget line shows all the possible combinations of the two goods that can be
bought by a consumer with given income and prices of goods.
Px
 Slope of the budget line is the price ratio, i.e.,
Py
 Slope of an indifference curve is called Marginal Rate of Substitution (MRSxy).
 A consumer is in equilibrium when he maximises his utility with his given income
and prices of the commodities. Equilibrium is reached at the point of tangency
between indifference curve and budget line.
Conditions for consumer equilibrium is:
MRSxy = Px ......... (1)

Py
MUx
or = Px ......... (2)
MUy Py
And Diminishing MRS
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Supply
1. Definition of Supply: Supply of a commodity at a given price is the quantity of the
commodity which is actually offered for sale per unit of time
2. There is difference between supply and stock. Supply is that part of stock which
is actually brought in the market for sale. In case of perishable goods there is no
differences between supply and stock.
3. The major factors affecting supply of a good are:

i. Price of the good (Px)
ii. Price of related goods (Pr)
iii. Prices of the factors of production (Pf)
iv. State of technology (T)
v. Government policy (G) etc.
4. The law of supply states that there is a direct relationship between price and quantity
supplied of a commodity, other things remaining constant.
5. The supply schedule shows the different quantities of a commodity supplied by a firm
within a given period of time at different prices.
6. The data of supply schedule is plotted on price-quantity axes to derive the supply curve.
7. Movement along a supply curve occurs due to changes in the price of good (PX) itself.
8. Shift of the supply curve occurs due to changes in factors affecting supply other than
commodity’s is own price.
9. Movement on supply curve can be expansion or contraction in supply whereas shift of

supply curve can be increase or decrease in supply.
10. The concept of Elasticity of supply (ES) was developed by Marshall. Elasticity of supply
is defined as the responsiveness of quantity supplied of a commodity due to change in
its own price. Symbolically,
∆Q P
Es = ×
∆P Q
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11. There are five degree of ES :

i. Perfectly inelastic supply (ES = 0)
ii. Inelastic supply (0 < ES < 1)
iii. Unitary elastic supply (ES = 1)
iv. Elastic supply (1 < ES < ∞)
v. Perfectly elastic supply (ES = ∞).
12. Methods of measurement of elasticity of supply –

% Change in quantity supplied
 Percentage method – es =
% change in prive
dq p
 Point elasticity method – es = ×
dp q
q –q P +P
 Arc method Es = q 1 + q2 × P1 – P 2
1 2 1 2
13. Diagrammatic Method -

The rule is that
 if the supply curve passes through the point of origin, es is equal to unity,
 if the supply curve intercepts the x-axis, es is less than unity and
 if supply curve intercepts the y-axis, es is greater than unity.
 if supply curve is a vertical line parallel to y-axis es is equal to zero.
 if supply curve is a horizontal line parallel to y-axis es is equal to infinite.
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r
Chapte
THEORY OF
3 PRODUCTION AND COST
Theory of Productions
1. Production means creation or addition of utilities which can be form utility, time utility,
place utility, knowledge utility and possession utility.
2. There are four factors of production namely, land, labour, capital and organisation.
3. Land:-
 Land is a primary factor which includes besides physical territory, all natural
resources such as water, soil, climate, wind, sea, etc.
 Features of land are:
(a) Its supply is perfectly inelastic. (e) It is a free gift of nature.
(b) It is imperishable (indestructible). (f) It is immobile.
(c) It is a passive factor. (g) It has heterogeneous use.
(d) It has perfectly inelastic supply(when taken as a whole).
4. Labour:-
Labour is any physical or mental exertion undertaken to create or produce goods or
services. Features of labour are:
(a) It is perishable. (f) It is an active factor.
(b) It is inseparable from a labourer. (g) Labour is a man, not a machine.
(c) He sells his services and not himself. (h) All labourers are not equally efficient.
(d) Supply curve of labour is backward (g) Labour is mobile.
bending.
(e) Labour is a live factor of production. (j) Individual labour has weak
bargaining power.
5. Capital is defined as man made goods that are used for further production of wealth.
It is produced means of production.
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6. Capital formation or investment is defined as the surplus of production over

consumption in an accounting year which is further used for production.
 Significance of capital formation lies in the following points:
(a) It determines the growth rate of an economy.
(b) It increases production.
(c) It raises productive capacity.
(d) It raises employment opportunities.
 There are three stages of capital formation which are inter-related. These are:
Stage I : Creation/Generation of Savings
Stage II: Mobilisation of Savings
Stage III: Investment of Savings.
7. Entrepreneur:-
 Entrepreneur is the person who organises. manages and coordinates all factors
of production.
 Functions of an entrepreneur are:
(a) Initiating a business enterprise and resource coordination
(b) To take advantage of changes in a dynamic economy
(c) To bring about innovations
(d) To bear uncertainties.
 Objectives of Entrepreneur –
I. Organic objectives
II. Economic objectives
III. Social objectives
IV. Human objectives
V. National objectives
 Problems of Enterprise - An enterprise faces a number of problems from its
inception, through its life time and till its closure. These may relate to objective,
location size, physical facilities, finance, organization structure, marketing, legal
formalities and industrial relations.
8. Factors of production can be divided into two categories – Fixed factors are those
factors whose quantity remains unchanged with change in output within a capacity
and variable factors are those the quantity of which change with a change in the level
of output.
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9. Production function is the process of getting the maximum output from a given quantity
of inputs in a particular time period. It establishes physical input-output relationship.
 There are two types of production function:
(a) Short-run production function: where some factors are in fixed supply.
(b) Long-run production function: where all factors are in variable supply.
10. Law of variable proportions

 The three concepts of production are total, average and marginal product.
 Total product is aggregate of the quantity of a good produced by a firm with the
given inputs during a specified period of time, i.e TP = ∑MP
 Average product is the amount of output per unit of the variable factor
employed,i.e. AP = TP
Q
 Marginal product is the change in total product resulting from the employment
of one more unit of variable factor, i.e. MP = ∆TP
∆Q
 TP curve starts from the origin. Initially rises with an increasing rate, then rises at
a decreasing rate, reaches a maximum and then starts falling.
Both AP and MP curves are graphically derived from the TP curve. Both AP and MP
curves are inverted-U shaped. They have special relationship which is as follows:
(a) When AP is rising, then MP > AP.
(b) When AP is at its maximum then MP = AP.
(c) When AP is falling then MP < AP.
Law of variable proportions states that 'when total output of a commodity is increased
by adding units of a variable factor, while the quantities of other inputs are held
constant, the increase in total production i.e. marginal product becomes after some
point smaller and smaller'. The three product curves are drawn to graphically illustrate
the law of variable proportions. The three stages are partitioned into increasing,
diminishing and negative returns. A rational producer will always operate in Stage II.
In this stage both AP and MP are declining but positive. The reason for diminishing
returns is optimal use of fixed factor and imperfect substitution between factors. The
law is applicable in short run.
11. Law of Returns to Scale

 It is a long-run law.
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 It states that 'when all factors of production are increased in the same proportion
then output will increase. but the increase may be at an increasing rate or
constant rate or decreasing rate'.
 The three stages of law of return to scale are increasing, constant and decreasing.
 Reasons behind increasing returns to scale are economies of scale which can be
internal or external, division of labour and specialization of activities.
 Reason behind decreasing returns to scale is diseconomies of scale which can also
be internal or external.
 Constant returns to scale operates when economies and diseconomies are counter
balanced.
12. Production Optimization

 It refers to cost minization. It explains producer’s equilibrium through isoquant
and iso-cost lines.
 Isoquants or product indifference curves show all those combinations of two factors
of production which give the same output to the producer.
 Isocost lines show various combinations of two factors which the firm can buy
with given expenditure or outlay.
 By combining Isoquants and isocost lines, a producer can find out the combination
of factors of production which is optimum i.e. the combination of factors of
production which would minimize his cost of production.
 For producing a given output, the tangency point of the relevant isoquant with
an isocost line represents the least cost combination of factors. i.e. producer’s
equilibrium.
Theory of Cost
1. Cost analysis refers to the study of behaviour of cost in relation to one or more
production criteria. It is concerned with the financial aspects of production.
2. Opportunity Cost vs. Outlay Cost-: Opportunity cost is defined as the cost of alternative
opportunity given up or forgone. It is also called alternative cost or transfer earnings.
Outlay cost is actual expenditure of firms.
3. Explicit Cost vs. Implicit Cost:- Explicit cost is the actual money expenditure incurred
by a firm in the production process. It is also called direct cost or money cost. Implicit
cost is the cost of factors owned by the firm and used by the firm in its own production
process. It is also called imputed cost.
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4. Direct Cost vs. Indirect Cost:- Direct cost can be traced to a particular product. Indirect
cost cannot be traced to a particular product.
5. Accounting Cost vs. Economic Cost:- Accounting costs are explicit cost or actual cash
payments. Economic cost is accounting cost plus implicit cost.
6. Incremental cost refers to the additional cost incurred by a firm as a result of a business
decision.
7. Sunk costs are already incurred once and for all, and cannot be recovered.
8. Historical cost refers to the cost incurred in the past on the acquisition of a productive
asset.
9. Replacement cost is the money expenditure that has to be incurred for replacing an
old asset.
10. Private costs are costs actually incurred or provided for by firms and are either explicit
or implicit.
11. Social cost refers to the total cost borne by the society on account of a business
activity and includes private cost and external cost.
12. Short-Run Cost Curves
(a) Short- run Total Costs -
 Total Cost is inverse-S shaped starting from the level of fixed cost.
 TFC is horizontal line parallel to X axis
 TVC is inverse S-shaped curve starting from origin
 Semi-variable cost is the cost which have a fixed element and a variable
element
 Stair-step cost which remain fixed over a certain range of output and
suddenly jump to a higher level when output goes beyond a given limit and
become constant for next range of output.
(b) Short-run Average Costs -

 AFC, is fixed cost per unit of output produced. AFC curve has a rectangular
hyperbole shape.
 AVC is variable cost per unit of output produced. It is U shaped due to law of
variable proportion.
 AC is also called average total cost (ATC). It can be obtained in two ways:
TC
ATC = Q or ATC = AFC + AVC. ATC is U-shaped curve.
The reason behind its shape is the law of variable proportions.
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(c) Marginal Cost -

MC is addition made to TC (or TVC) when one more unit of output is Produced.
∆TC
MC = or (MCn = TCn - TCn-1)
∆Q
MC is the slope of the TC curve at each and every point. MC curve

is U-shaped reflecting the law of variable proportions.(MCn = TCn - TCn-1)
MC is independent from TFC. It is function of variable cost and can also be

calculated as
∆TVC
MC =
∆Q
(d) Relationship between AC and MC

 When AC is falling, MC is below it. i.e. MC<AC
 When AC is rising, MC is above it. i.e. MC>AC
 When AC is minimum MC = AC.
13. Long run average Cost (LAC) curve is an envelope curve. It is also known as planning
curve. It envelopes infinite short run AC curves. Each point on LAC gives the minimum
cost per unit for corresponding level of output.
14. LAC curve is ‘U’ shaped curve because of operation of law of return to scale.
15. According to modern approach LAC curve is ‘L’ shaped curve because modern approach
believes technological advancement is possible during production process over the
period of time.
16. Economies of scale are of two kinds – External Economies of scale and Internal Economies
of Scale.
 External Economies of scale accrue to a firm due to factors which are external
a firm.
 Internal Economies of scale accrue to a firm when it engages in large scale
production.
 Increase in scale, beyond the optimum level, results in Diseconomies of scale.
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r
Chapte
PRICE DETERMINATION
4 IN DIFFERENT MARKETS
Meaning and Types of Markets

1. Definition:- A market is a complex set of activities by which potential buyers and sellers
interact to determine the price and quantity of a good or service.
2. Value and Price: Price is the value of good in terms of money and value is economic
worth of a good expressed in relation to another good.
3. Market Structures:
On the basis of the area
 Local Market
 Regional Market
 National Market
 International Market
On the basis of time

 Very short period Market or Market Period Market
 Short-period Market
 Long Period Market
 Very Long Period or secular Period Market
On the basis of Nature of Transactions

 Spot Market
 Future Market
On the basis of Regulation

 Regulated Market
 Unregulated Market
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On the basis of volume of business

 Wholesale Market
 Retail Market
On this basis of competition

 Perfect Competition
 Monopoly
 Monopolistic Competition
 Oligopoly
 Duopoly
4. Revenue is the money payment received by a firm from the sale of a commodity.
 TR is the total or aggregate of proceeds to the firm from the sale of all the units
of a commodity. It is given as: TR = P × Q.
 AR is revenue per unit of output sold and is always equal to price .i.e., AR = P
AR = TR =
Q Q[
P×Q
=P [
 MR is the addition made to TR when one more unit of output is sold. It is given as
MR = ∆TR . or MRn = TRn – TRn-1.

∆Q
)
MR = AR 1 –
1
e )
5. There are two basic principle governing all market conditions
(a) Firms should produce Only if TR ≥ TVC or AR ≥ AVC
(b) To be equilibrium i.e. to maximaize profits of minimize losses a firm should produce at
that level where MC = MR and MC must be rising.
Determination of Price
1. Equilibrium price is that price at which demand and supply equals each other and
quantity demanded and supplied at that price are regarded as equilibrium quantity.
2. Shifts in demand and supply curves takes place due to changes in factors other than
price of the commodity.
3. A change in demand, supply remaining constant, leads to a change in the equilibrium
price. If demand increases, both equilibrium price and quantity will rise. If demand
decreases, both equilibrium price and quantity will fall.
20
4. A change in supply, demand remaining constant, leads to a change in the equilibrium

price and quantity. If Supply increases, price will fall and quantity will rise and if
supply decreases, price will rise and quantity will fall.
5. If both demand and supply change – There can be simultaneous changes in both demand
and supply and the equilibrium price will change according to the proportionate
change in demand and supply. Which may be –
 When both demand and supply increase, the equilibrium quantity increases but the
change in equilibrium price in uncertain.
 When both demand and supply decrease, the equilibrium quantity decreases but
the change in equilibrium price is uncertain.
 When demand increases and supply decreases, the equilibrium price rises but nothing
certain can be said about the change in equilibrium quantity.
 When demand decreases and supply increases, the equilibrium price falls but nothing
certain can be said about the change in equilibrium quantity.
Price – Output Determination under Different Forms of Market

Perfect Competition
1. Perfect competition is a market situation where large number of sellers are selling
homogeneous product to large number of buyers at uniform price.
2. In perfect competition price is determined by the industry which individual firm has
accept as given and constant. Thus, firms under perfect competition is price taker.
3. Short-run equilibrium of a firm –

Conditions for equilibrium –
(i) MC=MR and
(ii) MC must be rising
4. In short run following three situations can take place –

(a) Supernormal or abnormal profits when price (AR)>ATC
(b) Normal profits when price(AR)=ATC and
(c) Losses when price (AR) < ATC
5. In the long – run, adjustment process takes place and all firms earn just normal profits
at the minimum point on LAC curve where SAC = LAC = SMC = LMC = P = AR = MR.
21
Monopoly:-
1. Monopoly is a market situation where single seller is selling the product having no
substitute available in the market to large number of buyers at same or differentiated
prices.
2. Monopolist is a price maker and faces a downward sloping demand curve.
3. In short-run following three situations can take place –

a) Supernormal or abnormal profits when price (AR)>ATC
b) Normal profits when price(AR)=ATC and
c) Losses when price (AR) < ATC
4. In a long-run monopolist can continue to enjoy super-normal profits because entry-exit is

restricted.
Pricing under Discriminating Monopoly:-

1. Discriminating monopoly is a situation where the monopolist charges different prices
from different buyers for same product.
2. Conditions necessary for price-discrimination:-

 Seller should have some monopoly power,
 Seller must be in a position to divide his total market in two or more than two
sub-markets,
 There should be effective separation of the market and
 Elasticity of demand should be different in different sub-markets.
3. Objective of Price discrimination:-

 To earn maximum profit
 To dispose of surplus stock
 To enjoy the economies of scale
 To capture foreign markets
 To secure equity through pricing
22
4. Degrees of price discrimination:-

 First degree-entire consumer surplus will be withdrawn
 Second degree a part of consumer surplus will be withdrawn
 Third degree price varies according to location or by customer segment
Pricing under Monopolistic Competition:-

1. Monopolistic competition is a market situation where large number of sellers are
selling slightly differentiated products to large number of buyers and price charged
by different sellers for their product is different.
2. In short-run following three situations can take place –

 Supernormal or abnormal profits when price (AR)>ATC
 Normal profits when price(AR)=ATC and
 Losses when price (AR) < ATC
3. In the long-run due to free entry and exit adjustment will take place and only normal
profits will be earned. But, at equilibrium level firm will have excess capacity i.e. firm will
be in equil. before optimum level of output.
Pricing under Oligopoly

1. Oligopoly is a market situation where few sellers (2 to 10) are selling slightly
differentiated or identical products to large number of buyers.
2. The demand curve is not defined as there are action-reaction patterns among firms.
There is no general theory of pricing under oligopoly.
3. Sweezy's Kinked demand curve model - It is based on the assumption that firms match
price cuts but not price rises. It rationalises price rigidity in oligopolistic market. It shows
that even if cost changes, prices charged for the commodity does not change.
23
Distinguishing features of major types of markets

Market types
Assumption Monopolistic
Pure competition Oligopoly Monopoly
competition
Number of sellers Many Many A few(2 to 10) One
Product differentiation None Slight None to Extreme
substantial
Price elasticity of demand of a firm Infinite Large Small Small
Degree of control over price None Some Some Very considerable
Note:- Other Important Market Forms are –

i. Duopoly – a subset of oligopoly, is a market situation in which there are only two firms
in the market.
ii. Monopsony – is a market characterized by a single buyer of a product or service and is
mostly applicable to factor markets in which a single firm is the only buyer of a factor.
iii. Oligopsony – is a market characterized by a small number of large buyers and is
mostly relevant to factor markets.
iv. Bilateral monopoly – is a market structure in which there is only a single buyer and a
single seller i.e. it is a combination of monopoly market and a monopsony market.
24
r
Chapte
BUSINESS CYCLES
5
1. The rhythmic fluctuations in aggregate economic activity that an economy experience

over a period of time are called business cycles or trade cycles and are manifested
in fluctuations in measured of aggregate economic activity such as gross national
product, employment and income.
2. A typical business cycle has four distinct namely.

 Expansion (also called boom or upswing) characterized by increase in national
output and all other economic variables.
 Peak or boom or prosperity refers to the top or the highest point of the business
cycle.
 Contraction (also called downs-wing or recession) when there is fall in the levels
of investment, employment.
 Trough or depression occurs when the process of recession is complete and there
is severe contraction in the economic activities.
3. Economists use changes in a variety of activities to measures the business cycle and
to predict where the economy is headed towards. These are called indicators.
4. A leading indicator is a measurable economic factor that changes before the economy
starts to follow a particular patter or trend. i.e. they change before the real output
changes.
5. Variables that change after real output changes are called ‘Lagging indicators”.
6. Coincident economic indicator, also called concurrent indictors, coincide or occur

simultaneously with the business-cycle movements.
25
7. According to Keynes, fluctuations in economic activities are due to fluctuations in

aggregate effective demand.
8. According to some economists, fluctuations in investments are the prime cause of

business cycles. Investment spending is considered to be the most volatile component
of the aggregate demand.
9. Fluctuations government spending with its impact on aggregate economic activity

result in business fluctuations.
10. Macroeconomic policies, (monetary and fiscal policies) also cause business cycle.
11. According to Hawtrey, trade cycle is purely monetary phenomenon. Unplanned

changes in the supply of money may cause business fluctuation in an economy.
12. According to Pigou, modern business activities are based on the anticipations of
business community and are affected by waves of optimism or pessimism.
13. According to Schumpeter, trade cycles occur as a result of innovations which take
place in the system from time to time.
14. Understanding what phase of the business cycle an economy is in and what implications
the current economic conditions have for their current and future business activity,
helps businesses to better anticipate the market and to respond with greater alertness.
26
r
Chapte
DETERMINATION OF
6 NATIONAL INCOME
UNIT 1: NATIONAL INCOME ACCOUNTING
PRECAUTIONS WHILE CALCULATING NATIONAL INCOME:

(1) National Income is a money value of all final Goods and services produced in
domestic territory during the FY plus net income from abroad.
(2) All earned income will be part of National Income and all unearned Income like gift,
grants, charity, donation, pension to be excluded from National Income.
(3) Anything produced for self-consumption will be added in National Income.
(4) Any kind of financial Investment where Investment is done in shares, bonds, FD,
debentures etc not to be included.
(5) Value of only Final product should be taken. Raw material, intermediate goods,
semi-finished goods, which should be excluded from National Income.
(6) Any kind of second hand product or transaction where goods are produced in the
previous year should be excluded from the National Income. However, commission
or brokerage earned over it should be included in NI calculation.
(7) Income earned by foreign companies in India value of goods produced will be added,
profit earned will be excluded.
(8) Any windfall Gain or Losses should be excluded from the calculation of National
Income.
(9) Any kind of Illegal income where money is earned through Smuggling, Hawala
money will be excluded from National Income.
(10) Rent, wages, Interest, Profit, Dividend, Mixed Income to be added in National Income.
(11) All export and receipts are added and all the imports and payment are deducted.
(12) Depreciation to be deducted and Indirect tax to be deducted. , Subsidies Added
DEFINE NATIONAL INCOME AND EXPLAIN THE USEFULNESS OF NATIONAL ESTIMATE:

National Income is defined as the net value of all economic goods and services produced
within the domestic territory of a country in an accounting year plus the net factor income
from abroad. According to the Central Statistical Organisation (CSO) ‘ National income
27
is the sum total of factor incomes generated by the normal residents of a country in the
form of wages, rent, interest and profit in an accounting year’.
Following are the Usefulness of estimating National Income:
 National income estimates provide a comprehensive, conceptual and accounting
framework for analyzing and evaluating the short-run performance of an economy.
 The distribution pattern of national income determines the pattern of demand for
goods and services and enables businesses to forecast the future demand for their
products.
 Economic welfare depends to a considerable degree on the magnitude and distribution
of national income, size of per capita income and the growth of these over time.
 It shows the composition and structure of national income in terms of different
sectors of the economy, the periodical variation in them and the broad sectoral
shift in an economy over time. Using these information, the governments can fix
various sector- specific development target for different sectors of the economy and
formulate suitable development plans and policies to increase growth rates.
 National income statistics also helps in assessing and selecting economic policies
and for objective statement as well as evaluation of governments’ economic policies.
 The national income data are also useful to determine the share of nation’s
contributions to various international bodies.(which helps to determine Income,
Standard of living and eligibility for loans)
 Combined with financial and monetary data, national income data provide a guide
to make policies for growth and inflation.
 National Income estimates helps in economic forecasting and to make projections
about the future development trends of the economy.
DESCRIBE THE GENERALLY USED CONCEPT OF NATIONAL INCOME:

The basic concept and definitions of the terms used in national accounts largely follow
those given in the UN System of National Account (SNA) developed by United Nations
to provide a comprehensive conceptual and accounting framework for compiling and
reporting macroeconomic statistic for analyzing and evaluating the performance of an
economy. Each of these concepts has a specific meaning, use and method of measurement.
Following are the generally used concepts of National Income:

Gross Domestic Product (GDP mp): Gross domestic product (GDP) is a measure of the market
value of all final economic goods and services, gross of depreciation, produced within
the domestic territory of a country during a given time period. It is the sum total of
28
‘value added’ by all producing units in the domestic territory and includes value added by
current production by foreign residents or foreign-owned firms. The term ‘gross’ implies
that GDP is measured ‘gross’ of depreciation. ‘Domestic’ means domestic territory or
resident production units.
Gross Domestic Product at Factor Cost (GDP fc): GDP at factor cost is called so because it
represents the total cost of factors viz. labour, capital and entrepreneurship.
Gross National Product (GNP): It is a measure of the market value of all final economic
goods and services, gross of depreciation, produced within the domestic territory of a
country by normal residents during an accounting year including net factor incomes from
abroad.
Net Domestic Product at market prices (NDP mp): It is a measure of the market value of all
final economic goods and services, produced within the domestic territory of a country by
its normal resident and non-residents during an accounting year less depreciation.
Net National Product at Market Prices (NNP mp): is a measure of the market value of all
final economic goods and services, produced by normal residents within the domestic
territory of a country including Net Factor Income from Abroad during an accounting year
excluding depreciation.
GDP mp = Value of Output in the Domestic Territory – Value of Intermediate Consumption

GDP mp = Σ Value Added
GNP mp = GDP mp + Net Factor Income from Abroad
GDP mp = GNP mp - Net Factor Income from Abroad
National = Domestic + Net Factor Income from Abroad
NDP mp = GDP mp - Depreciation

NDP mp = NNP mp - Net Factor Income from Abroad
Gross = Net + Depreciation or Net = Gross - Depreciation
29
NNP mp = GNP mp - Depreciation

NNP mp = NDP mp + Net Factor Income from Abroad
NNP mp = GDP mp + Net Factor Income from Aboard - Depreciation
Market Price = Factor Cost + Net Indirect Taxes

= Factor Cost + Indirect Taxes - Subsidies
Factor Cost = Market Price - Net Indirect taxes

= Market Price - Indirect Taxes + Subsidies
Gross Domestic Product at Factor Cost ( GDP fc)
= GDP mp - Indirect Taxes + Subsidies
= Compensation of employees
+ Operating Surplus (rent + interest + profit )
+ Mixed Income of Self - employed
+ Depreciation
NDP fc = NDP mp - Net Indirect Taxes
= Compensation of employees
= Operating Surplus (rent + interest = profit )
= Mixed Income of Self - employed
EXPLAIN THE TERM GROSS DOMESTIC PRODUCT (GDP). HOW IS IT ESTIMATED?

Gross domestic product (GDP) is a measure of the market value of all final economic
goods and services, gross of depreciation, produced within the domestic territory of a
country during a given time period. It is the sum total of ‘value added’ by all producing
units in the domestic territory and includes value added by current production by foreign
residents or foreign-owned firms. The term ‘gross’ means implies that GDP is measured
‘gross’ of depreciation. ‘Domestic’ means domestic territory or resident production units.
However, GDP excludes transfer payment, financial transaction and non – reported output
generated through illegal transaction such as narcotics and gambling (these are known
as ‘bads’ as opposed to goods which GDP accounts for).
30
Gross Domestic Product (GDP) is in fact Gross Domestic Product at market prices (GDP mp)
because the value of goods and services is determined by the common measuring unit
of money or it is evaluated at market prices. Money enables us to measure and find the
aggregate of different types of products expressed in different units of measurement by
converting them in terms of Rupees.
GDP can be estimated either at market price (MP) or at Factor Cost (FC). At Market Price
GDP includes all the indirect taxes while it excludes the subsidies given by the government.
While on the other hand GDP at Factor Cost includes all the cost incurred in the production
of goods. In other words GDP at factor cost does not include indirect taxes.
When the GDP is estimated at current price. It exhibits Nominal GDP, whereas Real GDP is
when the estimation is made at constant prices. Both Nominal and real GDP are considered
as a financial metric for evaluating country’s economic growth and development.
Nominal GDP is GDP evaluated at current market prices. Therefore, nominal GDP will
include all of the changes in market prices that have occurred during the current year due
to inflation or deflation.
Real GDP is GDP evaluated at the market prices of some base year. For example, if 1990
were chosen as the base year, then real GDP for 1995 is calculated by taking the quantities
of all goods and services purchased in 1995 and multiplying them by their 1990 prices.
Currently Base year is 2011-12
DISTINGUISH BETWEEN GDP CURRENT AND CONSTANT PRICES. WHAT PURPOSE

DOES REAL GDP SERVE?
Gross domestic product (GDP) at current prices is GDP at prices of the current reporting
period. It is the market value of goods and services produced in a country during a year.
It is known as nominal GDP. GDP at current prices includes the effect of inflation. On the
other hand GDP at constant prices also known as Real gross domestic product (GDP) is
measure that reflect the value of all goods and services produced by an economy in a
given year, expressed in base-year prices.
GDP, which is essentially a quantity measure, is sensitive to changes in the average price
level. The same physical output will correspond to a different GDP level if the average
level of market prices changes. That is, if prices rise. GDP measured at market prices will
also rise without any real increase in physical output. This is misleading because it does
31
not reflect the changes in the actual volume of output. To correct this i.e. to eliminate the
effect of prices, in addition to computing GDP in terms of current market prices, termed
‘nominal GDP’ or ‘GDP at current price’, the national income accountants also calculate
‘real GDP’ or ‘GDP at constant prices’ which is the value of domestic product in terms of
constant prices of a chosen base year.
WHAT IS THE DIFFERENCE BETWEEN THE CONCEPTS ‘MARKET PRICE’ AND ‘FACTOR
COST IN NATIONAL INCOME ACCOUNTING?
Factor cost is called so because it represents the total cost of factor viz. labor, capital and
entrepreneurship.
In addition to factor cost, the market value of the goods and services will include indirect
taxes which are:
 Product taxes like excise duties, customs, sales tax, service tax etc; levied by the
government on goods and services, and
 Taxes on production, such as factory license fee taxes to be paid to the local authorities,
pollution tax etc. which are unrelated to the quantum of production.
Government gives subsidy to many goods and services. The market price will be lower by
the amount of subsidies on products and production which the government pays to the
producer. Hence, the market value of final expenditure would exceed the total obtained
at factor cost by the amount of product and production taxes reduced by the similar kinds
of subsidies.
For example if the factor cost of a unit of goods X is Rs. 50/, indirect taxes amount to
Rs.15/per unit and the government gives a subsidy of Rs. 10/per unit, then market price
will be Rs.55/- Thus, we find that the basic of distinction between market price and
factor cost is net indirect taxes (i.e. Indirect taxes – Subsidies).'
Market Price = Factor Cost + Net Indirect Taxes
= Factor Cost + Indirect Taxes – Subsidies
Factor Cost = Market Price – Net Indirect Taxes
= Market Prices – Indirect Taxes + Subsidies
EXPLAIN VALUE ADDED METHOD AS APPLIED IN NATIONAL INCOME ACCOUNTING?

(1) Product method/ Output method/Inventory method/ Industry origin method/Value added
method/ Final goods method.
This method of measuring national income is also known as Industry origin method.
This method approaches NI from output side.
32
According to this method, economy is divided into different sectors, such as

Agriculture, Mining, Manufacturing, Transport.
The output or product method is calculated either by valuing all final goods and
services produced during the year or by adding all the values at each stage of
production till it becomes the Final product.
Final goods are those goods which are ready for final consumption According to
Approach value of all ‘Final goods and services produced in primary, secondary and
territory are Included and values of all Intermediate transactions are Ignored.
In order to Avoid Double Counting, Value Added method is used.

The difference between Value of material output & input at each stage of production
is called as “Value Added.
GVA mp = Value of output – Intermediate Consumption

GVA mp = Sales + change in stock (closing – opening) - Intermediate Consumption
Gross Value Added
= GVA
+ Primary sector
+ Secondary sector
+ Territory Sector
GDP mp
(+) NFIA
GNP mp
(-) Dep
NNP mp
(-) IT+S
NNP FC = National Income
Example: Bread.
Stage Value of Output Value of Input Value Added
Farmer 7.00 0.00 7.00
Flour mill 10.00 7.00 3.00
Bakery 13.00 10.00 3.00
Retailer 14.00 13.00 1.00
14.00
33
Per capita Income

The GDP per capita is a measure of a country’s economic output per person. It is obtained
by dividing the country’s gross domestic product, adjusted by inflation, by the total
population. It serves as an indicator of the standard of living of a country.
National income
PCI =
Total Population
Explain Personal Income

While national income is income earned by factors of production, Personal Income is
the income received by the household sector including Non-Profit Institutions Serving
Households. Thus, national income is a measure of income earned and personal income
is a measure of actual current income receipt of persons from all sources which may
not be earned from productive activities during a given period of time. In other words,
it is the income ‘actually paid out’ to the household sector, but not necessarily earned.
Examples of this include transfer payment such as social security benefits, unemployment
compensation, welfare payment etc. Individuals also contribute income which they do
not actually receive; for example, undistributed corporate profits and the contribution of
employers to social security. Personal income forms the basis for consumption expenditures
and is derived from national income as follows:
PI = NI + income received but not earned – income earned but not received
An important point to remember is that national income is not the sum of personal
incomes because personal income includes transfer payments (e.g. Pension) which are
excluded from national income. Also not all national income accrues to individuals as
their personal income.
 Personal Income  National Income
NFIA Less:
+ 1. Undistributed Corporate Profit
Rent 2. Corporate Tax
+ 3. Social Security Contribution
Interest
Add: Transfer Payment
+
Wages
+
Profit
+
Dividend
34
Explain Disposable Personal Income (PDI)

Disposable personal income is a amount of the money in the hands of the individual that
is available for their consumption or savings. Disposable personal income is derived from
personal income by subtracting the direct taxes paid by individual and other compulsory
payment made to the government.
DI = PI - Personal Incomes Taxes
HOW IS NATIONAL INCOME CALCULATED UNDER ‘INCOME METHOD’?

Production is carried out by the combined effort of all factors of production. The factors
are paid factor incomes for the services rendered. In other words, whatever is produced
by a producing unit is distributed among the factors of production for their services.
Under Factor Income Method, also called Payment Method or Distributed Share Method,
national income is calculated by summation of factor incomes paid out by all production
units within the domestic territory of a country as wages and salaries, rent, interest, and
profit by definition, it includes factor payment to both residents and non-residents.
Thus,
NDP FC = Sum of factor incomes paid out by all production units within the domestic
territory of a country
NNP FC or National Income = Compensation of employees + Operating Surplus (rent +
interest + profit) + Mixed Income of self-employed + Net Factor income from Abroad
Only incomes earned by owners of primary factors of production are included in national
incomes. Transfer incomes are excluded from national income. Thus, while wages of
labourers will be included, pensions of retried workers will be excluded from national
income. Labour income includes, apart from wages and salaries, bonus, commission,
employers’ contribution to provident fund and compensations in kind. Non-labour
income includes dividends, undistributed profits of corporations before taxes, interest,
rent, royalties and profit of unincorporated enterprises and of government enterprises.
EXPLAIN ‘EXPENDITURE METHOD’ FOR CALCULATION OF NATIONAL INCOME?

In the expenditure approach, also called Income Disposal Approach, national income is the
aggregate final expenditure in an economy during an accounting year. In the expenditure
approach to measuring GDP, we add up the value of the goods and services purchased by
each type of final user mentioned below:
35
1. Final Consumption Expenditure:

(a) Private Final Consumption Expenditure (PFCE)
To measure this, the volume of final sales and services to consumer households
and nonprofit institutions serving households acquired for consumption (not
for use in production) are multiplied by market prices and then summation
is done. It also includes the value of primary product which are produced for
own consumption by the households, payment for domestic services which
one household renders to another, the net expenditure on financial assets or
foreign investment. Land and residential buildings purchased or constructed by
household are not part of PFCE. They are included in gross capital formation.
Thus, only expenditure on final goods and services produced in the period for
which national income is to be measured and net foreign investment are include
in the expenditure method of calculating national income.
(b) Government Final Consumption Expenditure

Since the collective services provided by the governments such as defence,
education, healthcare etc. are not sold in the market, the only way they can be
valued in money terms is by adding up the money spent by the government in the
production of these services. This total expenditure is treated as consumption
expenditure of the government. Government expenditure on pensions,
scholarships, unemployment allowance etc. should be excluded because these
are transfer payments.
2. Gross Domestic Capital formation

Gross domestic fixed capital formation includes final expenditure on machinery and
equipment and own account production of machinery and equipments, expenditure
on construction, expenditure on changes in inventories, and expenditure on the
acquisition of valuables such as, jewelry and works of arts.
3. Net Exports
Net exports are the difference between exports and imports of a country during the
accounting year. It can be positive or negative.
To arrive at national income or NNP FC using expenditure method we first find the
sum of final consumption expenditure, gross domestic capital formation and net
exports. The resulting figure is gross domestic product at market price (GDP MP). To
this, we add the net factor income from abroad and obtain Gross National Product
36
at market price (GDP MP). Subtracting indirect taxes from GNP MP, we get Gross
National Product at Factor cost (GNP FC). National income or NNP FC is obtained
by subtracting depreciation from Gross national product at factor cost (GNP FC).
EXPLAIN GDP AND WELFARE:

(a) Income distributions and, therefore, GDP per capita is a completely inadequate
measure of welfare. Countries may have significantly different income distributions
and, consequently, different levels of overall well-being for the same level of per
capita income.
(b) Quality improvement in systems and processes due to technological as well as
managerial innovations which reflect true growth in output from year to year.
(c) Productions hidden from government authorities, either because those engaged in it
are evading taxes or because it is illegal (drugs, gambling etc.).
(d) Non-market production (with a few exception) and Non-economic contributors to
well-being for example: health of a country’s citizens, education levels, political
participation, or other social and political factors that may significantly affect well-
being levels.
(e) The dis-utility of loss of leisure time. We known that, other things remaining the
same a country’s GDP rises if the total hours of work increase.
(f) Economic ‘bads’ for example: crime, pollution, traffic congestion etc. which makes us
worse off.
(g) The volunteer work and services rendered without remuneration undertaken in the
economy, even though such work can contribute to social well-being as much as
paid work.
(h) Many things that contribute to our economic welfare such as, leisure time, fairness,
gender equality, security of community feeling etc..,
(i) The distinction between production that makes us better off and production that
only prevents us from becoming worse off, e.g. defense expenditure such as on police
protection. Increased expenditure on police due to increase in crimes may increase
GDP but these expenses only prevent us from becoming worse off.
EXPLAIN LIMITATION OF NATIONAL INCOME:

There are innumerable limitations and challenges in the computation of national income.
The task is more complex in underdeveloped and developing countries. Following are
the general dilemmas in measurement of national income. GDP measures ignore the
following:
37
Conceptual difficulties:
(a) Lack of an agreed definition of national income,
(b) Accurate distinction between final goods and intermediate goods,
(c) Issue of transfer payments,
(d) Services of durable goods,
(e) Valuation of government service
(f) Valuation of a new product at constant price
Other challenges relate to:

(a) Inadequacy of data and lack of reliability of available data,
(b) Presence of non-monetized sector,
(c) Absence of recording of income due to illiteracy and ignorance,
(d) Lack of proper occupational classification, and
(e) Accurate estimation of consumption of fixed capital.
(f) Production for self consumption
CONSTANT PRICES VS. CURRENT PRICES

At Constant Prices At Current Prices
1. Measurement of Value of Output at Measurement of Value of Output at the
the Price level of a selected “Base Price level of the “Current Year”
Year”
2. National Income is affect only by National Income is affected by changes
changes in Output levels. in Price levels and Output levels.
3. National Income changes only when National Income changes even if
production/physical output changes. price change, without any change in
production/physical output.
4. This is also called Real Value of This also called Nominal Value of
National Income, e.g. GDP at Constant National Income, e.g. GDP at Current
Price = Real GDP. Prices = Nominal GDP.
Private Income
Private income is a measure of the income (both factor income & transfer income) which
accrues to private sector from all sources within & outside the country.
Private Income
=
Factor Income from Net domestic product
38
+
Net factor income from abroad
+
National debt interest
+
Current transfer from Govt.
+
Other Net transfer from the Rest of the world.
GDP deflator
• It is a measure of general price inflation.
• It taken into consideration both Nominal GDP as well as Real GDP.
• The word deflator indicates to ‘deflate’ or take inflation out of GDP.
• It is a Price index used to convert Nominal GDP into real GDP.
• The deflator measures the changes in Price that has occurred between base year
and Current year
GDP deflator = x 100
Example 2.
Real GDP ` 4700
Nominal GDP ` 3000
Calculate GDP deflator
GDP deflator = x 100
(Price has fallen)
Example 3.
2010 2018
Nominal GDP ` 600 1200
Price index 100 110
39
Year GDP deflator

2018 100
2019 113.63
2020 130.25
Example 4.
Example 5.

= 14.62%
COMPARISON:
Market Prices Factor Cost
(a) Market Prices refer to the Final Money Net Value Added by each Entry gets
Value of goods & service, i.e. Net Value distributed as Income to the Owners
Added in the course of production of of Factors of Production, i.e. as rent,
goods & services. Wages, Interest and Profits for the
Owner of Land, Labour, Capital and
Entrepreneurship respectively. This
total is called Factor Cost.
(b) Measurement at Market Prices Measurement at Factor Cost constitute
constitute external sale price angle. internal value addition angle.
(c) Value at Market Prices = Value at Factor Cost =
Value at Factor Cost Value at Market Prices
Add: Indirect Taxes Less: Indirect Taxes
Less: Subsidies Add: Subsidies
40
NET DOMESTIC PRODUCT (NDP) & NET NATIONAL PRODUCT (NNP) AT MKT PRICES.
Based on the concept of “Domestic” and “National” measurements, as well as the concept of
“Gross” and “Net” measurements given above, the following concepts of measurement arise –
GDP at Factor Cost GNP at Factor Cost
1. Meaning GDPfc is the Total of Income GNPfc is the Total of Income
of Factor of Production, i.e. of Factors of Production, i.e.
Land, Labour, Capital and Land, Labour, Capital and
Entrepreneurship. entrepreneurship, adjusted for
Net Factor Income from abroad.
2. Formula GDPfc = GDPmp (-) Net Indirect GNPfc = GNP (-) Net Indirect Taxes
(a) Mp vs FC Route Taxes
(b) Total Factor Compensation of Employees Compensation of Employees
Cost Route + Operating Surplus + Operating Surplus
+ Mixed Income of Self- Employed + Mixed Income of Self – Employed
+ Depreciation + Depreciation
+ Net Factor Incomes from Abroad
Note:
Net Indirect Taxes = Indirect Taxes (-) Subsidies.
Operating Surplus = Rent + Interest + Profits.
NET DOMESTIC PRODUCT (NDP) & NET NATIONAL PRODUCT (NNP) AT FACTOR COST:
Based on the concept of “Domestic” and “National” measurements as well as the concept
of “Market Prices” and “Factor Cost” given above, the following concepts of measurement
arise –
NDP at Factor Cost NNP at Factor Cost
1. Meaning NDPfc is the Total of Incomes NNPfc is Total of Incomes of
of Factor of Production, i.e. Factor of Production, i.e. Land,
Land, Labour, Capital and Capital and Entrepreneurship,
Entrepreneurship, net of net of Depreciation, adjusted for
Depreciation. Net Factor Incomes of Abroad.
2. Concept NDPfc is the Total Domestic Factor NNPfc is the Total Factor Incomes
Income, net of Depreciation. accruing to normal resident of a
country during a period.
3. Formula NDPfc = GDPfc (-) Depreciation NNPfc = GNPfc (-) Depreciation
(a) Gross vs
Net Route
41
(b) MP vs FC NDPfc = NDPmp (-) Net Income NNP fc = NNPmp (-) Net Indirect
Net Route Taxes Taxes
(c) Total Compensation of Employees Compensation of Employees
Factor Cost + Operating Surplus + Operating Surplus
Route + Mixed Income of Self- Employed +Mixed Income of Self – Employed
- Depreciation
+ Net Factor Incomes from Abroad
COMPARISON:
National Income Personal Income

(a) Income “earned by Factor of Production Current Income “received” by Persons
from all sources.
(b) It is measure of Income earned from It is measured of actual current
productive activities. Income receipts, from both productive
and non-productive activities.
(c) It forms the basis of Overall Income in It forms the basis for Consumption
the economy. Expenditure.
Note:
Personal Income is generally less than the National Income, unless Transfer Payment are very
high.
Intermediate goods and final goods:
 Those goods which have crossed boundary line of production and ready for use by
end user is known as final goods. Final goods are o1 two types.
1. Consumer final goods (all the goods purchase by households)
2. Producers final goods (capital goods): Agoods purchased by firm is capital

goods if fulfilled all the following conditions -
(i) Durable.
(ii) Not for resale,
(iii) Not use as raw material,
(v) Comparatively costly.
(If any of the above condition not fulfil then it will know as intermediate goods,
which is described Below)
42
 Those goods which are within the boundary line of production and which are not
ready for use by final user are known as intermediate goods,
Student mu st note that only final goods are included in national income not
intermediate otherwise it leads to problem of double counting (which will be discuss
later in this chapter)
So it is impo rtant to identify which good is intermediate and which good is final,
List showing some examples of intermediate and final goods:

ITEMS GOODS REASON
Machine purchased by dealer Intermediate Dealer purchased machines
of machine for the purpose of resale
A car purchased by household Final consumer Household is the final user
of the car,
Furniture purchased by a Final consumer School will finally use
school furniture as capital assets.
Chalks, duster etc. Purchased Intermediate These goods will be
by school consumed for the creation
of educational service
during a year.
Computers installed in a Final producer School will finally use
school computers as capital
assets.
Mobile sets purchased by Intermediate Dealer purchased mobile
mobile dealer sets (or the purpose of
resale.
Maintenance of office building Intermediate Items purchased for
maintenance will be used
up during the period of one
year.
Improvement of a machine in Final producer It will increase the value
factory of assets or it will leads to
creation of assets.
Electricity consumed by firms Intermediate It will be used for production
of goods and services in
short period of time.
43
Purchase of rice by grocery Intermediate Grocery shop is purchasing

shop rice to resale.
Cloth used for making a sofa- Intermediate As it used as raw material in
set by the carpenter manufacturing of sofa set.
GST book purchased by tax Final producer GST book is an asset for tax
consultant consultant.
Book purchased by a student Final Consumer Student is a household.
Factor income and trust transfer income

Basis Factor income Transfer
Meaning It refer to income received It is the income received without
by factors of production for rendering any service or selling
Rendenng factor service or any product.
selling a product
Inclusion It is Included in the calculation It is included in calculation of
of national income as well as only disposable income
disposable income.
Example Rent, wages, interest and profit Old age pension, scholarship,
charity, grants, retirement
FACTOR COST VS BASIC PRICE VS MARKET PRICE:

At this stage, we need to clearly understand the difference between the concepts: ‘market
price’ and ‘factor cost and Basic Price
GDP at Basic Price excludes any taxes on products the producer receives from the purchaser
and passes on to the government (Eg: GST or Sales Tax or Services Tax) but includes any
subsidies the producer receives from the government and uses to lower the prices charged
to purchasers. In simple terms, the basic price is the subsidised price without tax.
Basic price = factor cost + Production taxes – Production subsidy
Relationship between Factor Cost and Basic Price:

Factor cost + production tax – production subsidies = Basic prices.
Relationship between Basic Price and Market Price:

Basic Price + Product tax – Product Subsidy = Market Price.
Note: Thus, market price includes both product tax as well as production tax while
excluding both product and production subsidies.
44
DATA REQUIREMENTS AND OUTCOMES OF DIFFERENT METHODS OF NATIONAL INCOME

CALCULATION:
Method Data required What is measured
Phase of Output: The sum of net values added by Contribution of production
Value added method all the producing enterprises of units
(Product Method) the country
Phase of income: Total factor incomes generated Relative contribution of factor
Income Method in the production of goods and owners
services
Phase of disposition: Sum of expenditures of the Flow of consumption and
Expenditure method three investment expenditures
spending units in the economy,
namely, government, consumer
households, and producing
enterprises
Some Dos and Don'ts

Do not include the following items in the estimation of national income:
1. Gifts from Abroad: These are transfer payments and, therefore, not included in
national income.
2. Unemployment Allowance: This is available to those persons who are not employed.
This is, therefore, only a transfer payment not included in national income.
3. Financial Help to Tsunami Victims: It is not included in national income since it is a
transfer payment.
4. Purchase of Vegetables by a Restaurant: It is not included in national income since it is
an intermediate consumption.
5. Expenses on Electricity by a Factory: It is not included in national income since it is a
part or intermediate consumption.
6. Leisure-time Activities like Growing Vegetables by Household his Kitchen Garden: By
convention, value added through such activities is not accounted for in the estimation
of national income/product.
7. Services rendered by the Housewives: These are included in national income because
it is difficult to find their market value, and these are not rendered for the purpose
of earning income.
8. Money received by Individual from his son Working Abroad: It is not included in national
income of India because it is a kind of transfer income.
45
9. Interest Received from a Friend on Loans offered to him for the Purchase of a Motorbike:
It is not included in national income because loans are used not for production
purpose
10. Corporate Profit Tax: it is not included in the estimation of national income as it
flows out of profits as transfer payment to the government.
[Note: If profit is not known (in any numerical question) we can find its value by
adding up: (a) dividends, (b) undistributed profits, and (c) corporate profit tax.
However, if the question is: how do we treat corporate tax in the estimation of
national income then the answer is as in point (x) above.]
Do include the following items in the estimation of national income:

1. Defense and Security Services: For maintaining law& order and defense of the country,
the government has to employ defense personnel, policemen, judges and others.
The services of these persons may be taken as intermediary or final. These are final
services so far as they provide security and peaceful existence to the households.
2. Free Services by the Government: Free services by the government like free education,
Tree medical facilities or street lighting involve expenditure by the government
which is a part of government final consumption expenditure.
Hence, expenditure on these services is taken as a part of expenditure on final
goods and services. These are included in national income while using expenditure
method.
3. Employer's Contribution to Provident Fund: It is included in national income, since it is
paid by the employers on behalf of the employees.
4. Rent Received by Indian Residents on Building Rented out to Foreign Embassies in India:
It is income from the rest of the world and forms a part of net factor income from
abroad. Tit is included in national income.
5. Profits Earned by a Branch of an Indian Bank in London: It is included in national Income
since Indian employees of Pakistan Embassy are normal residents of India.
6. Salary to Foreign Technical Specialists: As a payment of factor income to the 'non-
resident'. It reduces national income.
7. Dividend Received by an Indian Resident from his Investment in a Foreign Financial Firm: It
is included in national income of India because it is a part of net factor income from
abroad.
46
NUMERICAL SUMS
Question 1
From the following data, calculate NNPFC, NNPMP, GNPMP and GDPMP.
Items ` in Crores
Operating surplus 2000
Mixed income of self-employed 1100
Rent 550
Profit 800
Net indirect tax 450
Consumption of fixed capital 400
Net factor income from abroad -50
Compensation of employees 1000
Answer
GDPMP = Compensation of employees + mixed income of self-employed + operating
surplus + depreciation + net indirect taxes
(Note: operating surplus = rent+ profit + interest)
= 1000 + 1100 + 2000 + 400 + 450 =4950

GNPMP = GDPMP + NFIA = 4950 + (-50) = 4900
NNPMP = GNPMP + P consumption of fixed capital = 4900 – 400 = 4500
NNPFC or NI = NNPMP – NIT = 4500 – 450 = = 4050 Crores
Question 2
From the following data, estimate National Income and Personal Income.
Items ` in Crores
Net national product at market price 1,891
Income from property and entrepreneurship accruing to government
administrative departments 45
Indirect taxes 175
Subsidies 30
Saving of non-departmental enterprises 10
Interest on National debt 15
47
Current transfers from government 35

Current transfers from rest of the world 20
Saving of private corporate sector 25
Corporate profit tax 25
Answer:
National Income = Net national product at market price – Indirect taxes + Subsidies
= 1,891 – 175 + 30 = 1746 crores
Personal Income = National income – Income from property and entrepreneurship

accruing to government administrative departments – Saving of
non-departmental enterprises + National debt interest + Current
transfers from government + Current transfers from rest of the
world – Saving of private corporate sector – Corporate profit tax
= 1746 – 45 –10 + 15 + 35 + 20 – 25 – 25
= 1711 Crores
Question 3
Calculate the aggregate value of depreciation when the GDP at market price of a country in
a particular year was ` 1,100 Crores. Net Factor Income from Abroad was ` 100 Crores. The
value of Indirect taxes – Subsidies was ` 150 Crores and National Income was ` 850 Crores.
Answer
Given
GDPMP = 1100 Crores, NFIA = 100 Crores, NIT =150 Crores, NNPFC = 850 Crores
\ GDPFC = GDPMP – NIT = 1100 – 150 = 950
GNPFC = GDPFC + NFIA = 950 + 100 = 1050
NNPFC = GNPFC – Depreciation
850 = 1050 – Depreciation
Depreciation = 1050 – 850 = 200 Crores.
Question 4
On basis of following information, calculate NNP at market price and Disposable personal income
Items ` in Crores
NDP at factor cost 14900
Income from domestic product accruing to government 150
Interest on National debt 170
48
Transfer payment by government 60

Net private donation from abroad 30
Net factor income from abroad 80
Indirect taxes 335
Direct taxes 100
Subsidies 262
Taxes on corporate profits 222
Undistributed profits of corporations 105
Answer
NNP at Market price = NNP at factor cost + indirect tax - subsidies
Where NNP at factor cost = NDPFC + NFIA
= 14900 + 80 = 14980
Therefore, NNPMP = Therefore, NNP MP = 14980 + 335 – 262 = 15053
Disposable personal income (DI) = PI- Personal income tax
PI = NI + income received but not earned – income earned but not received
= 14980 + 170 + 60 + 30 -150 -222- 105 = 14763
Therefore, DI = 14763- 100 = 14663 Crores
Question 5
Calculate National Income by Value Added Method with the help of following data-
Particulars ` (in Crores)
Sales 700
Opening stock 500
Intermediate Consumption 350
Closing Stock 400
Net Factor Income from Abroad 30
Depreciation 150
Excise Tax 110
Subsidies 50
Answer
NVA(FC) = GDP(MP) –Depreciation +NFIA- Net Indirect Tax
Where GVA(MP) = Value of output- intermediate consumption
Value of Output = Sales + change in stock
= 700 + (400-500) = 600
GVA(MP) = 600 – 350 = 250
49
Therefore NI = 250 - 150 + 30 - (110 - 50)

= 70 Crores
Question 6
Calculate the Operating Surplus with the help of following data-
Particulars ` in Crores
Sales 4000
Intermediate consumption 600
Rent 400
Interest 300
Net indirect tax 500
Consumption of Fixed Capital 200
Mixed Income 400
Answer
GVAMP = Gross Value OutputMP – Intermediate consumption
= (Sales + change in stock) – Intermediate consumption
= 4000 - 600 = 3400
GDPMP = GVAMP = 3400 Crores
NDPMP = GDPMP – consumption of fixed capital
= 3400 – 200
= 3200 Crores
NDPFC = NDPMP – NIT
= 3200 – 500 = 2700 Crores
NDPFC = Compensation of employees + Operating surplus + Mixed income
2700 = 800 + Operating Surplus + 400
Operating surplus = 1500 Crores
Question 7
Calculate national income by value added method.
Particulars (` in crores)
Value of output in primary sector 2000
Intermediate consumption of primary sector 200
Value of output of secondary sector 2800
Intermediate consumption of secondary sector 800
50
Value of output of tertiary sector 1600

Intermediate consumption of tertiary sector 600
Net factor income from abroad -30
Net indirect taxes 300
Depreciation 470
Answer
GDPMP = (Value of output in primary sector - intermediate consumption of primary
sector) + (value of output in secondary sector - intermediate consumption
of secondary sector) + (value of output in tertiary sector - intermediate
consumption of tertiary sector)
Value of output in primary sector = 2000
- Intermediate consumption of primary sector = 200
+ Value of output in secondary sector = 2800
- Intermediate consumption in secondary sector = 800
+ Value of output in tertiary sector = 1600
- Intermediate consumption of tertiary sector = 600
GDPMP = ` 4800 Crores
NNPFC = GDPMP + NFIA -NIT-Depreciation
NNPFC = National income= 4800+(-30) - 300 - 470 = 4000 Crores
Question 8
Calculate Net Value Added by Factor Cost from the following data.
Items ` in Crores
Purchase of materials 85
Sales 450
Depreciation 30
Opening stock 40
Closing stock 30
Excise tax 45
Intermediate consumption 200
Subsidies 15
Answer
GVAMP = Sales + change in stock - Intermediate consumption
= 450 + (30 - 40) -200
= 240 Crores
51
NVAMP = GVAMP – Depreciation

NVAMP = 240 - 30 = 210 Crores
NVAFC = NVAMP – (indirect tax - subsidies)
= 210 – (45 -15) = 180 Crores
Question 9
Calculate NI with the help of Expenditure method and income method with the help of following
data:
Items ` in Crores
Compensation of employees 1,200
Net factor income from Abroad 20
Profit 800
Private final consumption expenditure 2,000
Net domestic capital formation 770
Consumption of fixed capital 130
Rent 400
Interest 620
Mixed income of self-employed 700
Net export 30
Govt. final consumption expenditure 1100
Operating surplus 1820
Employer’s contribution to social security scheme 300
Answer
By Expenditure method
GDPMP = Private final consumption expenditure + Government final consumption
expenditure + Gross domestic capital formation (Net domestic capital
formation+ depreciation) + Net export
= 2000 + 1100 + (770+ 130) + 30= 4030Crores
NNPFC or NI = GDPMP- depreciation + NFIA – NIT

= 4030 – 130 + 20 – 120= 3800 Crores
52
By Income method
NNPFC or NI = compensation of employees + operating surplus + Mixed income of
selfemployed + NFIA
= 1200 + 1820 + 700 + 20 = 3740Crores
Question 10
From the following data calculate (a) Gross Domestic Product at Factor Cost, and (b) Gross
Domestic Product at Market price
Items ` in Crores
Gross national product at factor cost 61,500
Net exports (-) 50
Rent 800
Interest 900
Profit 1,300
Net domestic capital formation 800
Gross domestic capital formation 900
Factor income to abroad 80
Answer
(a) GDP at factor cost = NDP at factor cost + Depreciation
= Compensation of employees+ Rent+ Interest + Profit + Mixed
income + (Gross domestic capital formation - Net domestic
capital formation)
= ` 3,000 + ` 800 + ` 900 + ` 1,300 + (` 900 - ` 800)
= ` 6100 Crores
(b) Gross Domestic Product at Market Price

= GDP at factor cost + Net Indirect taxes = ` 6100 + ` 300
= 6400 Crores
53
Question 11
Calculate NNPFC. By expenditure method with the help of following information-
Items ` in Crores
Private final consumption expenditure 10
Net Import 20
Public final consumption expenditure 05
Gross domestic fixed capital formation 350
Depreciation 30
Subsidy 100
Income paid to abroad 20
Change in stock 30
Net acquisition of valuables 10
Answer
Calculation of national income by expenditure method:
GDPMP = Government final consumption expenditure (Public final consumption
expenditure) + Private final consumption expenditure + Gross domestic
capital formation (Gross domestic fixed capital formation + change stock
+ Net acquisition of valuables) + Net export (Note: As net import is 20,
hence, net export is -20)
= 5 + 10 + [350 + 30 +10 ]+(- 20) = 5 + 10 + 390 - 20 = 385 Crores
NNPFC = GDPMP – Depreciation + Net factor income from abroad (Income from
abroad – Income paid to abroad) – Net Indirect tax (Indirect tax – subsidies)
= 385 – 30 + [0 – 20] – [0-100] = 385 – 30 – 20 + 100 = 435 Crores.
54
MODULE MULTIPLE CHOICE QUESTIONS
1. The concept of ‘resident unit’ involved in the definition of GDP denotes

(a) A business enterprise which belongs to a citizen of India with production units
solely situated in India
(b) The unit having predominant economic interest in the economic territory of the
country for one year or more irrespective of the nationality or legal status
(c) A citizen household which had been living in India during the accounting year
and one whose economic interests are solely in India
(d) Households and business enterprises composed of citizens of India alone living
in India during the accounting year
2. Read the following statements and answer the following question.

I. Intermediate consumption consists of the value of the goods and services
consumed as inputs by a process of production,
II. Intermediate consumption excludes fixed assets whose consumption is recorded
as consumption of fixed capital.
(a) Only I is true (b) Both I and II are true
(c) Only II is true (d) Neither I nor II is true
3. Gross Domestic Product (GDP) of any nation

(a) excludes capital consumption and intermediate consumption
(b) is inclusive of capital consumption or depreciation
(c) is inclusive of indirect taxes but excludes subsidies
(d) None of the above
4. Read the following statements

I. ‘Value added’ refers to the difference between value of output and purchase of
intermediate goods.
II. ‘Value added’ represents the contribution of labour and capital to the production
process.
(a) Statements I and II are incorrect
(b) Statements I and II are correct
(c) Statement I is correct and II is incorrect
(d) Statement II is correct and I is incorrect
55
5. Non-economic activities are

(a) those activities whose value is excluded from national income calculation as it
will involve double counting
(b) those which produce goods and services, but since these are not exchanged in
a market transaction they do not command any market value
(c) those which do not involve production of goods and services as they are meant
to provide hobbies and leisure time activities
(d) those which result in production for self consumption and therefore not included
in national income calculation
6. Which of the following does not enter into the calculation of national income?
(a) Exchange of previously produced goods
(b) Exchange of second hand goods
(c) Exchange of stocks and bonds
(d) All the above
7. Which of the following enters into the calculation of national income?

(a) The value of the services that accompany the sale
(b) Additions to inventory stocks of final goods and materials
(c) Stocks and bonds sold during eth current year
(d) (a) and (b) above
8. Gross National Product at market prices GNP MP is

(a) GDP MP + Net Factor Income from Abroad
(b) GDP MP - Net Factor Income from Abroad
(c) GDP MP - Depreciation
(d) GDP MP + Net Indirect Taxes
9. Choose the correct statement

(a) GNP includes earnings of Indian corporations overseas and Indian residents
working overseas; but GDP does not include these
(b) NNPFC = National Income = FID (factor income earned in domestic territory) –
NFIA.
(c) Capital goods and inventory investment are excluded from computation of
GDP
(d) NDPMP = GDPMP + Depreciation
56
10. The basis of distinction between market price and factor cost is
(a) net factor income from abroad
(b) net indirect taxes (i.e., Indirect taxes - Subsidies)
(c) net indirect taxes (i.e., Indirect taxes + Subsidies)
(d) depreciation ( consumption of fixed capital)
11. If net factor income from abroad is positive, then

(a) national income will be greater than domestic factor incomes.
(b) national income will be less than domestic factor incomes.
(c) net exports will be negative
(d) domestic factor incomes will be greater than national income
12. The GDP per capita is

(a) a measure of a country's economic output per person
(b) actual current income receipts of persons
(c) national income divided by population
(d) (a)and (c) above
13. Which of the following is an example of transfer payment?

(a) Old age pensions and family pensions
(b) Scholarships given to deserving diligent students.
(c) Compensation given for loss of property due to floods
(d) All the above
14. Mixed income of the self -employed means

(a) net profits received by self -employed people
(b) outside wages received by self- employed people
(c) combined factor payments which are not distinguishable,
(d) wages due to non- economic activities
15. Which of the following is added to national income while calculating personal
income?
(a) Transfer payments to individuals
(b) Undistributed profits of corporate
(c) Transfer payments made to foreigners
(d) Mixed income of self employed
57
ANSWERS:
1 (b) 2 (b) 3 (b) 4 (b) 5 (b)
6 (d) 7 (d) 8 (a) 9 (a) 10 (b)
11 (a) 12 (d) 13 (d) 14 (c) 15 (a)
58
SUMMARY
 National income accounts are extremely useful for analyzing and evaluating the
performance of an economy, knowing the composition and structure of the national
income, income distribution, economic forecasting and for choosing economic
policies and evaluating them.
 Gross domestic product (GDPMP) is a measure of the market value of all final economic
goods and services, gross of depreciation, produced within the domestic territory of
a country during a given time period gross of depreciation.
 Capital goods (business plant and equipment purchases) and inventory investment—
the net change in inventories of final goods awaiting sale or of materials used in the
production are counted in GDP
 To eliminate the effect of prices, in addition to computing GDP in terms of current
market prices, termed ‘nominal GDP’ or GDP at current prices,the national income
accountants also calculate ‘real GDP ’or GDP at constant prices which is the value
of domestic product in terms of constant prices of a chosen base year.
 GNPMP = GDPMP + Net Factor Income from Abroad
 NDPMP = GDPMP - Depreciation
 NDPMP =NNPMP - Net Factor Income from Abroad
 NNPMP = GNPMP - Depreciation
 Market Price = Factor Cost + Net Indirect Taxes= Factor Cost + Indirect Taxes –
Subsidies
 Gross Domestic Product at Factor Cost (GDPFC) = GDPMP – Indirect Taxes + Subsidies
 Net Domestic Product at Factor Cost (NDPFC)is defined asthe total factor incomes
earned by the factors of production.
 Net National Product at Factor Cost (NNPFC)or National Income
NNPFC = National Income = FID (factor income earned in domestic territory) + NFIA.
 Personal income is a measure of the actual current income receipt of persons from
all sources. Disposable Personal Income (DI) that is available for their consumption
or savings DI = PI - Personal Income Taxes
 Circular flow of income refers to the continuous interlinked phases in circulation of
production, income generation and expenditure involving different sectors of the
economy.
59
 Product Method or Value Added Method is also called Industrial Origin Method or
Net Output Method and entails the consolidation of the production of each industry
less intermediate purchases from all other industries.
 Under income method, national income is calculated by summation of factor
incomes paid out by all production units within the domestic territory of a country
as wages and salaries, rent, interest, and profit. Transfer incomes are excluded.
 Under the expenditure approach, also called Income Disposal Approach, national
income is the aggregate final expenditure in an economy during an accounting year
composed of final consumption expenditure (private& government), gross domestic
capital formation and net exports.
60
UNIT 2: THE KEYNESIAN THEORY OF DETERMINATION

OF NATIONAL INCOME
1. Circular Flow of National Income Two Sector Model

Factor Services
Goods & Services

1. Households are the owners of factor of production and consumers of goods
and services.
2. Business sector produces goods & services and sells them to household sector.
3. Household sector is the owner of Land, Labour and Capital.
4. Household sector receives Income by selling those services to business sector.
5. Business sector consist of producer who produces goods and services and sells
them to household sector. Thus, one man’s Income is another man’s expenditure.
The above diagram Indicates money flows from household towards banking
system which leads to borrowing by business which finally leads to Investment
in the economy. Suppose planned saving exceeds planned Investment Income,
Output and employment will fall and flow of money will decline. Now if
planned Investment exceeds planned savings income, output & employment
will Increase so saving are considered as leakage and Investment are considered
as Injection.
The outer circle at the diagram shows Real flow (i.e.) the flow at factor service
from household to business and flow of goods from business, to household.
The inner circle shows money flow, (i.e.) flow of factor payments from business
to household & consumption expenditure from household to business.
61
Conclusion:
In the circular flow of income production generates factor income which is converted
in to expenditure, this flow of income is a continuous activity due to never ending
human wants.
Equilibrium level of national income two sector model
Explanation of diagram
1. Income is measured on the X – axis while
aggregate demand is measured on the Y –
Axis.
2. The C + I line is obtained through addition
of consumption function (C) and
investment function (I) at each level of
income.
3. The C + I curve shows that aggregate
demand rises with the rise in level of
income.
4. Only at point E*, aggregate demand =
output. Hence, point E* shows equilibrium level of income at OYo.

1. At OYo, planned spending of households exactly equal to actual production of
business sector ie AD=AS.
2. At any income level below OYo, aggregate demand > Aggregate supply (C + l
Iine is above 450 line). Alternatively, at income levels above OYo, AS > AD ie C+S
>C + I
3. In both the above cases, market mechanism will drive the income back to OYo
through changes in the level of investment, employment and output.
4. Panel B of dig shows saving and investment function. Saving schedule (S) slopes
upward to indicate that savings rise with increase in income
5. At point E*, investment also equals savings as shown by intersection of saving
and investment schedule.
6. At any income level above OYo savings > planned investment while at income
levels below OY0, planned investment > savings.
7. Hence, only OYo indicates the equilibrium level where S = I (Leakages are equal to
injections)
62
2. Short note on Consumption Function
Agg. Income Agg. Consumption Savings

Y C S=Y–C
0 500 - 500 Dis Saving
1000 1200 - 200 Dis Saving
2000 2000 000
3000 2600 + 400 Savings
4000 3300 + 700 Savings
15000 4000 + 1000 Savings

Lord J.M.Keynes explains the relationship between consumption and income in terms
of psychological law of consumption in his book General theory of employment
income (i.e.) money 1936.
According to this law, as aggregate income increases total consumption in the
economy also increases but in lesser proportion than increase in income. This is
because as income increases individual wants are satisfied to larger and larger
extent. So when income increases further people do not consume entire income,
they will save a part of it. Here, there is balance to be gap between income and
consumption.
63
According Keynes with increase in income both consumption and saving increase.
However
1. Consumption Increases at diminishing rate.
2. Saving Increases at increasing rate.
In the above Horizontal axis represents Aggregate Income and vertical axis represent
consumption expenditure.
OA on vertical axis shows Autonomous consumption at zero level of income. Thus
consumption curve starts at moves to B and further C. (i.e.) C = a + by.
Point B denotes break-even point at this point c = y
The ∆OAB Indicates Dis savings, however after point B. saving are positive and saving
increase with Increasing Income.
3. Saving Function.
S = Y – C / S = F(Y)
Table same as consumptions function
64
Savings is the income left after consumption. Savings function is the counter part of
consumption function, i.e. s = y – c
In the above diagram the gap between income and consumption measures the
saving. This gap after point B goes on increasing with rising income. This indicates
that savings rises with rising income ‘S’ curve represents saving function. The savings
function derives from consumption function. If we draw ┴ from breakeven point, B to
C. and after joining the point If we further extend the line we derive ‘S’ curve that is
nothing but saving curve.
4. APC, MPC, APS, MPS

Average propensity to consume, Marginal propensity to consume, Avg propensity to
save, marginal propensity to Savings.
(1) APC = Consumption C
Total Income Y
(2) MPC = Change in consumption ∆C

Change in Income ∆Y
(3) APS = Savings S

Total Income Y
(4) MPS = Change in savings ∆S

Change in income ∆Y
MPS = I – MPC (1 = income)

Or
= I–b (Induced consumption)
Income Consumption Apc Mpc Mps

0 500 - - -
1000 1250 1.25 0.75 0.25
2000 2000 1 0.75 0.25
3000 2150 092 0.75 0.25
6000 5000 0.83 0.75 0.25
10,000 8000 0.8 0.75 0.25
65
APC + APS = 1
C+S =Y
Dividing both sides by Y.
C+S+ Y
Y + Y +Y
↓ ↓ ↓
APC + APS = 1
Prove:
MPC + MPC = 1
∆C + ∆S = ∆Y
Dividing both sides by ∆Y
∆C + ∆S + ∆Y
∆Y ∆Y ∆Y
↓ ↓ ↓
MPC + MPS + 1
Marginal Propensity to Consume (MPC)

The consumption function is based on the assumption that there is a constant
relationship between consumption and income, as denoted by constant b which
is marginal propensity to consume. The concept of MPC describes the relationship
between change in consumption (∆C) and the change in income (∆Y). The value of the
increment to consumer expenditure per unit of increment to income is termed the
Marginal Propensity to Consume (MPC).
Although the MPC is not necessarily constant for all changes in income (in fact, the
Total Consumption cc
APC = =
Total Income YY
The Marginal Propensity to Save (MPS)

The slope of the saving function is the marginal propensity to save. If a one-unit
increase in disposable income leads to an increase of b units in consumption, the
remainder (1 - b) is the increase in saving. This increment to saving per unit increase
in disposable income (1 - b) is called the marginal propensity to save (MPS). In other
words, the marginal propensity to save is the increase in saving per unit increase in
disposable income.
∆S
MPS = 1-b
∆Y
66
Average Propensity to Save (APS)

The ratio of total saving to total income is called average propensity to save (APS).
Alternatively, it is that part of total income which is saved.
Total Saving S
APS = =
Total Income Y
5. Explain Circular Flow of National Income [ 3 sector]
From the above circular chart we can find that government sector Adds following things,
1. Taxes on household & business sector to find government purchase.
2. Transfer payment to household sector & subsidy payment to business sector.
3. Government purchases goods & services from business sector & factor of
production from household sector.
4. Government borrowings in banking system to finance the deficit, when tax is
fall short of government purchase.
EQUILILIBIRIUM LEVEL OF INCOME: [THREE SECTORS]

Explanation of diagram:
1. The X – axis represents income while the Y – axis represents Aggregate Exp
2. Investment and government expenditures are exogenously determined. Thus, in
67
Panel B, I and G are shown as horizontal lines. Their level does not depend on
income
3. Since I and G are determined outside the model, C + I + G schedule lies above C by
constant amount at all level of income.
4. S + T curve denoted the total
leakages from household sector.
It is positive sice savings vary
positively with income. Level of
Taxes are decided by Govt
5. Equilibrium is determined at point
E1 where C + I + G schedule intersects
450 line. This gives equilibrium level
of income at OY1 where Aggregate
demand = Income.
6. At E1, S + T = I + G which can be
seen in Panel B.
7. At any level of income below OY1,
aggregate demand > income and
I +G > S + T. Conversely, at any level of income above OY1, S+T > I +G

8. In both the above cases, demand and Supply will drive the income back to OY1,
through changes in the level of investment, employment and output.
Circular Flow of National Income. [4 Sector]
68
Introduction:
The circular flow model in four sector economy provides the Realistic picture of
circular flow of national income. Four sector model studies the circular flow in open
economy which consist of household, business sector, government sector & Foreign
sector.
Foreign sector has Important role in the economy when domestic business firm
exports goods & services to the foreign market Injection are made to circular flow. On
the other ha¬¬nd, domestic household, firms or government Import something from
foreign market Leakages occurs in circular model. From the view point of circular
flow of Income, each sector has dual role to play in the economy while a sector
receives certain payment from other sectors it pays back to those sector as well,
circular flow income in different sectors is explained as follows (2 sector explanation
to be taken from previous question except conclusion).
Government Sectors.
Receipts:
The major source of income for government sector includes taxes paid by household
and business sector besides these it also receives Interest and dividend for the
investment made.
Payments:
Government sector makes payment to different sectors in the form of transfer
payments, subsidies and grants etc. It pays to business sector in return for goods
purchased, makes transfer payment like pension fund, scholarship to the household
etc.
Government receipts > government expenditure the surplus go to financial market /
banking sector. In case of deficit government borrows from capital market / banking
to maintain balance in the economy.
Foreign Market:
Receipts:
Foreign sector receives income from business sector in return for goods & services
imported by business sector. Income could also be earned through unilateral receipts.
E.g. Gifts, grants, donation, charity.
69
Payments:
Foreign sector needs to make payment to business sector from where Imports have
been made. If export > import the economy has surplus balance of payment. Incase
import > export the economy faces deficit balance between exports and imports.
Explanation of diagram: 4 sector model

1. The X – axis represents income while the
Y – axis represent C + I + G + (X – M).
2. The investment, government
expenditure and the net exports are
exogenously determined. Hence, in Panel
B, I + G + X is shown as horizontal line.
3. Equilibrium level of income is determined
at point E* where C + I + G + (X – M)
curve intersects the 450 line. At this
level of national income leakages
from the circular flow (S + T +M)
are equal to injection (I + G + X).
4. As exports are income and imports are leakages, increase in the level of exports
increases the level of national income, while increase in the level of imports, and
reduces the national income.
6. Explain in Detail Investment Multiplier or Income Multiplier

The relationship between increase in investment and increase in income explained in
terms of multiplier. The multiplier is important concept of Macroeconomics developed
by J.M. Keynes in General theory 1936.
“Multiplier” introduction by R.F. Kahn in 1931. According to him, it was Employment
Multiplier.
Keynes redesigned and redefined it in terms of income. Hence the multiplier shows
the effect increase in investment on income. So Keynes multiplier is known as Income
or Investment Multiplier.
Definition:
“Investment multiplier is the ratio of final changes in income to initial change in
Investment”.
Arithmetically it is defined as
70
∆Y
K=
∆I
I
K=
I – MPC
Thus, if investment increases by 100cr, Income rises by 400cr. Then the multiplier is
4 (i.e.) K = 4times. Hence the multiplier is the number by which change in Investment
must be multiplied in order to determine resulting change in total income. The
multiplier is determined by tape, higher the MPC, higher the MPC, higher will be the
multiplier and vice versa.
Assumptions:
1. MPC should be constant.
2. Economy should be closed Economy.
3. One man’s expenditure another man’s Income.
Working of Multiplies:
Suppose Government Invested 100cr. In Expansion of Factory.
↓
Income of the Employees 100cr.
↓
MPC taken as constant 75%
100 x 75 = 75cr.→ [spend on Goods & Services]

100
↓
Income of producer 75cr.
↓
[MPC constant] = 75x 75 = 56.25cr...........
100
Stages ∆I ∆Y ∆C ( 75% MPC ) ∆S ( 25% MPS )

1 100 100 75 25
2 75 56.25 18.75
3 56.25 42.18 14.06
4 42.18 31.64 10.55
Total 100 400 300 100
∆Y = ∆C + ∆S
71
1 1
K= = = 4 times
MPC 25 %
∆Y ∆Y
K= ' 4= ∆Y = 400
∆I 100
YY1, > AE.
The ‘C’ curve is consumption curve, it is drawn on Assumption that Mpc is constant
at all level of Income. When we super Impose a Fixed Amount of Investment on the
consumption curve C, we get total expenditure curve C + I , which Interested 45 line
at point E. and original equilibrium level at Income is Y.
When Investment rises total expenditure curve shifts upwards to C + I + I,.
The Increase in Investment ∆I is equal to vertical distance between two expenditure
curve i.e. AE.
The new expenditure curve C + I + I, intersects 45º line at E, which gives new
equilibrium level of Income Y1, which is Larger than original income Y.
So, from the above diagram we conclude, Increase in Income ∆Y is multiple of Increase
IN Investment ∆I (i.e.) YY1, > AE.
72
Leakages in the working of multiplier:

1. Paying off debts.
2. Holding of Idle cash balance.
3. Imports
4. Taxation
5. Increase in price level. ( Inflation ) → Higher the price lower the demand.
6. Purchase of old shares & securities.
7. Explain four sector equilibrium Level of National Income

When Import >Exports.
Effects on Income When Imports are Greater than Exports
When the foreign sector is included in the model (assuming M > X), the aggregate demand
schedule C+I+G shifts downward with equilibrium point shifting from F to E. The inclusion
of foreign sector (with M > X) causes a reduction in national income from Y0 to Y1.
Nevertheless, when X > M, the aggregate demand schedule C+I+G shifts upward causing
an increase in national income. Learners may infer diagrammatic expressions for possible
changes in equilibrium income for X>M and X =M
A change in autonomous expenditures— for example, a change in investment spending,—

will have a direct effect on income and an induced effect on consumption with a further
effect on income. The higher the value of v, larger the proportion of this induced effect on
demand for foreign, not domestic, consumer goods. Consequently, the induced effect on
demand for domestic goods and, hence on domestic income will be smaller. The increase
73
in imports per unit of income constitutes an additional leakage from the circular flow of
(domestic) income at each round of the multiplier process and reduces the value of the
autonomous expenditure multiplier.
An increase in demand for exports of a country is an increase in aggregate demand for

domestically produced output and will increase equilibrium income just as an increase in
government spending or an autonomous increase in investment. In summary, an increase
in the demand for a country’s exports has an expansionary effect on equilibrium income,
whereas an autonomous increase in imports has a contractionary effect on equilibrium
income. However, this should not be interpreted to mean that exports are good and
imports harmful in their economic effects.
INFLATIONARY GAP
 If the aggregate demand for an output is greater than full employment level of
output, then it leads to excess demand.
 Excess demand gives rise to inflationary situation or inflationary gap.
 This situation of occurs during expansion phase of business cycle which leads to
demand pull inflation.
 Inflationary gap which is the amount by which aggregate demand exceeds the level
of aggregate demand required to establish full employment equilibrium.
Excess Demand – Inflationary Gap
74
DEFLATIONARY GAP
 If the aggregate demand for an output is less than the full employment level of
output then it is called deficient demand.
 Deficient demand gives rise to deflationary gap or recessionary gap.
 It happens when equilibrium level of aggregate production is less than full
employment.
 Deflationary gap is thus a measure of extent of deficiency of aggregate demand
and it leads to decline in income output & employment thus pushing economy into
unemployment
Deficient Demand – Deflationary Gap

The leakages are caused due to:
1. progressive rates of taxation which result in no appreciable increase in
consumption despite increase in income
2. high liquidity preference and idle saving or holding of cash balances and an
equivalent fall in marginal propensity to consume
3. increased demand for consumer goods being met out of the existing stocks or
through imports
4. additional income spent on purchasing existing wealth or purchase of
government securities and shares from shareholders or bondholders
5. undistributed profits of corporations
6. part of increment in income used for payment of debts
7. case of full employment additional investment will only lead to inflation, and
8. scarcity of goods and services despite having high MPC
75
NUMERICAL SUMS
Question 1
Calculate marginal propensity to consume and marginal propensity to save from the following
data about an economy which is in equilibrium:
National income = 2500, Autonomous consumption expenditure = 300, Investment expenditure = 100
Answer
Y = C + I
By putting the value we get,
2500 = C + 100
C = 2500 -100 = 2400
C = C + bY
2400 = 300 + 2500 b
2400-300 = 2500b
b = 0.84; MPS = 1- MPC = 1- 0.84 = 0.16
Question 2
An economy is in equilibrium. Calculate national income from the following-
Autonomous consumption = 100; Marginal propensity to save= 0.2; Investment expenditure = 200
Answer
Y = C+I
Y = C + MPC (Y) + I where MPC = 1- MPS
Y = 100 + 0.8Y + 200 = 300 + 0.8Y
Y – 0.8Y = 300
0.2Y = 300,
Y = 1500
Question 3
Suppose the consumption of an economy is given by C = 20 + 0.6 Y and investment
I = 10 + 0.2Y. What will be the equilibrium level of National Income?
Answer
Y = C + I = 20 + 0.6 Y + 10 + 0.2 Y
Y = 30 + 0.8 Y
Y – 0.8 Y = 30
Y = 150
76
Question 4
Suppose the consumption function C= 7+ 0.5Y, Investment is ` 100, Find out equilibrium level of
Income, consumption and saving?
Answer
Equilibrium Condition–
Y = C + I, Given C = 7 + 0.5Y and I = 100
Therefore Y = 7 + 0.5Y + 100
Y - 0.5Y = 107
107
Y = = 214
0.5
Y = C+I
214 = C + 100
C = 114
S = Y – C = 100
Question 5
If the consumption function is C= 250 + 0.80 Y and I = 300. Find out equilibrium level of Y, C and S?
Answer
1
Y = (a + I ) or Y = C + I
1–b
1
Y = (250 + 300) = 2750
1 – .80
b
C = a+ (a + I )or C = 250 + 0.80 Y
1–b
C = 250 + 0.8(2750) C = 2450

S = Y - C where C = a + bY
S = Y - (a + bY)
S = -a + (1 - b) Y
= - 250 + (1 – 0.80)2750 = 300
Or directly,
S = Y-C
S = 2750 – 2450 = 300.
77
Question 6
If saving function S = -10 + 0.2Y and autonomous investment I = 50 Crores. Find out the
equilibrium level of income, consumption and if investment increases permanently by
`5 Crores, what will be the new level of income and consumption?
Answer
S=I
-10 + 0.2Y = 50
0.2Y = 50+ 10
Y = 300 Crores
C = Y- S
Where S = -10 + 0.2 (300) = 50
C = 300-50 = 250 Crores
With the increase in investment by ` 5 Crores, the new investment will become equal to
` 55 Crores.
S=I
-10 + 0.2Y = 55
Y = 325 Crores
C = 270 Crores
Question 7
Given the empirical consumption function C = 100 +0.75Y and I = 1000, calculate equilibrium level
of national income. What would be the consumption expenditure at equilibrium level national
income?
Answer
C = 100 + 0.75Y and I = 1000,
Y = C + I in equilibrium
I
Y = 100 + 0.75 Y + 1000 ⇒ Y = (100 + 1000)
1 – 0.75
I
Y = (1100) = 1/0.25 (1100) = 4400.
1 – 0.75
Y = C + I;
C = 4400 – 1000
= 3400
78
Question 8
In an economy investment expenditure is increased by ` 400 Crores and marginal propensity to
consume is 0.8. Calculate the total increase in income and saving.
Answer
MPC = 0.8; ∆I = 400 Crores
Multiplier (K) = 1 /1- MPC = 1 /1- 0.8 =1/ 0.2= 5
MPS = 1 - MPC = 1 – 0.8 = 0.2
Increase in income (∆Y) = K ×∆I = 5 × 400 = 2,000 Crores
Increase in saving = ∆Y × MPS = 2,000 × 0.2 = 400 Crores
Question 9
An increase in investment by 400 Crores leads to increase in national income by 1,600 Crores.
Calculate marginal propensity to consume.
Answer
Increase in investment (∆I) = 400 Crores
Increase in national income (∆Y) = 1,600 Crores
Multiplier (K) =∆Y/∆I = K = 1,600/400 = 4
We know,
K = 1 /1 –MPC
4 = 1 /1 -MPC
 MPC = 0.75
Question 10
In an economy, investment is increased by Rs 600 Crores. If the marginal propensity to consume
is 0.6, calculate the total increase in income and consumption expenditure.
Answer
MPC = 0.6; ∆I = ` 600 Crores
Multiplier (K)
= 1/ 1- MPC = 1/ 1 – 0.6 = 1/ 0.4 =25.
Increase in income (∆Y)

= K × ∆I = 2.5 × Rs 600 Crores = ` 1,500 Crores
Increase in consumption (∆C)

= ∆Y × MPC = Rs 1, 500Crores × 0.6 = ` 900 Crores.
79
Question 11
Suppose in a country investment increases by ` 100 Crores and consumption is given by C = 10
+ 0.6Y (where C = consumption and Y = income). How much increases will there take place in
income?
Answer
Multiplier
I
k = ,
1 – MPC
I
k = = 2.5
1 – 0.6
Substituting the value of k and ∆I value in ∆Y = k ∆ I

∆Y = 2.5 x 100 = ` 250Crores
Thus, increase in investment by Rs 100 Crores will cause equilibrium income to rise by
` 250 Crores.
Question 12
Suppose we have the following data about a simple economy:
C = 10 + 0.75Yd, I = 50, G = T = 20 where C is consumption, I is investment, Yd is disposable
income, G is government expenditure and T is tax.
(a) Find out the equilibrium level of national income.
(b) What is the size of the multiplier?
Answer
(a) Since G = T, budget of the government is balanced
Substituting the values of C, I and G in Y we have
Y = C+I+G
Y = a + bYd + I + G
Y = 10 + 0.75 (Y – 20) + 50 + 20
Y = 10 + 0.75 Y - 15 + 50 + 20
or, Y – 0.75 Y = 65
or, Y (1 – 0.75) = 65
or, 0.25 Y = 65
or, Y = 65 /.25 = 260
The equilibrium value of Y = 260
80
(b) The value of the multiplier is = 1/ (1 – MPC) = 1/ (1 – b) = 1/ (1 – 0.75) = 1/0.25 = 4

(ii) Income Determination with Lump Sum Tax and Transfer payments
The consumption function is defined as –
C = a + b Yd
Where Yd = Y - T + TR where T is a lump sum tax and TR is autonomous transfer
payments
C = a + b (Y - T + TR)
Y = C+I+G
Y = a + b (Y - T + TR) + I + G
Y = a + bY – bT + bTR + I + G
Y – bY = a – bT + bTR + I + G
Y(1-b) = a – bT + bTR + I + G
I
Y= (a – bT + bTR + I + G)
1–b
Question 13
Suppose C = 100 + 0.80 (Y - T + TR); I = 200; T = 25 + 0.1Y; TR = 50; G = 100
Find out equilibrium level of Income?
Answer
Y = C+I+G
Y = 100 + 0.80 (Y - T + TR) + I+ G
Y = 100 + 0.80(Y – 25 - 0.1Y + 50) + 200 + 100
Y – 0.80 Y + 0.08 Y = 420
Y(1-0.8+ 0.08) = 420
Y = 1500
Question 14
An economy is characterised by the following equation-
Consumption C = 60 + 0.9Yd
Investment I = 10
Government expenditure G = 10
Tax T=0
Exports X = 20
Imports M = 10 + 0.05 Y
What is the equilibrium income?
Calculate trade balance and foreign trade multiplier.
81
Answer
Y = C + I + G + (X – M)
= 60 + 0.9(Y – 0) + 10 + 10 + (20- 10 -0.05Y)
= 60 + 0.9 Y + 30 -0.05 Y
Y = 600
Trade Balance = X – M = 20 - 10 - 0.05(600) = -20

Thus, trade balance in deficit.
I I
Foreign trade multiplier = = = 6.66
1–b+m 1- 0.9 + 0.05
82
1. In the Keynesian model, equilibrium aggregate output is determined by

(a) aggregate demand (b) consumption function
(c) the national demand for labor (d) the price level
2. Keynes believed that an economy may attain equilibrium level of output

(a) only at the full-employment level of output
(b) below the full-employment level of output
(c) only if prices were inflexible
(d) (a) and (c) above
3. According to Keynes, consumption expenditure is determined by

(a) the level of interest rates
(b) extent of government taxes and subsidies
(c) disposable income
(d) autonomous investment expenditure
4. The marginal propensity to consume (MPC) can be defined as

(a) a change in spending due to a change in income
(b) a change in income that is saved after consumption
(c) part of income that is spent on consumption.
(d) part of income that is not saved.
5. If the consumption function is expressed as C = a + bY then b represents

(a) autonomous consumer expenditure when income is zero
(b) the marginal propensity to consume.
(c) the expenditure multiplier when consumption is increased
(d) part of disposable income
6. If the consumption function is expressed as C = a + bY then a represents

(a) autonomous consumer expenditure.
(b) the marginal propensity to consume.
(c) the consumption income relationship
(d) Non- linear consumption function
83
7. If the consumption function is C = 20 + 0.5Yd, then an increase in disposable income

by ` 100 will result in an increase in consumer expenditure by `__________.
(a) 25 (b) 70
(c) 50 (d) 100
8. If the autonomous consumption equals ` 2,000 and the marginal propensity to

consume equals 0.8. If disposable income equals ` 10,000, then total consumption
will be ` _____
(a) 8,000 (b) 6,000
(c) 10,000 (d) None of the above
9. In the Keynesian cross diagram, the point at which the aggregate demand function
crosses the 45-degree line indicates the
(a) level of full employment income.
(b) less than full employment level of income.
(c) equilibrium level of income which may or may not be full employment level of
income
(d) autonomous level of income which may not be full employment level of income
10. In a closed economy, aggregate demand is the sum of

(a) consumer expenditure, demand for exports and government spending.
(b) consumer expenditure, planned investment spending and government
spending.
(c) consumer expenditure, actual investment spending, government spending and
net exports.
(d) consumer expenditure, planned investment spending, government spending,
and net exports.
11. Under equation C= a+by, b=0.8, what is the value of 2 sector expenditure multiplier?
(a) 4 (b) 2 (c) 5 (d) 1
12. _____________ means the actual income, which can be spent on consumption by
individuals and families.
(a) Personal Disposable Income (b) Net National Income
(c) Gross National Income (d) Per Capita Income
84
13. The formula to derive NNP at Factor costs:

(a) NNP at Market Prices+ Subsidies
(b) NNP at Market Prices – Indirect taxes •Subsidies
(c) NNP at Market Prices + Indirect taxes+ Subsidies
(d) NNP at Market Prices – Indirect taxes + Subsidies
14. _____________ is a index of price changes or goods and services Included In GOP.
(a) GOP Inflator (b) GOP deflator
(c) GDP accelerator (d) GOP decelerator
15. The term National Income represents

(a) Gross National Product (GNP) at market price minus depreciation
(b) Gross National Product (GNP) at market price minus depreciation plus net
factor income abroad
(c) Gross national Product (GNP) market price minus depreciation and indirect
taxes plus subsidies
(d) Gross National Product (GNP) at market prices minus net factor income from
abroad
16. Which of the following is not included in the estimates of National Income?
(a) Sale of collector's item
(b) Addition to inventory, but not sale of the company's products
(c) Market rent of self-owned house
(d) Cost of government services
17. Which one of the following the most appropriate method to measure the economic
growth of a country?
(a) National Income
(b) Net National Product
(c) Gross Capital formation
(d) Gross Domestic Product
18. National income is often estimated

(a) NDPFC (b) NNPMP
(c) NDPMP (d) NNPFC
85
19. Which of the following is not correct?

(a) NNP at market Price = GN at market price + Depreciation at
(b) NDP at Market Price = NNP at market price - Net factor from abroad income
(c) NDP at Factor Cost = NOP at market price - indirect taxes+ Subsidies
(d) GOP a t Facto r Cost= NOP at actor cost + Depreciation
20. Which one leads to factor cost?

(a) Market price - Indirect taxes
(b) Market price - Net Indirect taxes
(c) Market price + Indirect taxes
(d) Market price + Net Indirect taxes
21. Which one includes deprecation.

(a) GNP at market price (b) NNP at market price
(c) NNP at factor cost (d) None of these
22. The difference between national and domestic income is that of:
(a) Net indirect taxes (b) Net factor income from abroad
(c) Consumption of fixed capital (d) Both (a) and (b)
23. National income (NNPFC) is equal to:

(a) GNPFC + Depreciation (b) GNP FC – Depreciation
(c) NNPMP – Net indirect taxes (d) Both (b) and (c)
24. Remittances from a relative working abroad are:

(a) Included in national income
(b) Not included in national income
(c) Transfer payments
(d) Both (b) and (c)
25. Value added refers to:

(a) Production of durable goods
(b) Output – intermediate consumption
(c) Production of non – durable goods
(d) Expenditure on intermediate goods
86
26. Which of the following is not a transfer payment?

(a) Interest on national debt (b) Retirement pensions
(c) Old-age pensions (d) Donations
27. Difference between closing stock and opening stock during an accounting year is
known as:
(a) Increase in stock (b) Change in stock
(c) Decrease in stock (d) None of these
28. Compensation of employees Include:

(a) Wages and salaries in cash (b) Wages and salaries in kind
(c) Pension on retirement (d) All of these
29. Which or the following is not a part of final expenditure?

(a) Consumer goods purchased by the government
(b) Consumer goods exported too rest to of the world
19. National Income term can be interchangeably used with:

(a) National Dividend (b) National output
(c) National Expenditure (d) All of the above
30. National income includes factor incomes only.

(a) True (b) False
(c) Partially true (d) Can’t say
31. Factor income is also called as:

(a) Earned income (b) Unearned income
(c) Gift income (d) Substitute income
32. Transfer income is also called as:

(a) Earned income (b) Unearned income
(c) Gift income (d) Substitute income
33. The only difference between GDP and NDP is:

(a) Interest (b) Wages
(c) Depreciation (d) Profit
87
34. Two sector economy does not consists of:

(a) Producer sector (b) Household sector
(c) Government Sector (d) Both a & b
35. GDPFC stands for:

(a) gross domestic product at market price
(b) gross domestic product at factor cost
(c) net domestic product at market price
(d) net national product at market price
36. NDPFC stands for:

(a) gross domestic product at market price (b) gross domestic product at factor cost
(c) net domestic product at market price (d) net national product at market price
37. Nominal GOP is the GDP at:

(a) Current Prices (b) Constant Prices
(c) Base Year Prices (d) (d)' Both b & c
38. Real GOP is the GDP at:

(a) Current Prices (b) Constant Prices
(c) Base Year Prices (d) Both b & c
39. Higher Nominal GDP implies improvement in quality of life

(a) True (b) False
(c) Partially true (d) Cant say
40. Nominal GDP can be converted into real GDP using:

(a) Price index (b) Trade index
(c) Forex index (d) Either a or b
41. GDP Deflator is:

(a) ratio between GDP at current prices and GDP at constant prices
(b) GDP at current prices + GDP at constant prices x 100
(c) change in GDP due to change in price level
(d) all of the above
88
42. Product method of calculation of GDP is also called as:

(a) Value added method
(b) Industrial origin method
(c) Net output method
(d) All of the above
43. Value of the sale and purchase of second – hand goods is accounted for the purpose
of calculating national income under – Valued added method:
(a) True (b) False
44. When producers buy final goods, there is consumption expenditure

(a) True (b) False
(c) Partially (d) Can’t say
45. Income method is also called as:

(a) Final output method (b) Distributed share method
(c) Factor payment method (d) Both b & c
46. Compensation to the employees can be classified as:

(a) Salary in cash (b) Perquisites
(c) Employer’s contribution to social security
47. Operating surplus includes:

(a) Compensation to employees (b) Rent
(c) Interest (d) Both b & c
48. Profit can be classified as:

(a) Dividend (b) Direct tax
(c) Rent (d) Both a & b
49. Retirement pensions are to be included in national income.

(a) True (b) False
89
50. Estimation or expenditure on the final goods produced during the year within the
domestic territory of a country, is equal to:
(a) GDPMP (b) GDPFC
(c) NDPMP (d) NDPFC
51. Which of the following is the fixed investment?

(a) Plant purchased for production
(b) Expenditure for construction or residential home
(c) Expenditure on rework of road by government
52. While calculating national income, expenditure on shares and bonds is to be included
in total expenditure.
(a) True (b) False
(c) Partially (d) Cant say
53. Expenses on Electricity by a Factory is not included in national income since

(a) It does nor form part of the cost of the product
(b) II is indirect expense
(c) II is intermediate expense
54. While arriving at private income from NNP at Factor Cost, which of the following
items are added?
(a) Transfer Payments (b) Interest on Public Debt
(c) Social Security payments (d) Both a & b
55. The formula for per capita income is:
National Income Real National Income

(a) (b)
Population Population
Personal Income Private Income
(c) (d)
Population Population
90
ANSWERS:
1 (a) 2 (b) 3 (c) 4 (a) 5 (b) 6 (a)
7 (c) 8 (c) 9 (c) 10 (b) 11 (c) 12
13 14 15 16 17 18
19 20 21 22 23 24
25 26 27 28 29 30
31 32 33 34 35 36
37 38 39 40 41 42
43 44 45 46 47 48
49 50 51 52 53 54
55
91
SUMMARY
 John Maynard Keynes in his masterpiece ‘The General Theory of Employment Interest
and Money’ published in 1936 put forth a comprehensive theory to explain the
determination of equilibrium aggregate income and output in an economy.
 The equilibrium analysis is best understood with a hypothetical simpletwo-sector

economy which has only households and firms with all prices (including factor
prices), supply of capital and technology constant; the total income produced Y,
accrues to the households and equals their disposable personal income.
 The equilibrium output occurs when the desired amount of output demanded by
all the agents in the economy exactly equals the amount produced in a given time
period.
 In the two-sector economy aggregate demand (AD) or aggregate expenditure consists

of only two components: aggregate demand for consumer goods and aggregate
demand for investment goods, I being determined exogenously and constant in the
short run.
 Consumption function expresses the functional relationship between aggregate

consumption expenditure and aggregate disposable income, expressed as C = f (Y).
The specific form consumption function, proposed by Keynes C = a + bY
 The value of the increment to consumer expenditure per unit of increment to income
(b) is termed the Marginal Propensity to Consume (MPC).
 The Keynesian assumption is that consumption increases with an increase in

disposable income (b >0), but that the increase in consumption will be less than the
increase in disposable income (b <1).
 The propensity to consume refers to the proportion of the total and the marginal
incomes which people spend on consumer goods and services.
92
 The proportion or fraction of the total income consumed is called ‘average propensity
to consume’ (APC)= Total Consumption /Total Income
 Since Y = C + S, consumption and saving functions are counterparts of each other.

The condition for national income equilibrium can thus be expressed as C + I = C + S
 Changes in income are primarily from changes in the autonomous components of

aggregate demand, especially from changes in the unstable investment component.
 The investment multiplier k is defined as the ratio of change in national income (∆Y)
due to change in investment (∆I)
 The marginal propensity to consume (MPC) is the determinant of the value of the
multiplier. The higher the marginal propensity to consume (MPC) the greater is the
value of the multiplier.
 The more powerful the leakages are, the smaller will be the value of multiplier.
 Aggregate demand in the three sector model of closed economy (neglecting foreign
trade) consists of three components namely, household consumption(C), desired
business investment demand(I) and the government sector’s demand for goods and
services(G).
 The government sector imposes taxes on households and business sector,effects

transfer payments to household sector and subsidy payments to the business sector,
purchases goods and services and borrow from financial markets.
 In equilibrium, it is also true that the (S + T) schedule intersects the (I + G) horizontal

schedule.
 Taxes act as leakage from the economic system. Thus, tax multiplier when,
T = T -tY, is
1 1
<
1-b(1 –t) 1 –b)
93
 The four sector model includes all four macroeconomic sectors, the household
sector, the business sector, the government sector, and the foreign sector and in
equilibrium, we have Y = C + I + G + (X-M)
 The domestic economy trades goods with the foreign sector through exports and
imports.
 Imports are subtracted from exports to derive net exports, which is the foreign
sector's contribution to aggregate expenditures. If net exports are positive (X > M),
there is net injection and national income increases. Conversely, if X < M, there is net
withdrawal and national income decreases.
 The autonomous expenditure multiplier in a four sector model includes the effects
1 1
of foreign transactions and is stated as against in a closed
(1-b+m) (1-b)
economy.
 The greater the value of m, the lower will be the autonomous expenditure multiplier.
 An increase in the demand for exports of a country is an increase in aggregate

demand for domestically produced output and will increase equilibrium income
just as would an increase in government spending or an autonomous increase in
investment.
94
NUMERICAL SUMS
Q.1 Computation of national Income:

Consumption = 750.00
Investment = 250.00
Gov. Purchase = 100.00
Export = 100.00
Import = 200.00
Q.2 Calculate GDPMP & National Income.

Personal consumption Expenditure 6,500.00
Indirect taxes – subsidies 150.00
State Gov. Consumption & investment exp. 2,000.00
Central Gov. Consumption & investment exp. 500.00
Change in inventory 100.00
Gross private domestic fixed investment 1,200.00
Exports 900.00
Net factor payment to abroad (-) 100.00
Imports 1,200.00
Depreciation 200.00
Q3. Calculate GDPMP & National Income

Inventory Investment 100.00
Indirect taxes 100.00
Export 200.00
Net factor Income from abroad - (50).00
Personal consumption expenditure 3,500.00
Gross residential construction investment 300.00
Depreciation 50.00
Imports 100.00
Stock Gov. purchased goods & services 1,000.00
Gross public investment 200.00
Gross business fixed investment 300.00
95
Q.4 Calculation national Income & personal Disposable Income.

GDPMP 6,000.00
Receipts of factor income from abroad 150.00
Depreciation 800.00
Indirect taxes 700.00
Payment of factory income from abroad 225.00
Corporates profits 1,200.00
Dividend 600.00
Transfer payment 1,300.00
Personal Income Tax 1,500.00
Q.5 Calculate GNPMP by using value method.

Value of output in primary sector 500.00
NFIA (-) 20.00
Value of output in Tertiary 700.00
Value of output in secondary sector . 900.00
Govt. transfer payments 600.00
Intermediate consumption in tertiary 300.00
Intermediate consumption in primary sector 250.00
Intermediate consumption in secondary sector 300.00
Q.6. Illustration: Relationship between National Income Measures.

From the following data, calculate Personal Income and Disposable Income. Rs. Crores
(a) Net Domestic Product at Factor Cost (e) Interest Received by Households
8,000 1,500
(b)Net Factor Income from Abroad (f) Interest Paid by Households
200 1,500
(c) Undisbursed Profit (g) Transfer Income
1,000 300
(d) Corporate Tax 500 (h) Personal Tax
500
96
Q.7 Illustration: Consumption Function

Assume that an Economy’s Consumption Function is specified by the equation C =
6,000 + 0.75Y. Answer the following –
(a) What will be the Consumption when Disposable Income (Y) is Rs. 20,000, Rs.
25,000 and Rs. 30,000?
(b) Find the saving when disposable Income is Rs. 20,000, Rs. 25,000 and Rs. 30,000.
(c) What amount of Consumption for Consumption Function C is autonomous?
(d) What amount is induced when Disposable Income is Rs. 20,000, Rs. 25,000 and Rs.
30,000?
Q8. Illustration: Consumption Function

Consider the following information and frame the Consumption Function. Also
compute Income (Y), when the amount of consumption is Rs. 36,000.
 Autonomous Consumption even at Zero Level of Disposable Income = Rs. 9,000
 Marginal Propensity to save = 0.40
Q9. On the basis of the following data about an economy which consists of only two
Firms, find out:
(a) Value Added by firm A and B and
(b) Gross Value Added or Gross Domestic Product at Factor Cost.
Items (` in Lakh)
(i) Sales by firm A 100
(i) Purchases from firm B by firm A 40
(ii) Purchases from firm A by firm B 60
(iii) Purchases from firm A by firm B 60
(Iv) Sales by firm B 200
(v) Closing stock from A 20
(vi) Closing stock from B 35
(vii) Opening stock of firm A 25
(viii) Opening stock of firm B 45
(ix) Indirect taxes paid by both firms 30
97
Q.10 Calculate:
(a) Gross Value Added at Market Price, and
(b) National Income from the following data.
Items (`in lakhs )
(i) Value of output:
(a) Primary sector 800
(b) Secondary sector 200
(c) Tertiary sector 300
(ii) Value of intermediate inputs purchased by:
(a) Primary sector 400
(b) Secondary sector 100
(c) Tertiary sector 50
(iii) Indirect taxes paid by all sectors 50
(iv) Consumption of fixed capital of all sectors 80
(v) Factor income received by the residents from rest of
the world 10
(vi) Factor income paid to non-residents 20

(vii) Subsidies received by all sectors 20
Q.11.Given the following data and using income method calculate:

(a) Net Domestic Income, (b) Gross Domestic Income,
(c) Net National Income, and (d) Net National Product at market Price.
Items (` in crore)
(i) Indirect taxes 9,000
(ii) Subsidies 1,800
(iii) Depreciation 1,700
(iv) Mixed income of self – employed 28,000
(v) Operating Surplus 10,000
(vi) Net factor income from abroad (-) 300
(vii) Compensation of employees 24,000
98
Q.12. From the following data, calculate the GDP at both (a) market price, and (b)
Factor cost.
Items (` in crore)
(i) Gross Investment 90
(ii) Net exports 10
(iii) Net indirect taxes 5
(iv) Depreciation 15
(v) Net factor income from abroad (-) 5
(vi) Private consumption expenditure 350
(vii) Government purchases of goods and services 100
Q.13.Calculate GDPMP, GDPFC & National Income

Private final consumption expenditure 290.00
Gov. Final consumption expenditure 50.00
Subsidies 20.00
Gross Domestic fixed capital formation 105.00
Indirect Tax 70.00
Consumption of fixed capital 45.00
NFIA (-) 5.00
Net addition to stock 15.00
Net exports -5.00
Q14. Calculate NDPMP & National Income

Subsidies 10.00
Sales 1,000.00
Closing stock 100.00
Indirect tax 50.00
Intermediate consumption 300.00
Opening Stock 200.00
NFIA 10.00
99
Q.15. Illustration – Estimation of National Income by Value Addition

Suppose only the following transactions take place in an economy:
 Industry A imports goods worth Rs. 100. It sells goods worth Rs. 400 to Industry
B, goods worth Rs. 200 to Industry C, and goods worth Rs. 1,000 for Private
Consumption.
 Industry B sells goods worth Rs. 500 to Industry C and goods worth Rs. 800 for
Private Consumption.
 Industry C sell goods worth Rs. 600 to Private Consumption and Export goods
valued at Rs. 500.
 Depreciation Coast during the year is Rs. 100,
 Government realizes Indirect taxes of the valued of Rs. 100. Subsidies paid by
Government is Rs. 50.
Calculate the following with the help of Net Value Added Method: (a) GNP (MP) (b)
GNP (FC) (c) NNP (MP) and (d) NNP (FC)
Q16. Illustration: Relationship between National Income Measures

GDP at Market Prices of a country in a particular year was Rs. 1,100 Crores. Net
Factor Income from Abroad was Rs. 100 Crores. The value of Indirect Taxes –
Subsidies was Rs. 150 Crores. NNPfc `850 Cr. Calculate the aggregate value of
Depreciation.
Q17. An economy has only two firms A and B. on the basis of following information about
these firms, find out:
(a) Value Added by firms A and B, and
(b) Gross Domestic Product at Market Price.
Items (` in Lakh)
(i) Exports by firm A 20
(i) Imports by firm A 50
(ii) Sales to households by firm A 90
(iii) Sales to firm B by firm A 40
(Iv) Sales to firm A by firm B 30
(v) Sales to households by firm B 60
100
Q.18. Calculate Net Domestic Product at Factor Cost from the following data using product
method.
Items Primary Sector Secondary Tertiary

Sector Sector
(i) Sales 100 150 130
(ii) Closing stock 15 20 25
(iii) Intermediate Consumption 15 25 15
(iv) Opening stock 10 10 15
(v) Indirect tax 12 13 17
(vi) Subsidies 7 8 7
(vii) Consumption of fixed capital 10 12 15
(viii) Expenses of electricity and 3 4 3
fuel
Q.19. The Following information is available for an economy. On the basis of this Information
using income method, calculate: (a) Domestic Income, and (b) National income
Items (` in crore)
(i) Wages 10,000
(ii) Rent 5,000
(iii) Interest 400

(iv) Dividend 3,000
(v) Mixed Income 400
(vi) Undistributed profit 200
(vii) Social security contribution 400
(viii) Corporate Profit Tax 400
(ix) Net Factor Income from abroad 1,000
Q20. Find NDPFC from the following
Items (` in crore)
(i) Gross domestic fixed investment 10,000
101
(ii) Inventory investment 5,000

(iii) Depreciation 2,000
(iv) Indirect taxes 1000
(v) Subsidies 2000
(vi) Consumption expenditure 20,000
102
NUMERICAL SUMS
Q.1
Solution:
Consumption = 750.00
+ Investment = 250.00
+ Gov. Purchase = 100.00
+(X - M) 100 - 200 = (100.00)
NNPfc 1,000.00

Q.2
Solution:
Personal consumption Expenditure 6,500.00
State Gov. Consumption & invest. Exp. 2,000.00
Central Gov. Consumption & invest. Exp. 500.00
Gross private domestic fixed investment 1,200.00
(Import- Export ( 1,200.00 – 900.00) 300.00
GDPMP 10,000.00
National Income.
Personal consumption Exp. 6,500.00
Indirect taxes – subsidies (150).00
State Gov. Consumption & investment 2,000.00
Central Gov. Consumption & investment 500.00
Gross private domestic fixed invest. 1,200.00
(Import – Export) (1,200.00 – 900.00) (300).00
Net factor payment to abroad 100.00
Dep. (200).00
9,750.00

103
Q.3
Solution:
Import – Export (100 – 200) 100.00
Personal consumption exp 3,500.00
Gross residential contru. Invest 300.00
Gov. purchased good & services 1,000.00
Gross business fixed invest. 300.00
GDPMP 5,500.00
Import – Export (100 – 200) 100.00
Indirect Taxes (100).00
Net factor Income from abroad (50).00
Personal consumption exp. 3,500.00
Gross residential constr. Invest 300.00
Dep. (50).00
Gov. Purchase goods & serv. 1,000.00
Gross business fixed inv. 300.00
5,300.00
Q.4
Solution:
National Income
GDPMP 6,000.00
Recepits of factor income from abroad 150.00
Dep. (800).00
Indirect taxes (700).00
Payments of factor income from abroad (225).00
National Income 4,425.00
National Income 4,225.00
Retained earnings (1,200.00 – 600.00) (600).00
+ Transfer payment 1,300.00
(-) Personal Income Tax (1,500).00
3,625.00

104
Q.5
Solution:
Value of output in primary sector 500.00
Value of output in secondary sector 700.00
Value of output in tertiary sector 900.00
(A) 2,100.00

Value of intermediate in primary 250.00
Value of intermediate in secondary 300.00
Value of intermediate in tertiary 300.00
(B) 850.00
(A – B) 1,250.00
- NFIA 20.00
1,230.00

Q.6
Solution:
Relationship between NDP at FC, NNP, at FC, Personal Income and Personal Disposable
Income is given in the following Table. Since Interest Received and Paid by Household is
the same, its Net Effect is ignored. Rs. Crores
Net Domestic Product at Factor Cost 8,000
Add: Net Factor Income from Abroad 200
National Income = Net National Product at Factor Cost 8,200
Add: Incomes Received but not “earned”, i.e. Transfer Payments 300
Less: Incomes Earned, but not received, e.g. Contribution to Social 1,000 + 500 =
Insurance, Corporate Income Taxes, Retained Corporate Earning, (1,500)
etc.
Personal Income 7,000
Less: Personal Income Taxes (500)
Personal Disposable Income 6,500
105
Q.7
Solution:
If Disposable Income (Y) is Rs. 20,000 Rs. 25,000 Rs. 30,000
(a) Consumption (C) = 6,000 + (0.75 x 6,000 + (0.75 x 6,000 + (0.75 x
6,000+0.75Y 20,000) 25,000) 30,000)
= Rs. 21,000 = Rs. 24,750 = Rs. 28,500
(b) Saving (S) = Y- C 20,00-21,000= 25,000 – 30,000 –
[Note 1] Dissaving (Rs. 24,750 28,500
1,000) = Rs. 250 = Rs. 1,500
(c) Autonomous Consumption [Note 2] Rs. Rs. 6,000 Rs. 6,000
6,000
(d) Induced Consumption Rs. 15,000 Rs. 18,750 Rs. 22,500
= C-a
Note:
1. Saving is the difference between Disposable Income and Consumption. It is the
difference between the Consumption line and the 45 Degree line at each level of
Disposable Income.
2. For the consumption Function C = a + by, where “a” = a constant which represents
the positive value of Consumption at Zero Level of Disposable Income. Hence, in this
case, a = Rs. 6,000. This is also the point at which the consumption Line intersects
the vertical axis (Y – Axis). This is called Autonomous Consumption, i.e. unconnected
with Income.
3. Induced Consumption is determined by the level of Income, i.e. it is Income-induced
Consumption and is computed as Total Consumption (-) Autonomous Consumption.
Q.18
Solution:
1. Consumption Function (C) = a + by. In case, a = 9,000 (given), b = MPC = 1 – MPS =1
– 0.4 = 0.6 Hence, Consumption Function (C) = 9,000 + 0.6Y
2. If the Consumption is 36,000, then (C) 36,000 = 9,000 + 0.6Y. Solving, we have,
Income (Y) = Rs. 45,000
106
Q.9
Solution:
(a) Value Added by firm A
= Sales by firm A – Purchases from firm B + Change in stock (Closing stock -
Opening stock)
= `100 lakh - `40 lakh + (` 20 lakh - ` 25 lakh)
= `100 lakh - `40 lakh `5 lakh
= `55 lakh
Value Added by firm B
= Sales by firm B – Purchases from firm A + Change in stock (Closing stock –
Opening stock)
= `200 lakh - ` 60 lakh + (`35 lakh - ` 45 lakh)
= `200 lakh - ` 60 lakh - `10 lakh
= `130 lakh
Ans. Value added by firm A = `55 lakh.
Value Added by firm B = `130 lakh.
(b) Gross Value Added or Gross Domestic Product at Factor Cost

= Value added by firm A + Value added by firm B – Indirect taxes
= `55 lakh + `130 lakh - `30 lakh
= `185 lakh - `30 lakh
= `155 lakh
Ans. Gross domestic product at factor cost = `155 lakh.
[ Note: Value by firm A and firm B here implies gross value added at market price.]
Q.10
Solution:
(a) Gross Value added at market Price
= Value of output of different sectors – value of intermediate inputs purchased by
different sectors
= `800 lakh + `200 lakh + `300 lakh - `400 lakh - `100 lakh - `50 lakh
= `750 lakh
Ans. Gross value added at market price = `750 lakh.
107
(b) National Income

= Gross domestic product at market price – Consumption of fixed capital – Indirect
taxes + subsidies + Factor income received by the residents from rest of the
world – Factor income paid to non-residents
= `750 lakh - `80 lakh - `50 lakh + `20 lakh + `10 lakh - `20 lakh
= `630 lakh
Ans. National Income = `630 lakh.
Q.11
Solution:
(a) Net Domestic Income
= Mixed income of self-employed + Operating surplus +
Compensation of employees
= `28,000 crore + `10,000 crore + `24,000 crore
= `62,000 crore
Ans. Net Domestic income = ` 62,000 crore
(b) Gross Domestic income

= Net domestic income + Depreciation
= `62,000 crore + `1,700 crore
= `63,700 crore
Ans. Gross domestic income = `63,700 crore
(c) Net National Income

= Net domestic Income + Net Factor income from abroad
= `62,000 crore + (-) `300 crore
= `62,000 crore - `300 crore
= `61,700 crore
Ans. Net national Income = `61,700 crore.
(d) Net National Product at Market price

= Net National Income + Indirect taxes - Subsidies
= `61,700 crore + `9,000 crore - `1,800 crore
= `68,900 crore
Ans. Net National Product at Market price = `68,900 crore.
108
Q.12
Solution:
(a) GDPMP = Gross investment + Net exports + Private consumption expenditure +
Government purchase of goods and service
= `90 crore + `10 crore + `350 crore + `100 crore
= `550 crore
Ans. GDPMP = `550 crore
(b) GDPFC = GDPMP – Net Indirect taxes

= `550 crore - `5 crore
= `545 crore
Ans. GDPFC = `545 crore
Q.13
Solution:
i) GDPMP
Private final consumption exp. 290.00
Net exports (-) 5.00
455.00

ii) GDPFC
Net exports 5.00
Indirect Tax (70).00
Subsidies 20.00
GDPFC 405.00

109
ii) National Income:

Subsidies 20.00
Indirect Tax (70).00
NFIA (5).00
Net exports (5).00
National Income 355.00
Q.14
Solution:
Sales 1,000.00
Change in stock (200 – 100) (100) .00
Intermediate cons. (300) .00
Consumption of fixed capital (150) .00
NDPMP 450.00
NDP 450.00
Subsidies (10).00
NFIA 10.00
Indirect tax (50).00
420.00
Q.15
Solution:
Particulars Industry A Industry B Industry C
Sale Price of Output 400 + 200 + 500 + 800 600 + 500
1,000 = 1,300 = 1,100
= 1,600
Less: Cost of Intermediate Consumption 100 400 200 + 500 =
700
Value Added by Industry 1,500 900 400
110
GDP at Market Price = GNP at Market Prices (no Net Factor Income from 2,800
abroad (100)
Less: Indirect Taxes
Add: Subsidies 50
Gross National Product at Factor Cost 2,750
Less: Depreciation (100)
Net National Product at Factor Cost 2,650
Less: Subsidies (50)
Add: Indirect Taxes 100
Net National Product at Market Prices 2,700
Q.16
Solution:
1. GNP at Market Prices = GDP at Market Prices + Net Factor Income from Abroad =
1,100 + 100 = 1,200.
2. NNP at Market Prices = NNP at Factor Cost + Net Indirect Taxes = 850 + 150 = 1,000
3. Hence, Depreciation = GNP at Market Prices (-) NNP at Market Prices = 1,200 – 1,000
= Rs. 200 Crores.
Q.17
Solution:
(a) Value Added by firm A

= Sales to households + Sales to firm B + Exports – Imports – Purchase
= `90 lakh + `40 lakh + `20 lakh - `50 lakh - `30 lakh
= `70 lakh
Value added by firm B
= Sales to firm A + sales to households – Purchases from firm A
= `30 lakh + `60 lakh - `40 lakh
= `50 lakh
Ans. Value added by firm A = `70 lakh.
Value added by firm B = `50 lakh.
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(b) Gross Domestic product at Market Price

= Value added by firm A + Value added by firm B
= `70 lakh + `50 lakh
= `120 lakh
Ans. Gross domestic product at market price = `120 lakh.
[Note: Sum total of value added by firm A and firm B implies gross value added
because, there are only two firms in the economy.]
Q.18
Solution:
Gross Domestic Product at Market Price
= Sales + Closing stock – Opening stock – Intermediate consumption
= (100 + 150 + 130) + (15 + 20 + 25) – (10 + 10 + 15 ) – (15 + 25 + 15)
= 380 + 60 – 35 – 55
= 350
Net Domestic Product at Factor Cost
= Gross domestic Product at market price – Consumption of fixed capital – Indirect
tax + Subsidies
= 350 – (10 + 12 + 15) – (12 + 13 + 17) + (7 + 8 + 7)
= 350 – 37 – 42 + 22
= 293
Ans. Net domestic product at factor cost = 393.
Q.19
Solution:
(a) Domestic Income
= Wages + Rent + Interest + Dividend + Mixed income + Undistributed Profit +
Social security contribution + Corporate profit tax
= `10,000 crore + `5,000 crore + ` 400 crore + `3,000 crore + `400 crore + `200
crore + `400 crore + `400 crore = `19,800 crore
Ans. Domestic Income = `19,800 crore.
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(b) National Income

= Domestic Income + Net Factor Income from abroad
= `19,800 crore + `1,000 crore
= `20,800 crore
Ans. National income = `20,800 crore
Q.20
Solution:
GDPMP
= Gross domestic fixed investment + Inventory investment + Consumption
expenditure
= `10,000 crore + `5,000 crore + `20,000 crore
= `35,000 crore
NDPFC
= GDPMP – Depreciation - Indirect taxes + Subsidies
= ` 35,000 crore - `2,000 crore - `1,000 crore + `2,000 crore
= ` 34,000 crore
Ans. NDPFC = `34,000 crore
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Extra sum Chapter 1 & 3

Illustration 1
If the required reserve ratio is 10 percent, currency in circulation is ` 400 billion, demand
deposits are ` 1,000 billion, and excess reserves total ` 1 billion, find the value of money
multiplier.
Solution
r = 10% = 0.10
Currency = 400 billion
Deposits = 1000 billion
Excess Reserves = 1 billion
Money Supply is M = Currency + Deposits = 1400 billion
c = C/D =
400 billion/1000 billion =0.4 or depositors hold 40 percent of their money as currency
e = 1 billion/1000 billion = 0.001 or banks hold 0.1% of their deposits as excess reserves
Multiplier
= 1 + 0.4/0.1 + 0.001 + 0.4 = 1.5/0.501 = 2.79
Therefore, a 1 unit increase in MB leads to a 2.79 units increase in M.
Illustration 2
An economy is in equilibrium. Calculate national income from the following –
Autonomous consumption = 100; Marginal propensity to save = 0.2; Investment
expenditure = 200
Solution
Y=C+1
Y = C + MPC (Y) + 1 where MPC = 1 – MPS
Y = 100 + 0.8Y + 200 = 300 + 0.8Y
Y – 0.8YY = 300
0.2YY = 300
Y = 1500
Illustration 3
Calculate marginal propensity to consume and marginal propensity to save from the
following data about an economy which is in equilibrium.
National income = 25000, Autonomous consumption expenditure = 300, Investment
expenditure = 100
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Solution
Y=C+1
By putting the value we get, 2500 = C + 100
C = 2500 – 100 = 2400
C = C + bY
2400 = 300 + 2500 b
2400 – 300 = 2500b
b = 0.84; MPS = 1 – MPC = 1 – 0.84 = 0.16
Illustration 4
An economy is characterised by the following equation –
Consumption C = 60 + 0.9Yd
Investment 1 = 10
Government expenditure G = 10
Tax T = 0
Exports X = 20
Imports M = 10 + 0.05Y
What is the equilibrium income?
Calculate trade balance and foreign trade multiplier.
Solution
Y = C + I + G + (X – M)
= 60 + 0.9(Y – 0) + 10 + 10 + (20 – 10 – 0.05Y)
= 60 + 0.9Y + 30 – 0.05Y
Y = 600
Trade Balance = X – M = 20 – 10 – 0.05(600) = - 20
Thus, trade balance in deficit.
Foreign trade multiplier = = 6.66
Illustration 5
Suppose the consumption function C = 7 + 0.5Y, Investment is ` 100. Find out equilibrium
level of Income, consumption and saving?
Solution
Equilibrium Condition –
115
Y = C + I, Given C = 7 + 0.5Y and I = 100

Therefore, Y = 7 + 0.5Y + 100
Y – 0.5Y = 107
Y= = 214
Y=C+I
214 = C + 100
C = 114
S = Y – C = 100
Illustration 6
Suppose the structural model of an economy is given –
C = 100 + 0.75 Yd; I = 200, G = T = 100; TR = 50, find the equilibrium level of income.
Solution
Y=C+I+G
Y = 100 + 0.75 Yd + 200 + 100
Y = 100 + 0.75(Y – 100 + 50) + 200 + 100
Y = 100 + 0.75Y – 75 + 37.5 + 200 + 100
Y = 1450
Or use Y = (a – bT + bTR + I + G) to calculate income.
Illustration 7
Suppose we have the following data about a simple economy:
C = 10 + 0.75Yd, I = 50, G = T – 20 where C is consumption, I is investment, Yd is disposable
income, G is government expenditure and T is tax.
(a) Find out the equilibrium level of national income.
(b) What is the size of the multiplier?
Solution
(a) Since G = T, budget for the government is balanced
Substituting the values of C, I and G in Y we have
Y=C+I+G
Y = a + bYd + I + G
Y = 10 + 0.75 (Y – 20) + 50 + 20
Y = 10 + 0.75 Y – 15 + 50 + 20
or, Y – 0.75 Y = 65
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or, Y (1 – 0.75) = 65
or, 0.25 Y = 65
or, Y = 65/2.5 = 260
The equilibrium value of Y = 260
(b) The value of the multiplier is = 1/(1 – MPC) = 1/(1 – b) = 1/(1 – 0.75) = 1/0.25 = 4
Illustration 8
If saving function S = - 10 + 0.2Y and autonomous investment I = 50 Crores. Find out the
equilibrium level of income e, consumption and if investment increases permanently by
`5 Crores, what will be the new level of income and consumption?
Solution
S=I
- 10 + 0.2Y = 50
0.2Y = 50 + 10
Y = 300 Crores
C=Y–S
Where, S = 10 + 0.2 (300) = 50
C = 300 – 50 = 250 Crores
With the increase in investment by ` 5 Crores, the new investment will become equal to
` 55 Crores.
S=I
- 10 + 0.2Y = 55
Y = 325 Crores
C = 270 Crores
Illustration 9
The consumption function is C = 40 + 0.8Yd, T = 0.1Y, I = 60 Crores, G = 40 Crores,
X = 58 and M = 0.05Y. Find out equilibrium level of income, Net Export, net export if
export were to increase by 6.25.
Solution
C = 40 + 0.8Yd
C = 40 + 0.8(Y – 0.1Y)
Y = C + I + G + (X – M)Y = 40 + 0.8(Y – 0.1Y) + 60 + 40 + (58 – 0.05Y)
Y = 40 + 0.8(0.9Y) + 60 + 40 + 58 – 0.05Y
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Y – 0.72Y + 0.05Y = 198

Y(1 – 0.72 + 0.05) = 198
Y(0.33) = 198
Y = 198/0.33 = 600 Crores
Net Export = X – M = 58 – 0.05Y
58 – 0.05 (600) = 58 – 30 = 28
If exports increase by 6.25, then exports = 64.25
Then Y = 40 + 0.8(Y – 0.1Y) + 60 + 40 + (64.25 – 0.05Y)
Y(1 – 0.72 + 0.05) = 204.5
Y(0.33) = 204.5
Y = 204.5/0.33 = 619.697
Then import = .05 ` 619.697 = 30.98
Net Export = 64.25 – 30.98 = 33.27 Crores
Thus, there is surplus in balance of trade as Net Exports are positive.
Illustration 10
Suppose the consumption of an economy is given by C = 20 + 0.6Y and investment
I = 10 + 0.2YY. What will be the equilibrium level of National Income?
Solution
Y = C + I = 20 + 0.6YY + 10 + 0.2Y
Y = 30 + 0.8Y
Y = 0.8Y = 30
Y = 150
Illustration 11
In an economy, investment is increases by `600 Crores. If the marginal propensity to
consume is 0.6, calculate the total increase in income and consumption expenditure.
Solution
MPC = 0.6, ∆I = ` 600 Crores
Multiplier (K) = 1/1 – MPC = 1/1 – 0.6 = 1/0.4 = 25.
Increase in income (∆Y) = K ` ∆I = 2.5 x ` 600 Crores = ` 1,500 Crores
Increase in consumption (∆C) = ∆Y x MPC = ` 1, 500 Crores x 0.6 = ` 900 Crores.
118
Illustration 12
Suppose in a country investment increases by ` 100 Crores and consumption is given by C
= 10 + 0.6Y (where C = consumption and Y = income). How much increases will there take
place in income?
Solution
Multiplier = k = = 2.5
Substituting the value of k and ∆I value in ∆Y = k∆I
∆Y = 2.5 x 100 = ` 250 crores
Thus, increase in investment by ` 100 Crores will cause equilibrium income to rise by `250
Crores.
Illustration 13
If the consumption function is C = 250 + 0.80Y and I = 300. Find out equilibrium level of
Y, C and S?
Solution
C = 250 + 0.8(2750) C = 2450

S = Y – C where C = a + bY
S = Y – (a + bY)
S = - a + (1 – b) Y
= - 250 + (1 – 0.80) 2750 = 300
Or directly,
S=Y–C
S = 2750 – 2450 = 300
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Speak Your Mind
120
121
r
Chapte
PUBLIC FINANCE
7
UNIT 1 - FISCAL FUNCTIONS: AN OVERVIEW, CENTRE AND STATE FINANCE
1.1 INTRODUCTION
Governments at various levels involve in several operations for running the state.
We have experienced in our day-to-day life that though governments at various
levels impose many rules and regulations in the economy, some matters still go
unregulated. For a variety of reasons, we believe that governments should accomplish
some activities and should not do others.
There are three main macroeconomic goals for any nation:

(1) The first is economic growth.
(2) The second goal is high levels of employment which will ensure higher income
and higher output.
(3) The third macroeconomic goal is stable price levels.
The government does not expect the economy to function automatically; rather
it intervenes to direct them to function in particular directions.
1.2 THE ROLE OF GOVERNMENT IN AN ECONOMIC SYSTEM

The basic economic problem of scarcity arises from the fact that wants are unlimited
and the resources available to any society are limited.
The modern society, in general, offers three alternate economic systems through
which the decisions of resource reallocation may be made namely, the market, the
government and a mixed system where both markets and governments simultaneously
determine resource allocation. Correspondingly, we have three economic systems
namely, capitalism, socialism and mixed economy, each with different degrees of
state intervention in economic activities.
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Adam Smith is often described as a bold advocate of free markets and minimal
governmental activity. Smith believed that government's roles in society should be
limited, but well defined. However, Smith saw an important resource allocation role
for the government when he underlined the role of government in:
(a) national defence to protect the nation from external violence and invasion,
(b) establishing a system of justice to provide internal law and order and to protect
property
(c) establishment and maintenance of highly beneficial public institutions and
public works such as roads, bridges, canals, harbours, and postal system that
profit-seeking individuals may not be able to efficiently build and operate.
Since the 1930s, more specifically, as a consequence of the great depression, the
state’s role in the economy has been distinctly gaining in importance, and therefore,
the traditional functions of the state have been supplemented with what is referred
to as economic functions (also called fiscal functions or public finance function).
Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959),
introduced the three-branch taxonomy of the role of government in a market
economy. The functions of the government are to be separated into three, namely,
(a) resource allocation (to ensure efficiency),
(b) income redistribution (to guarantee fairness), and
(c) macroeconomic stabilization (to ensure price stability).
1.3 THE ALLOCATION FUNCTION

One of the most important functions of an economic system is the optimal or efficient
allocation of scarce resources so that the available resources are put to their best
use and no wastages are there. Economic efficiency indicates a situation in which all
resources are allocated to serve each person in the best way possible, minimising
waste and inefficiency.
The private sector resource allocation is characterized by market supply and demand
and price mechanism as determined by consumer sovereignty and producer profit
motives. The state’s allocation, on the other hand, is accomplished through the
revenue and expenditure activities of governmental budgeting. In the real world,
resource allocation is determined by both market and the government.
Allocative efficiency is concerned with utilizing limited resources to produce goods
and services that would maximize value to the society.
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Efficient allocation of available resources in an economy is assumed to take place

only when the markets are perfectly competitive and economic agents make rational
choices and decisions. Market failures which hinder efficient allocation of resources
occur mainly due to the following reasons:
• Imperfect competition and presence of monopoly power
• Markets typically fail to provide collective public goods
• Incomplete markets;
• Common property resources (e.g. environment) are overused
• Externalities
• Factor immobility
• Imperfect information
• Inequalities
In the absence of appropriate government intervention, market failures may occur

and the resources are likely to be misallocated with too much production of certain
goods or too little production of certain other goods.
The resource allocation role of government’s policy focuses on the potential for
the government to improve economic performance through its expenditure and tax
policies. The allocative function in budgeting determines:
(a) who and what will be taxed
(b) how much and on what the government revenue will be spent
(c) the process by which the total resources of the economy are divided among
various uses
(d) the optimum mix of various social goods (both public goods and merit goods).
(e) the level of involvement of the public sector in the national economy
(f) the reallocation of society’s resources from private use to public use.
A variety of allocation instruments are available by which governments can influence
resource allocation in the economy.
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They are as follows :
1.4 THE REDISTRIBUTION FUNCTION

The distribution responsibility of the government arises from the fact that, left to
the market, the distribution of income and wealth among individuals in the society
is likely to be skewed and therefore, the government has to intervene to ensure a
more socially optimal and egalitarian distribution.
The distributive function of budget is related to the basic question of ‘for whom’
should an economy produce goods and services.
The distribution function of the government aims at:
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A few examples of the redistribution function (or market intervention for socio-
economic reasons) performed by governments are:
In modern times, most of the egalitarian welfare states provide free or subsidized
education and health-care system, unemployment benefits, pensions and such
other social security measures. There is, nevertheless, an argument that in exercising
the redistributive function, there would be a conflict between efficiency and equity.
An optimal budgetary policy towards any distributional change should reconcile
the conflicting goals of efficiency and equity by exercising an appropriate trade-off
between them. In other words, redistribution measures should be accomplished
with minimal efficiency costs by carefully balancing equity and efficiency objectives.
1.5 STABILIZATION FUNCTION

Macroeconomic stability is said to exist when:
• an economy's output matches its production capacity,
• the economy's total spending matches its total output
• the economy's labour resources are fully employed, and
• Inflation is low and stable.
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The stabilization function is concerned with the performance of the aggregate

economy in terms of:
• labour employment and capital utilization,
• overall output and income,
• general price levels,
• balance of international payments, and
• the rate of economic growth.
Government’s stabilization intervention may be through monetary policy as well as
fiscal policy. Monetary policy works through controlling the size of money supply
and interest rate in the economy which in turn would affect consumption, investment
and prices.
Centre and State Finance

Fiscal federalism, a term introduced by Richard Musgrave, deals with the division
of governmental functions and financial relations among the different levels of
government.
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India is a federation of 28 states and 8 union territories. Fundamentally, federalism

is an institutional arrangement to accommodate two sets of government — one at
the national level and the other at the regional level.
The constitution of India has provided for the division of powers between the central
and the state governments. Article 246 of the Constitution demarcates the powers
of the union and the state by classifying their powers into three lists, namely
(1) union list,
(2) state list and
(3) the concurrent list.
The union list contains items on which the union parliament alone can legislate, the
state list has items on which the state legislative assemblies alone can legislate,
and the concurrent list, on which both the parliament and the legislative assemblies
can legislate. In the event of conflicting legislation in concurrent list, the law passed
by the centre prevails.
(1) Taxes are levied by the centre and the states. The central government has
greater revenue raising powers. The union government can levy taxes such as
tax on income, other than agricultural income, customs and export duties,
excise duties on certain goods, corporation tax, tax on capital value of assets
excluding agricultural land, terminal taxes, security transaction tax, central
GST, union excise duty, taxes other than stamp duties etc.
(2) The state governments can levy taxes on agricultural income, lands and buildings,
mineral rights, electricity, vehicles, tolls, professions, collect land revenue and
impose excise duties on certain items. The property of the union is exempt from
state taxation. The property and income of the states are not liable to be taxed
by the centre.
Distribution of revenue between the union and states is based on the constitutional
provisions as follows:
Article 268
Article 269
Article 270
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Article271
Article275
Article 293
The Finance Commission helps in maintaining fiscal federalism in India by performing

following functions:
(a) The distribution between the union and the states of the net proceeds of taxes
(b) Determination of principles and quantum of grants-in-aid to states which are
in need of such assistance.
(c) To make recommendations to the President on measures needed to augment
the consolidated fund of a state to supplement the resources of the panchayats
and municipalities in the state on the basis of the recommendations made by
the Finance Commission of the state.
(d) Any other matter referred to the Commission by the President in the interests
of sound finance.
While recommending transfers, the Finance Commission considers issues related
to vertical equity (deciding about the share of all states in the revenue collected
by centre) and horizontal equity (allocation among states their share of central
revenue).
The Fifteenth Finance Commission was constituted on 27, November 2017 against
the background of the abolition of Planning Commission (as also of the distinction
between Plan and non-Plan expenditure) and the introduction of the goods and
services tax (GST). The commission recommended the share of states in the central
taxes (vertical devolution) for the 2021-26 to be 41%, which is the same as that
for 2020-21. This is less than the 42% share recommended by the 14th Finance
Commission for 2015-20. The adjustment of 1% is to provide for the newly formed
union territories of Jammu and Kashmir, and Ladakh from the resources of the
centre. The criteria for distribution of central taxes among states for 2021-26 period
are same as that for 2020-21. They is:
(a) Income Distance i.e the distance of a state’s income from the state with the
highest income.
(b) Area
(c) Population (2011)
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(d) Demographic performance (to reward efforts made by states in controlling

their population)
(e) Forest and ecology:
(f) Tax and fiscal efforts:
The GST has made India’s indirect tax regime unitary in nature.
The states levy and collect state GST (SGST) and the union levies and collects the
central GST (CGST). For any particular good or service or a combination of the two,
the SGST and CGST rates are equal. An integrated GST (IGST) is applied on inter-
state movement of goods and services and on imports and exports. GST accounts
for 35 per cent of the gross tax revenue of the union and around 44 per cent of own
tax revenue of the states.
During the five-year transition period, the top five GST compensation-receiving
states were Maharashtra, Karnataka, Gujarat, Tamil Nadu, and Punjab.
130
QUESTIONS AND ANSWER
Question 1
Explain the role of government in a market economy.
Answer
The modern society, in general, offers three alternate economic systems through which
the decision of resource reallocation may be made namely, the market, the government
and a mixed system where both market and governments simultaneously determine
resource allocation.
Adam Smith is often described as a bold advocate of free markets and minimal
governmental activity. However, smith saw an important resource allocation role for
government when he underlined the role of government in national defense, maintenance
of justice and the rule of law, establishment and maintenance of highly beneficial public
institutions and public works which the market may fail to produce on account of lack
of sufficient profits. Since the 1930s, more specifically as a consequence of the great
depression, the state’s role in the economy has been distinctly gaining in importance
and therefore, the traditional function of the state have been supplemented with what is
referred to as economic function (also called fiscal or public finance function).
Richard Musgrave, in his classic treatise ‘The Theory of Public Finance ‘(1959),
introduced the three branch taxonomy of the role of government are to be separated
into three, namely, resource allocation, (efficiency), income redistribution (fairness) and
macroeconomic stabilization.
The allocation and distribution functions are primarily microeconomic functions, while
stabilization is a macroeconomic function. The allocation function aims to correct the
sources of inefficiency in the economic system while the distribution role ensures that the
distribution of wealth and income is fair.
Monetary and fiscal policy, the problems of macroeconomic stability, maintenance of
high levels of employment and price stability etc. fall under the stabilization function.
131
Question 2
Describe the various interventional measures adopted by the government.
Answer
Following are the fundamental reason which justifies Government’s intervention in markets:
1. Allocation function: A market economy is subject to serious malfunctioning in several
basic respects. There is also the problem of nonexistence of market in a variety of
situations. While private goods will be sufficiently provided by the market, public
goods will not be produced in sufficient quantities by the market. Efficient allocation
of resources is assumed to take place only in perfectly competitive markets. In
reality, markets are never perfectly competitive. Market failures which hold back
the efficient allocation of resources.
In the absence of appropriate government intervention, market failures may occur
and the resources are likely to be misallocated by too much production of certain
goods or too little production of certain other goods. The allocation responsibility
of the governments involves suitable corrective action when private markets fail to
provide the right and combination of goods and services. Briefly put, market failures
provide the rationale for government’s allocation function.
2. Redistribution Function: The outcomes of this growth have not spread evenly across
the households. The distribution responsibility of the government arises from the
fact that, left to the market, the distribution of income and wealth among individual
in the society is likely to be skewed and therefore the government has to intervene
to ensure a more desirable and just distribution.
The redistribution function of the government aims at:
 redistribution of income to achieve an equitable distribution of societal output
among household
 advancing the well-being of those members of the society who suffer from
deprivations of different types
 providing equality in income, wealth and opportunities
 providing security for people who have hardships, and
 ensuring that everyone enjoys a minimal standard of living
3. Stabilization Function: Market economy does not automatically generate full

employment and price stability and therefore the government should pursue
deliberate stabilization policies. Business cycles are natural phenomena in any
economy and they tend to occur periodically. In the absence of appropriate corrective
132
intervention by the government, the instabilities that occur in the economy in the
form of recessions, inflation etc. may be prolonged for longer periods causing
enormous hardship to people especially the poorer sections of society. It is also
possible that a situation of stagflation (a state of affair in which inflation and
unemployment exist side by side) may set in and make the problem more severe.
The stabilization function is one of the key function of fiscal policy and aims at
eliminating macroeconomic fluctuation arising from suboptimal allocation.
The stabilization function is concerned with the performance of the aggregate
economy in terms of:
 labour employment and capital utilization,
 overall output and income,
 general price levels,
 balance of international payments and
 The rate of economic growth.
Question 3
Explain how economic stability can be achieved through fiscal policy.
Answer
Government’s stabilization intervention may be through monetary policy as well as fiscal
policy. Monetary policy has a singular objective of controlling the size of money supply
and interest rate in the economy which in turn would affect consumption, investment
and prices.
Fiscal policy for stabilization purposes attempts to direct the actions of individuals and
organizations by means of its expenditure and taxation decisions. On the expenditure
side. Government can choose to spend in such a way that it stimulates other economic
activities. For example, government expenditure on building infrastructure may initiate
a series of productive activities. Production decisions, investment, saving etc. can be
influenced by its tax policies.
During recession, the government increases its expenditure or cut down taxes or adopts a
combination of both so that aggregate demand is boosted up with more money put into
hands of the people. On the other hand, to control high inflation the government cuts
down its expenditure or raises taxes.
In other words, expansionary fiscal policy is adopted to alleviate recession and
contractionary fiscal policy is resorted to for controlling high inflation.
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Question 4
What are the different instruments available to the government to improve allocation efficiency
in an economy?
Answer
A variety of allocation instruments are available by which government can influence
resource allocation in the economy. For example,
 government may directly produce the economic good (for example, electricity and
public transportation services)
 government may influence private allocation through incentive and disincentive (for
example, tax concessions and subsidies may be given for the production of goods
that promote social welfare and higher taxes may be imposed on goods such as
cigarettes and alcohol)
 government may influence allocation through its competition policies, merger
policies etc. which will affect the structure of industry and commerce (for example,
the Competition Act in India promotes competition and prevents anti-competitive
activities).
 governments’ regulatory activities such as licensing, control, minimum wages, and
directives on location of industry influence resource allocation
 government sets legal and administrative frameworks, and
 any of a mixture of intermediate techniques may be adopted by governments.
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1. Redistribution policies are likely to have efficiency costs because

(a) They will reduce the efficiency of governments
(b) They may create disincentives to work and save
(c) Governments have to forego taxes
(d) They are likely to make the poor people dependent on the rich
2. Macroeconomic stabilization may be achieved through

(a) Free market economy (b) Fiscal policy
(c) Monetary policy (d) (b) and (c) above
3. Which of the following policies of the government fulfils the redistribution function
(a) Parking the army on the northern borders of the country
(b) Supply of food grains at subsidized prices to the poor people
(c) Controlling the supply of money through monetary policy

(a) Fiscal policy involves the use of changes in taxation and government spending;
while monetary policy involves the use of price and profit controls.
(b) Fiscal policy involves the use of price and profit controls; while monetary policy
involves the use of taxation and government spending.
(c) Fiscal policy involves the use of changes in taxation and government spending;
while monetary policy involves the use of changes in the supply of money and
interest rates.
(d) Fiscal policy involves the use of changes in the supply of money and interest
rates; while monetary policy involves the use of changes in taxation and
government spending.
5. The justification for government intervention is best described by

(a) The need to prevent recession and inflation in the economy
(b) The need to modify the outcomes of private market actions
(c) The need to bring in justice in distribution of income and wealth
(d) All the above
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6. Read the following statements:

1. The market-generated allocation of resources is usually imperfect and leads
to inefficient allocation of resources in the economy
2. Market failures can at all times be corrected through government intervention
3. Public goods will not be produced in sufficient quantities in a market economy
Of the three statements above:
(a) 1,2 and 3 are correct (b) 1 and 3 are correct
(c) 2 and 3 are correct (d) 3 alone is correct
7. When a government offers unemployment benefits and also resorts to progressive

taxation which function does it seem to fulfill?
(a) It is trying to establish stability in an economy
(b) It is trying to redistribute income and wealth
(c) It is trying to allocate resources to their most efficient use
(d) It is creating a source of market failure
8. Government of Emeline Land decides to provide most modern road infrastructure

throughout the nation. This can be classified as
(a) Distribution function (b) Allocation function
(c) Stabilization function (d) None of the above
9. Which function does the government perform when it provides transfer payments to
offer support to the underprivileged
(a) Allocation (b) Efficiency
(c) Distribution (d) None of the above
10. Which of the following is true in respect of centre and state government finances?
(a) The centre can tax agricultural income and mineral rights
(b) Finance commission recommends distribution of taxes between the centre and
states
(c) GST subsumes majority of direct taxes and a few indirect taxes
(d) IGST is collected by the state governments
11. GST compensation is given to

(a) to the industries which have made losses due to the introduction of GST
(b) to compensate for the lower rates of GST on essential items
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(c) to the states to compensate for the loss of revenue due to the introduction of
GST
(d) to compensate for the loss of input tax credit in manufacturing
12. Which of the following is true in respect of the role of Finance Commissions in India?
I. The distribution between the union and the states of the net proceeds of taxes
II. Allocation between the states of the respective shares of such proceeds.
III. Make Recommendations on integrated GST on inter-state movement of goods
and services
IV. To recommend expenditure decentralization among different states
(a) I and II are correct
(b) II and III are correct
(c) I, II and III are correct
(d) All the above are correct
13. In a federal set up, the stabilization function can be effectively performed by
(a) Respective state governments (b) Ministry of taxes
(c) The government at the centre (d) None of the above
14. Which of the following is concerned with division of economic responsibilities

between the central and state Government of India?
(a) NITI Aayog (b) central bank
(c) Finance Commission (d) Parliament
15. Fiscal Federalism refers to ______________.

(a) Organizing and implementing development plans
(b) Sharing of political power between centers and states
(c) The management of fiscal policy by a nation
(d) Division of economic functions and resources among different layers of the
government
16. Which one of the following taxes is levied by the state government only?
(a) Corporation tax (b) Wealth tax
(c) Income tax (d) None of the above
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17. The percentage of share of states in central taxes for the period 2021-26
recommended by the Fifteenth Finance Commission is
(a) 38 percent
(b) 41 percent
(c) 42 percent
(d) The commission has not submitted its report
18. Which of the following is not a criterion for determining distribution of central taxes
among states for 2021-26 period
(a) Demographic performance (b) Forest and ecology
(c) Infrastructure performance (d) Tax and fiscal efforts
19. As per the supreme court verdict in May 2022

(a) The union has greater powers than the states for enacting GST laws
(b) The union and state legislatures have “equal, simultaneous powers “to make
laws on Goods and Services Tax
(c) The union legislature’s enactments will prevail in case of a conflict between
those of union and states
(d) The state legislatures can make rules only with the permission of central
government
20. Providing social sector services such as health and education is

(a) the responsibility of the central government
(b) the responsibility of the respective state governments
(c) the responsibility of local administrative bodies
(d) none of the above
ANSWERS:
1 (b) 2 (d) 3 (b) 4 (c) 5 (d) 6 (b)

7 (b) 8 (b) 9 (c) 10 (b) 11 (c) 12 (a)
13 (c) 14 (c) 15 (d) 16 (d) 17 (b) 18 (c)
19 (b) 20 (b)
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SUMMARY
 Government intervention to direct the functioning of the economy is based on the

belief that the objective of the economic system and the role of government is to
improve the wellbeing of individuals and households.
 An economic system should exist to answer the basic questions such as what, how
and for whom to produce and how much resources should be set apart to ensure
growth of productive capacity.
 Richard Musgrave (1959) introduced the three-branch taxonomy of the role of
government in a market economy namely, resource allocation, income redistribution
and macroeconomic stabilization.
 The allocation and distribution functions are primarily microeconomic functions,
while stabilization is a macroeconomic function.
 One of the most important functions of an economic system is the optimal or efficient
allocation of scare resources so that the available resources are put to their best
use and no wastages are there.
 Market failures, which hold back the efficient allocation of resources, occur mainly
due to imperfect competition, presence of monopoly power, collectively consumed
public goods, externalities, factor immobility, imperfect information, and inequalities
in the distribution of income and wealth.
 The allocation responsibility of the governments involves appropriate corrective
action when private markets fail to provide the right and desirable combination of
goods and services.
 A variety of allocation instruments are available by which governments can influence
resource allocation in the economy such as, direct production, provision of incentives
and disincentives, regulatory and discretionary policies etc.,
 The distributive function of budget is related to the basic question of for who should
an economy produce goods and services and aims at redistribution of income so
as to ensure equity and fairness to promote the wellbeing of all sections of people
and is achieved through taxation, public expenditure, regulation and preferential
treatment of target populations.
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 Redistribution policies are likely to have efficiency costs or deadweight losses and
herefore redistribution measures should be accomplished with minimal efficiency
cost by carefully balancing equity and efficiency objectives.
 A market economy does not automatically generate full employment and price
stability and therefore the governments should pursue deliberate stabilization
policies.
 Stabilization function is one of the key functions of fiscal policy and aims at
eliminating macroeconomic fluctuations arising from suboptimal allocation.
 The stabilization function is concerned with the performance of the aggregate
economy in terms of labour employment and capital utilization, overall output
and income, general price levels, economic growth and balance of international
payments.
 Government’s stabilization intervention may be through monetary policy as well as
fiscal policy. Monetary policy works through controlling the size of money supply
and interest rate in the economy, while fiscal policy aims at changing aggregate
demand by suitable changes in government spending and taxes. Centre and state
Finance
 Fiscal federalism deals with the division of governmental functions and financial
relations among the different levels of government.
 The central government should be responsible for the economic stabilization and
income redistribution, but the allocation of resources should be the responsibility of
state and local governments.
 Article 246 of the Constitution demarcates the powers of the union and the state by
classifying their powers into 3 lists, namely union list (on which the union parliament
alone can legislate) state list (on which the state legislative assemblies alone can
legislate) and the concurrent list on which both, the parliament and the legislative
assemblies can legislate.
 The union government can levy taxes such as tax on income, other than agricultural
income, customs and export duties, excise duties on certain goods, corporation tax,
tax on capital value of assets, excluding agricultural land, terminal taxes, security
transaction tax, Central GST, Union Excise Duty, taxes other than stamp duties etc.
 The state governments can levy taxes on agricultural income, lands and buildings,
mineral rights, electricity, vehicles, tolls, professions, as well as collect land revenue,
and impose excise duties on certain items.
 Articles 268 to 281 of the constitution contain specific provisions in respect of
distribution of finances among states.
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 Article 280, provides for an institutional mechanism, namely the Finance Commission,
to facilitate such transfers. It is responsible for evaluating the state of finances
of the union and state governments, recommending the sharing of taxes between
them and laying down the principles determining the distribution of these taxes
among States
 The Finance Commission considers issues related to vertical equity (deciding about
the share of all states in the revenue collected by centre) and horizontal equity
(allocation among states their share of central revenue).
 The Fifteenth Finance Commission recommended the share of states in the central
taxes (vertical devolution) for the 2021-26 to be 41%.
 The criteria for distribution of central taxes among states for 2021-26 are income
distance i.e the distance of a state’s income from the state with the highest income,
area, population (2011), demographic performance (to reward efforts made by
states in controlling their population), forest and ecology and tax and fiscal efforts.
 States levy and collect state GST (SGST) and the union levies and collects the central
GST (CGST). An integrated GST (IGST) is applied on inter-state movement of goods
and services and on imports and exports.
 For providing compensation to states, a cess is levied on luxury goods and demerit
goods and the proceeds are credited to the compensation fund. GST compensation
was extended beyond five years to enable states to tide over the pandemic induced
economic slowdown.
 The central government is entrusted with the responsibilities of provision of
nationally important areas like defence, foreign affairs, foreign trade and exchange
management, money and banking, cross-state transport and communication.
 The state governments are entrusted with the responsibility of facilitating agriculture
and industry, providing social sector services such as health and education, police
protection, state roads and infrastructure.
 The local self governments such as municipalities and panchayats are entrusted
with the responsibility of providing public utility services such as water supply and
sanitation, local roads, electricity etc. For items that fall in the concurrent list, both
central and state governments are responsible for providing services.
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UNIT 2 - MARKET FAILURE
2.2 THE CONCEPT OF MARKET FAILURE

The inefficient allocation of resources in an economy is described as market failure.
Market failure is a situation in which the free market leads to misallocation of society's
scarce resources in the sense that there is either overproduction or underproduction of
particular goods and services leading to a less than optimal outcome. There are two
types of market failure namely;
1.
2.
2.3 WHY DO MARKETS FAIL?

1.
2.
3.
4.
5.
2.3.1 MARKET POWER

Market power or monopoly power is the ability of a firm to profitably raise the market
price of a good or service over its marginal cost. Firms that have market power are
price makers and therefore, can charge a price that gives them positive economic
profits. Excessive market power causes the single producer or a small number of
producers to restrict output (i.e produce and sell less output than would be produced
in a competitive market) and charge price higher than what would prevail under
perfect competition. These profits are not achieved due to operating efficiency, but
due to market power and dominance. Thus, market fails to produce the right quantity
of goods and services at the right price.
Eg.:
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2.3.2 EXTERNALITIES
Externalities are costs (negative externalities) or benefits (positive externalities),
which are not reflected in free market prices. They are called externalities because
they are “external” to the market. Externalities are also referred to as 'spillover
effects', 'neighbourhood effects' 'thirdparty effects' or 'side-effects', as the originator
of the externality imposes costs or benefits on others who are not responsible for
initiating the effect.
Externalities can be positive or negative. Negative externalities occur when the
action of one party imposes costs on another party. Positive externalities occur
when the action of one party confers benefits on another party.
Production Externalities
A negative production externality initiated in production which imposes an external
cost on others may be received by another in consumption or in production. As an
example,
 A negative production externality is received in consumption when a factory
which produces aluminium discharges untreated waste water into a nearby
river and pollutes the water causing health hazards for people who use the
water for drinking and bathing.
 A negative production externality is received in production when pollution of
river affects fish output as there will be less catch for fishermen due to loss of
fish resources.
The firm, however, has no incentive to account for the external costs that it imposes
on consumers of river water or on fishermen when making its production decision.
Additionally, these external costs are never reflected in the price of the product.
A positive production externality initiated in production that confers external benefits
on others may be received in production or in consumption.
 A firm which offers training to its employees for increasing their skills generates
positive benefits on other firms when they hire such workers as they change
their jobs.
 A positive production externality is received in consumption when an individual
raises an attractive garden and the persons walking by enjoy the garden.
These external effects were not in fact taken into account when the production
decisions were made.
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Consumption Externalities
Negative consumption externalities initiated in consumption which produce external
costs on others may be received in consumption or in production.
 smoking cigarettes in public place causing passive smoking by others, creating
litter and diminishing the aesthetic value of the room and playing the radio
loudly obstructing one from enjoying a concert are examples of negative
consumption externalities affecting consumption
 The act of undisciplined students talking and creating disturbance in a
class preventing teachers from making effective instruction and the case of
excessive consumption of alcohol causing impairment in efficiency for work
and production are instances of negative consumption externalities affecting
production.
A positive consumption externality initiated in consumption that confers external

benefits on others may be received in consumption or in production.
 if people get immunized against contagious diseases, they would confer a
social benefit to others as well by preventing others from getting infected.
 Consumption of the services of a health club by the employees of a firm would
result in an external benefit to the firm in the form of increased efficiency and
productivity.
we need to understand the difference between private costs and social costs.
Private cost is the money cost of production incurred by the firm i.e. costs such
as ages, raw materials, heating and lighting which must be paid to carry out
production, and these which would appear in the firm's accounts.
Social costs refer to the total costs to the society on account of a production or
consumption activity.
Social Cost = Private Cost + External Cost
The external costs are not included in firms’ income statements or consumers’
decisions.
2.4 PUBLIC GOODS

Paul A. Samuelson who introduced the concept of ‘collective consumption good’ in
his path - breaking 1954 paper ‘The Pure Theory of Public Expenditure’ is usually
recognized as the first economist to develop the theory of public goods.
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Private Goods:
1. Private goods do not face any have free-rider problem.
2. Private goods are ‘excludable’
3. Consumption of private goods is ‘rivalrous’
4. Normally, the market will efficiently allocate resources for the production of
private goods.
5. A few examples are: food items, clothing, movie ticket, television, cars, houses
etc.
Public Goods:
1. Public goods are products (goods or services) whose consumption is essentially
collective in nature.
2. Public good is non-rival in consumption.
3. Public goods are non-excludable.
4. Public goods are characterized by indivisibility.
5. Public goods are generally more vulnerable to issues such as externalities,
inadequate property rights, and free rider problems.
2.5 INCOMPLETE INFORMATION

Complete information is an important element of a competitive market. Perfect
information implies that both buyers and sellers have complete information about
anything that may influence their decision making. However, this assumption is not
fully satisfied in real markets because of
 complexity of products and services (e.g. cardiac surgery, financial products
like mutual funds),
 difficulty of getting correct information, and
 deliberate misinformation by interested parties (e.g. highly persuasive
advertisements). Information failure results in market failure.
2.5.1 ASYMMETRIC INFORMATION

Asymmetric information occurs when there is an imbalance in information between
the buyer and the seller i.e. when the buyer knows more than the seller or the seller
knows more than the buyer. This can distort choices. For example,
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Adverse Selection
Asymmetric information generates adverse selection and affects a transaction
before it occurs.
Thus, asymmetric information leads to elimination of high-quality goods from the

market. Economic agents end up either selecting a sub-standard product or leaving
the market altogether.
Moral Hazard
Moral hazard arises whenever there is an externality (i.e., whenever an economic
agent can shift some of its costs to others). It is about actions made after making
a market exchange which may have adverse impact on the less-informed person.
In other words, it is about the opportunism characterized by an informed person’s
taking advantage of a less-informed person through an unobserved action. It arises
from lack of information about someone’s future behaviour.
2.6 GOVERNMENT INTERVENTION TO MINIMIZE MARKET POWER

Governments intervene by establishing rules and regulations designed to promote
competition and prohibit actions that are likely to restrain competition. These
legislations differ from country to country. For example, in India, we have the
Competition Act, 2002 (as amended by the Competition (Amendment) Act, 2007) to
promote and sustain competition in markets. The Antitrust laws in the US and the
Competition Act, 1998 of UK etc are designed to promote competitive economy by
prohibiting actions that are likely to restrain competition.
Other measures include:

 Market liberalisation.
 Controls on mergers and acquisitions.
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 Price capping and price regulation

 Profit or rate of return regulation
 Patronage to consumer associations
 Tough investigations into cartelisation and unfair practices such as collusion
and predatory pricing
 Restrictions on monopsony power of firms
 Reduction in import controls and
 Nationalisation
2.7 GOVERNMENT INTERVENTION TO CORRECT EXTERNALITIES

To promote the overall welfare of all members of society, social returns should be
maximized and social costs minimized.
Governments have numerous methods to reduce the effects of negative externalities
and to promote positive externalities. We shall first examine how government
regulation can deal with the inefficiencies that arise from negative externalities.
Government initiatives towards negative externalities may be classified as:

1. Direct controls or regulations that openly regulate the actions of those involved
in generating negative externalities, and
2. ‘Market-based’ policies that would provide economic incentives
(I) Direct controls, also known as command solutions:

 The government may, through legislation, fix emissions standard which is
the legal limit on how much pollutant a firm can emit.
 Licensing, production quotas and mandates.
 Production, use and sale of many commodities and services are prohibited
in our country.
 Smoking is completely banned in many public places.
 Stringent rules are in place in respect of tobacco advertising, packaging
and labeling etc.
 Governments may pass laws to alleviate the effects of negative
externalities.
 Government may limit the amounts of certain pollutants released into
water and air by individual firms or make it mandatory to use pollution
control devices.
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 Government may insist that the polluting firms install pollution-

abatement mechanisms to ensure adherence to the emission standards.
 Governments may also form special bodies/ boards to specifically address
the problem: for instance the Ministry of Environment & Forest, the
Pollution Control Board of India and the State Pollution Control Boards.
(II) The market-based approaches – environmental taxes and cap-and-trade –

operate through price mechanism to create an incentive for change. In other words,
the government tries to alter the prices of goods through taxes and subsidies and
thus change the behaviour of market participants. This is achieved by:
1. Setting the price directly through a pollution tax
2. Setting the price indirectly through the establishment of the cap-and-
trade system.
Pollution taxes are also called as..

 Pollution taxes are difficult to determine and administer .
 If the demand for the good is inelastic, the tax may have only an
insignificant effect in reducing demand.
 Pollution taxes also have potential negative consequences on employment
The second approach to establishing prices indirectly is ‘tradable emissions

permits’. You might have heard of ‘carbon credits’. The use of tradable permits
to limit emissions is often called ‘cap and trade’.
Each firm has permits specifying the number of units of emissions that the firm
is allowed to generate.
Tradable permits have been used since the early 1980s to reduce several types
of pollution in the United States. In 1994 the United States began a cap and
trade system for sulphur dioxide emissions that cause acid rain by issuing
permits to power plants based on their historical consumption of coal. India
does not have an explicit carbon price or a market-based mechanism such
as cap-and-trade; but India has many schemes and mechanisms that put
an implicit price on carbon. For example, the Perform, Achieve & Trade (PAT)
scheme, carbon tax in the form of a cess on coal, lignite and peat, Renewable
Purchase Obligations (RPO) and Renewable Energy Certificates (REC), Internal
Carbon Pricing (ICP) etc. In 2017, the coal cess was abolished and replaced by
the GST compensation cess since it failed to achieve the desired outcomes. The
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Energy Conservation (Amendment) Bill, 2022 empowers the central government

to specify a carbon credit trading scheme and to stipulate energy consumption
standards.
The cap and trade method is administratively cheap and simple to implement
and ensures that pollution is minimised in the most cost-effective way.
So far we have been discussing about negative externality. We shall now look
into positive externality.
When positive externalities are present, government may attempt to solve the
problem through -
 corrective subsidies to the producers aimed at increasing the supply of the
good
 corrective subsidies to consumers aimed at increasing the demand for the
good.
E.g. fertilizer subsidy. A subsidy on fee for education is an example of
consumption subsidy.
2.8 GOVERNMENT INTERVENTION IN THE CASE OF MERIT GOODS

Merit goods are goods that have substantial positive externalities and hence they are
socially desirable. Merit goods can be provided through the market, but are likely to
be under-produced and under-consumed through the market mechanism so that
social welfare will not be maximized. Examples of merit goods include education,
health care, welfare services, housing, fire protection, waste management, public
libraries, museum, public parks etc.
The ultimate encouragement to consume is to make the good completely free at the
point of consumption: for example freely available hospital treatment for various
diseases. When merit goods are directly provided free of cost by government, there
will be substantial demand for the same.
2.9 GOVERNMENT INTERVENTION IN THE CASE OF DEMERIT GOODS

Demerit goods are goods which are believed to be socially undesirable. Examples of
demerit goods are cigarettes, alcohol, intoxicating drugs etc.
However, it should be kept in mind that all goods with negative externalities are not
essentially demerit goods; e.g. Production of steel causes pollution, but steel is not
a socially undesirable good.
How do governments correct market failure resulting from demerit goods?
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 At the extreme, the government may enforce complete ban on a demerit good.
e.g. the possession, trading or consumption of intoxicating drugs is made
illegal.
 Through persuasion which is mainly intended to be achieved by negative
advertising campaigns which emphasize the dangers associated with
consumption of demerit goods.
 Through legislations that prohibit the advertising or promotion of demerit
goods in whatsoever manner.
 Strict regulations of the market for the good may be put in place so as to
limit access to the good, especially by vulnerable groups such as children and
adolescents.
 Regulatory controls in the form of spatial restrictions e.g. smoking in public
places, sale of tobacco to be away from schools, and time restrictions under
which sale at particular times during the day is banned.
 Imposing unusually high taxes on producing or purchasing the good making
them very costly and unaffordable to many is perhaps the most commonly
used method for reducing the consumption of a demerit good. Refer the GST
rates in India for demerit goods, you will find how high they are.
 The government can fix a minimum price below which the demerit good should
not be exchanged.
The effect of stringent regulation such as total ban is seldom realized in the
form of complete elimination of the demerit good; conversely such goods are
secretly driven underground and traded in a hidden market.
2.10 GOVERNMENT INTERVENTION IN THE CASE OF PUBLIC GOODS

Direct provision of a public good by government can help overcome the free-rider
problem which leads to market failure.
1. Excludable public goods such as parks, universities, museums etc can be
provided by government and the same can be financed through entry fees.
2. Some public goods are provided by voluntary contributions and private
donations by corporate entities and nongovernmental organisations.
3. Some goods are produced and consumed as public goods and services despite
the fact that they can be produced or consumed as private goods.
Examples are scientific approval of drugs, production of strategic products
such as atomic energy, provision of security at airports etc.
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2.11 PRICE INTERVENTION: NON-MARKET PRICING
2.12 GOVERNMENT INTERVENTION FOR CORRECTING INFORMATION FAILURE

Governments actively intervene in the market for combating the problem of market
failure due to information problems and considering the importance of information
in making rational choices. A few examples are:
 Government makes it mandatory to have accurate labeling and content
disclosures by producers.
E.g.
 Mandatory disclosure of information

E.g.
 Public dissemination of information to improve knowledge

E.g.
 Regulation of advertising and setting of advertising standards

E.g.
2.13 GOVERNMENT INTERVENTION FOR EQUITABLE DISTRIBUTION

One of the most important activities of the government is to redistribute incomes so
that there is equity and fairness in the society. Common policy interventions include:
1. progressive income tax,
2. targeted budgetary allocations,
3. unemployment compensation,
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4. transfer payments,
5. subsidies,
6. social security schemes,
7. job reservations,
8. land reforms,
9. gender sensitive budgeting etc.
Government intervention in a market that reduces efficiency while increasing equity
is often justified because equity is greatly appreciated by society.
Government failure occurs when:

 intervention is ineffective causing wastage of resources expended for the
intervention
 intervention produces fresh and more serious problems
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Question 1
Define the concept of market failure. Describe the different sources/reasons of market failure.
Answer
Market failure is a situation in which the free market leads to misallocation of society’s
scare resources in the sense that there is either overproduction or underproduction of
particular goods and services leading to a less than optimal outcome. The reason for
market failure lies in the fact though perfectly competitive markets failures are situations
in which a particular market, left to itself, is inefficient.
There are two aspects of market failures namely, demand-side market failures and supply
side market failures. Demand-side market failures are said to occur when the demand
curves do not take into account the full willingness of consumers to pay for a product.
Supply-side market failures happen when supply curves do not incorporate the full cost
of producing the product.
Following are the four major reasons for market failure:

1. Market Power: Market power or monopoly power is the ability of a firm to profitably
raise the market price of a good or service over its marginal cost. Firms that have
market power are price market and therefore, can charge a price that gives them
positive economic profits.
Market power can cause market to be inefficient because it keeps price higher and
output lower than the outcome of equilibrium of supply and demand. In the extreme
case, there is the problem of non-existence of markets or missing markets resulting
in failure to produce various goods and services, despite the fact that such product
and services are wanted by people. For example, the markets for pure public goods
do not exist.
2. Externalities: Sometimes, the actions of either consumers or producers result

in costs or benefits that do not reflect as part of the market price. Such costs or
benefits which are not accounted for by the market price are called externalities
because they are “external” to the market. In other words, there is an externality
when a consumption or production activity which has an indirect effect on other’s
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consumption or production activities and such effects are not reflected directly in
market prices.
The unique feature of an externality is that it is initiated and experienced not through
the operation of the price system, but outside the market. Since it occur outside the
price mechanism, it has not been compensated for or in word it is un-internalized or
the cost (benefit) of it is not borne (paid) by the parties.
3. Public Goods: Public goods provide a very important example of market failure, in
which the self-interested behaviour of individual does not produce efficient results.
Consumers can take advantage of public goods without contributing sufficiently to
their production. The absence of excludability in the case of public goods and the
tendency of people to act in their own self-interest will lead to the problem of free
riding. If individuals cannot be excluded from the benefit of a public goods, then they
are not likely to express the value of the benefits which they receive as an offer to pay.
If every individual plays the same strategy of free riding, the strategy will fail because
nobody is willing to pay and therefore, nothing will be provided by the market.
4. Incomplete Information: Information failure is widespread in numerous market

exchanges. When this happens misallocation of scarce resources takes place and
equilibrium price and quantity is not established through price mechanism. This
results in market failure. Asymmetric information occurs when there is an imbalance
in information between buyer and seller i.e. when the buyer knows more than the
seller or the seller knows more than the buyer. This can distort choices.
Adverse selection is a situation in which asymmetric information about quality elimates
high-quality goods from a market. Good quality products disappear because they
are kept by their owners and sold only to their friends and relatives, eventually
market may offer nothing but lemons
Moral hazard is opportunism characterized by an informed person’s taking advantage
of a less-informed person through an unobserved action. It arises from lack of
information about someone’s future behaviour. Moral hazard occurs when an
individual knows more about his or her own actions than other people do. This leads
to a distortion of incentives to take care or to exert effort when someone else bears
the costs of the lack of care or effort.
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Question 2
Explain the different types of externalities? Illustrate how externalities lead to welfare loss of
markets.
Answer
Anything that one individual does, may have, at the margin, some effect on others.
Sometimes, the actions of either consumers or producers result in cost or benefits that do
not reflect as part of the market price. Such costs or benefits which are not accounted for
by the market price are called externalities because they are “external” to the market. In
words, there is an externality when a consumption or production activity has an indirect
effect on other’s consumption or production activities and such effects are not reflected
directly in market prices.
The unique feature of an externality is that it is initiated and experienced not through the
operation of the price system, but outside the market. Externalities are also referred to as
‘spill over effects’, ‘neighbourhood effects’ ‘third-party effects’ or ‘side-effects’.
Externalities can be positive or negative. Negative externalities occur when the action of
one party imposes costs on another party. The four possible types of externalities are:
1. Negative production externalities: A negative externality initiated in production which
imposes an external cost on others may be received by another in consumption
or in production. As an example, a negative production externality occurs when a
factory which produces aluminium discharges untreated waste water into a nearby
river and pollutes the water causing health hazards for people who use the water
for drinking and bathing. Pollution of river also affect fish output as there will be
less catch for fishermen due to loss of fish resources. The former is a case where a
negative production externality is received in consumption and the latter presents a
case of a negative production externality received in production.
2. Positive production externalities: A positive production externality initiated in
production that confers external benefits on other may be received in production or
in consumption.an example of positive production externality received in production;
we can see the case of a firm which offers training to its employees for increasing
their skills. The firm generates positive benefits on other firm when they hire such
workers as they change their jobs..
3. Negative consumption externalities: Negative consumption externalities are extensively
experienced by us in our day to day life. Such negative consumption externalities
initiated in consumption which produce external costs on others may be received in
consumption or in production. Smoking cigarettes in public place causing passive
smoking by others, creating litter and diminishing the aesthetic value of the room
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and playing the radio loudly obstructing one from enjoying a concert are some are
instances of negative consumption externalities.
The act of undisciplined students talking and creating disturbance in a class preventing
teachers from making effective instruction and the case of excessive consumption of
alcohol causing reduction in efficiency for work and production are instances of
negative consumption externalities affecting production.
4. Positive consumption externalities: A positive consumption externalities initiated in
consumption that confers external benefit on others may be received in consumption
or in production. For example, if people get immunized against contagious diseases,
they would confer a social benefit to others as well by preventing others from getting
infected. Consumption of the services of a health club by the employees of a firm
would result in an external benefit to the firm in the form of increased efficiency and
productivity.
Question 3
Describe why markets have incentives to produce private goods?
Answer
A private good is a product that must be purchased to be consumed, and its consumption
by one individual prevents another individual from consuming it. Economist refer goods as
rivalrous and excludable. A good is considered to be a private good if there is competition
between individual to obtain the good and if consuming the good prevent someone else
from consuming it.
A private good is the opposite of a public good. Example of private goods include food,
airplane rides and cell phones. Private goods are less likely to experience the free rider
problem because a private good has to be purchased; it is not readily available for free.
Following are the incentives that accrue to the market in the production of Private Goods:
 Owner of private goods can exercise private property right and can prevent others
from using the good or consuming their benefits.
 Private goods are ‘excludable’ i.e. it is possible to exclude or prevent consumers who
have not paid for them from consuming them or having access to them. A buyer of a
private good is forced in a transaction to reveal what he or she is willing to pay for
a good or a service.
 Private goods do not have the rider problem. This means that the private goods will
be available to only those persons who are willing to pay for it.
 Normally, the market will efficiently allocate resources for the production of private
goods.
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 The producer and seller will be able to generate more revenue thereby increasing
their profit if they are able to increase the market demand for their products.
 Market equilibrium can be achieved in the production of private goods wherein the
supply will always try to match the quantity demanded.
Question 4
Why do markets fail to produce public goods? Illustrate your answer.
Answer
A public good is a product that one individual can consume without reducing its availability
to another individual, and from which no one is excluded. Economist refers to public goods
as “non-rivalrous” and “non-excludable.” National defence, sewage system, public parks
and other basic societal goods can all be considered public goods.
A public good is an item consumed by society as a whole and not necessarily by an
individual consumer. Public goods are financed by tax revenues. All public goods must
be consumed without reducing the availability of the good to others, and cannot be
withheld from people who do directly pay for them.
While public goods are important for a functioning society, there is an issue that arises
when these goods are provided, called the free-rider problem. For example, if a person
does not pay his taxes, he still benefits from the government’s provision of national
defence by free riding on the tax payments of his fellow citizens.
Public goods provide a very important example of market failure, in which the self-
interested behaviour of individual does not produce efficient results. Consumers can take
advantage of public goods without contributing sufficiently to their production.
Question 5
Distinguish between different types of public goods. How do public goods cause market failure?
Answer
A public good is a product that one individual can consume without reducing its availability
to another individual, and from which no one is excluded. Economists refer to public
goods as “non-rivalrous” and “non-excludable” National defence, sewer systems, public
parks and other basic societal goods can all be considered public goods.
A public good is an item consumed by society as a whole and not necessarily by an
individual consumer. Public goods are financed by tax revenues.
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Public Goods can be classified into the following categories:

1. Pure Public Goods: In economics, a pure public good is a good that is both non-
excludable and non-rivalrous in that individual cannot be effectively excluded from
use and where use by one individual does not reduce availability to others. The concept
of pure public good is often criticized by many who point out that such goods are not
in fact observable in the real world. They argue that goods which perfectly satisfy
non rivalrous and non-excludability are not easy to come across. For example, if the
government provides law and order or medical care, the use of law courts or medical
care by some individuals subtracts the consumption of others if they need to wait. As
another example, we may take defence. If armies are mostly deployed in the northern
borders, it may not result in the same amount of protection to people in the south.
2. Impure Public Goods: There are many hybrid goods that possess some features of both
public and private goods. These goods are called impure goods and are partially rivalrous
or congestible. Because of the possibility of congestion, the benefit that an individual
gets from an impure public good depends on the number of users. Consumption of
these goods by another person reduces, but does not eliminate, the benefits that other
people receive from their consumption of the same good. For example, open access
Wi-Fi networks become crowded when more people access it. Impure public goods also
differ from pure public goods in that they are often excludable.
An example of an impure public good would be cable television. It is non-rivalrous
because the use of cable television by other individual will into way reduce your
enjoyment of it. The good is excludable since the cable TV service provider can refuse
connection if you do not pay for set top box and recharge it regularly.
3. Quasi-Public Goods (Mixed Goods): Quasi Public Goods focuses on the mix services
that arise from the provision of the good. For example, if one gets sterilized against
measles, it confers not only a private benefit to the individual, but also an external
benefit because it reduces the chances getting infected of other person who are in
contact with him. You can observe here that the external effect associated with the
consumption of a private good may have the characteristic of a public good.
The quasi-public goods or services, also called a near public (for e.g. education,
health services) possess nearly all the qualities of the private goods and some of the
benefits of public good. It is easy to keep people away from them by charging a price
or fee. However, it is undesirable to keep people away from such goods because the
society would be better off if more people consume them.
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4. Common Access Resources: Common access resources or common pool resources are
a special class of impure public good which are non-excludable as people cannot be
excluded from using them. These are rival in nature and their consumption lessens
the benefits available for others. This rival nature of common resources is what
distinguishes them from pure public goods, which exhibit both non-excludability
and non-rivalry in consumption.
Since price mechanism does not apply to common resources, producers and consumer
do not pay for these resources and therefore, they overuse them and cause their
depletion and degradation. This creates threat to the sustainability of these resources
and, therefore, the availability of common access resources for future generations.
Economist use them ‘tragedy of the commons’ to describe the problem which occurs
when rivalrous but non-excludable goods are overuse, to the disadvantage of the
entire world. Example of common access resources are fishers, common pastures,
rivers, sea, backwaters biodiversity etc.
5. Global Public Goods: There are several public goods benefits of which accrue to
everyone in the world. These goods have widespread impact on different countries
and regions, population groups and generations. These are goods whose impacts
are indivisibly spread throughout the entire globe.
The WHO explains two categories of global public goods namely, final public goods
which are ‘outcomes’, (e.g. the eradication of polio) and intermediate public goods,
which contribute to the provision of final public goods. (e.g. International Health
Regulations aimed at stopping the cross-border movement of communicable
diseases and thus reducing cross-border health risks). Similarly, the World Bank
identifies five areas of global public goods which it seeks to address: namely,
the environmental commons (including the prevention of climate changes and
biodiversity), communicable diseases (including HIV/AIDS, tuberculosis, malaria,
and avian influenza), international trade, international financial architecture, and
global knowledge for development. The distinctive characteristic of global public
goods is that there is no mechanism (either market or government) to ensure an
efficient outcome.
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Question 6
Explain using diagram and examples, the concepts of negative externalities of production and
consumption, and the welfare loss associated with the production or consumption of a good or service.
Answer
Negative consumption externalities are extensively experienced by us in our day to day life.
Such negative consumption externalities initiated in consumption which produce external
costs on others may be received in consumption or in production. Smoking cigarettes
in public place causing passive smoking by others, creating litter and diminishing the
aesthetic value of the room and playing the radio loudly obstructing one from enjoying
a concert are some are instance of negative consumption externalities. The act of
undisciplined students talking and creating disturbance in a class preventing teacher from
making effective instruction and the case of excessive consumption of alcohol causing
impairment in efficiency for work and production are instance of negative consumption
externalities affecting production.
Negative externalities cause inefficiency and market failure. If we take the case of a
producer, his private cost includes direct cost of labour, material, energy and other indirect
overhead. Firms do not have to pay for the damage resulting from the pollution which
they generate. As a result, each firm’s private cost would be the direct cost of production
only which does not incorporate externalities.
Social Cost = Private Cost + External Cost

Externalities cause market inefficiencies because they hinder the ability of market prices
to convey accurate information about how much to produce and how much to consume.
Diagram showing Negative Externalities and Loss of Social welfare
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The equilibrium level of output that would be produced by a free market is Q1 at which
marginal private benefit (MPB) is equal to marginal private cost (MPC). Assuming that
there are no externalities arising from consumption, we can see that marginal social cost
(Q1S) is higher than marginal private cost (Q1E). Social efficiency occurs at Q2 level of
output where MSC is equal to MSB.
Output Q1 is socially inefficient because at Q1, the MSC is greater than the MSB and
represents over production. The shaded triangle represents the area of dead weight
welfare loss. It indicates the area of overconsumption. Thus, we conclude that when
there is negative externality, a competitive market failure where prices fall to provide the
correct signals.
Question 7
Describe the Free rider problem associated with public goods.
Answer
The incentive to let other people pay for a good or service, the benefit of which are enjoyed
by an individual is known as the free rider problem. In other words, free riding is ‘benefiting
from the actions of others without paying’. A free rider is a consumer or producer who does
not pay for a nonexclusive good in the expectation that others will pay.
Public goods provide a very important example of market failure, in which the self-
interested behaviour of individual does not produce efficient results. Consumers can take
advantage of public goods without contributing sufficiently to their production.
The absence of excludability in the case of public goods and the tendency of people to
act in their own self-interest will lead to the problem of free riding. If individual cannot
be excluded from the benefit of a public good, then they are not likely to express the
value of the benefit which they received as an offer to pay. In other words, they will
not express to buy a particular quantity at a price. Briefly put, there is no incentive for
people to pay for the good because they can consume it without paying for it. There is an
important implication for this behaviour. If every individual plays the same strategy of
free riding, the strategy will fail because nobody is willing to pay ad therefore, nothing
will be provided by the market. Then, a free ride for any one becomes impossible.
On account of the free problem, there is no meaningful demand curve for public goods.
If individual make no offer to pay for public goods, then the profit maximizing firms will
not produce them.
In fact, the public goods are valuable for people. If there is no free rider problem, people
would be willing to pay for them and they will be produced by the market. As such, if the
free-rider problem cannot be solved, the following two outcomes are possible:
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1. No public good will be provided in private markets

2. Private markets will seriously under produce public goods even though these goods
provide valuable service to the society.
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1. ‘Market failure’ is a situation which occurs when

(a) private goods are not sufficiently provided by the market
(b) public goods are not sufficiently provided by public sector
(c) The market fail to form or they allocate resources efficiently
(d) (b) and (c) above
2. Which of the following is an example of market failure?

(a) Prices of goods tend to rise because of shortages
(b) Merit goods are not sufficiently produced and supplied
(c) Prices fall leading to fall in profits and closure of firms
3. Which of the following is an outcome of market power?

(a) makes price equal to marginal cost and produce a positive external benefit on
others
(b) can cause markets to be efficient due to reduction in costs
(c) makes the firms price makers and restrict output so as to make allocation
inefficient
(d) (b) and(c) above
4. Markets do not exist

(a) for goods which have positive externalities
(b) for pure public goods
(c) for goods which have negative externalities
5. Which of the following is the right argument for provision of public good by
government?
(a) Governments have huge resources at their disposal
(b) Public goods will never cause any type of externality
(c) Markets are unlikely to produce sufficient quantity of public goods
(d) Provision of public goods are very profitable for any government
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6. Adequate amount of a pure public good will not be provided by the private market
because of
(a) the possibility of free riding
(b) the existence of very low prices and low profits
(c) governments would any way produce them, so there will be overproduction
(d) there are restrictions as well as taxes on production of public goods
7. The free rider problem arises because of

(a) ability of participants to produce goods at zero marginal cost
(b) marginal benefit cannot be calculated due to externalities present
(c) the good or service is non excludable
(d) general poverty and unemployment of people
8. A chemical factory has full information regarding the risks of a product, but continues
to sell it. This is possible because of
(a) asymmetric information (b) moral hazard
(c) free riding (d) (a) and (c) above
9. If an individual tends to drive his car in a dangerously high speed because he has a
comprehensive insurance cover, it is a case of
(a) free riding (b) moral hazard
(c) poor upbringing (d) Inefficiency
10. Smoking in public is a case of

(a) Negative consumption externality (b) Negative production externality
(c) Internalising externality (d) None of the above

I The market-based approaches to control externalities operate through price
mechanism
II. When externalities are present, the welfare loss would be eliminated
III. The key is to internalizing an externality is to ensure that those who create the
externalities include them while making decisions Of the above statements
(a) II and III are correct (b) I only is correct
(c) II only is correct (d) I and III are correct
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12. Which of the following statements is false?

(a) Tradable permits provide incentive to innovate and reduce negative externalities
(b) A subsidy on a good which has substantial positive externalities would reduce
its cost and consequently its price would be lower
(c) Substantial negative externalities are involved in the consumption of merit goods.
(d) Merit goods are likely to be under-produced and under consumed through the
market mechanism
13. Which one of the following would you suggest for reducing negative externality?
(a) Production subsidies (b) Excise duty
(c) Pigouvian taxes (d) All of the above
14. A Pigouvian subsidy

(a) cannot be present when externalities are present
(b) is a good solution for negative externality as prices will increase
(c) is not measurable in terms of money and therefore not practical
(d) may help production to be socially optimal when positive externalities are
present
15. If governments make it compulsory to avail insurance protection, it is because

(a) Insurance companies need to be running profitably
(b) Insurance will generate moral hazard and adverse selection
(c) Insurance is a merit good and government wants people to consume it
16. The Competition Act, 2002 aims to -

(a) protect monopoly positions of firms that have developed unique innovations
(b) to promote and sustain competition in markets
(c) to determine pricing under natural monopoly.
17. Rules regarding product labelling

(a) Seeks to correct market failure due to externalities
(b) Is a method of solving the problem of public good
(c) May help solve market failure due to information failure
(d) Reduce the problem of monopolies in the product market
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18. Identify the incorrect statement

(a) A minimum support price for agricultural goods is a market intervention
method to guarantee steady and assured incomes to farmers.
(b) An externality is internalised if the ones that generated the externality
incorporate them into their private cost- benefit analysis
(c) The production and consumption of demerit goods are likely to be less than
optimal under free markets
(d) Compared to pollution taxes, the cap and trade method is administratively
cheap and simple to implement and ensures that pollution is minimised in the
most cost-effective way.
19. The incentive to let other people pay for a good or service, the benefits of which are
enjoyed by an individual
(a) Is a case of negative externality
(b) Is a case of market efficiency
(c) Is a case of free riding
(d) Is inappropriate and warrant action
20. A government subsidy

(a) is a market-based policy
(b) involves the government paying part of the cost to the firms in order to promote
the production of goods having positive externalities
(c) is generally provided for merit goods
(d) all the above
21. The production and consumption of demerit goods are

(a) likely to be more than optimal under free markets.
(b) likely to be less than optimal under free markets
(c) likely to be subjected to price intervention by government
22. The argument for education subsidy is based on

(a) Education is costly
(b) the ground that education is merit good
(c) education creates positive externalities
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I. Social costs are the total costs incurred by the society when a good is consumed
or produced.
II The external costs are not included in firms’ income statements or consumers’
decisions
III. Each firm’s cost which is considered for determining output would be only
private cost or direct cost of production which does not include external costs
IV. Production and consumption decisions are efficient only when private costs are
considered Of the above
(a) Statements I and III are correct
(b) Statements I,II and III are correct
(c) Statement I only is correct
24. Government failure occurs when

(a) Government fails to implement its election promises on policies
(b) A government is unable to get reelected
(c) Government intervention is ineffective and produces fresh and more serious
problems
ANSWERS:
1 (c) 2 (b) 3 (c) 4 (b) 5 (c) 6 (b)

7 (c) 8 (a) 9 (b) 10 (a) 11 (d) 12 (c)
13 (c) 14 (d) 15 (c) 16 (b) 17 (c) 18 (c)
19 (c) 20 (d) 21 (d) 22 (d) 23 (b) 24 (c)
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SUMMARY
 Market failure is a situation in which the free market leads to misallocation of society's
scarce resources in the sense that there is either overproduction or underproduction
of particular goods and services leading to a less than optimal outcome.
 There are two types of market failure: complete market failure or “missing markets"
and partial market failure
 There are four major reasons for market failure. They are: market power, externalities,
public goods, and incomplete information.
 Excessive market power causes the single producer or small number of producers to
produce and sell less output than what would be produced in a competitive market
and charge higher prices.
 Externalities also referred to as ‘spill over effects’, ‘neighbourhood effects’ ‘third-
party effects’, or ‘side-effects’, occur when the actions of either consumers or
producers result in costs or benefits that do not reflect as part of the market price.
 Externalities are initiated and experienced, not through the operation of the price
system, but outside the market and therefore, are external to the market.
 Externalities can be positive or negative. Negative externalities occur when the
action of one party imposes costs on a third party who is not part of the transaction.
Positive externalities occur when the action of one party confers benefits a third
party.
 The four possible types of externalities are: negative externality initiated in
production which imposes an external cost on others; positive production externality,
less commonly seen, initiated in production that confers external benefits on others;
negative consumption externalities initiated in consumption which produce external
costs on others and positive consumption externality initiated in consumption that
confers external benefits on others. Each of the above may be received by another
in consumption or in production.
 Private cost is the cost faced by the producer or consumer directly involved in a
transaction and includes direct cost of labour, materials, energy and other indirect
overheads and does not incorporate externalities.
 Social cost is the entire cost which the society bears. Social Cost =Private Cost +
External Cost.
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 The firm or the consumer as the case may be, however, has no incentive to account
for the external costs that it imposes on others.
 When firms do not have to worry about negative externalities associated with their
production, the result is excess production and unnecessary social costs
 Public good (also referred to as a collective consumption good or a social good) are
those which are indivisible, nonrival, non-excludable and enjoyed in common by all
individuals. They are vulnerable to externalities and free rider problems.
 The incentive to let other people pay for a good or service, the benefits of which are
enjoyed by an individual is known as the free rider problem.
 Private goods are ‘rivalrous’ ‘and excludable’ and less likely to have the free r ider
problem.
 Complete information is an essential element of competitive market.
 Asymmetric information occurs when there is an imbalance in information between
the buyer and the seller i.e. when the buyer knows more than the seller or the seller
knows more than the buyer. This can distort choices.
 Adverse selection is a situation in which asymmetric information about quality
eliminates high-quality goods from a market. Buyers expect hidden problems in
items offered for sale, leading to lower prices and the good quality items being kept
off the market.
 Moral hazard is opportunism characterized by an informed person’s taking advantage
of a less-informed person through an unobserved action.
 Asymmetric information, adverse selection and moral hazard affect the ability
of markets to efficiently allocate resources and therefore, lead to market failure
because the party with better information has a competitive advantage.
 Governments intervene in various ways to correct market failure.
 Because of the social costs imposed by monopoly, governments intervene by
establishing rules and regulations designed to promote competition and prohibit
actions that are likely to restrain competition.
 Natural monopolies such as electricity, gas and water supplies are usually subject
to price controls.
 Government initiatives towards combating market failures due to negative
externalities are either direct controls or market-based policies.
 Direct controls prohibit specific activities that explicitly create negative externalities
or require that the negative externality be limited to a certain level, for instance
limiting emissions.
 Government may pass laws to alleviate the effects of negative externalities or fix
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emissions standard which is a legal limit on how much pollutant a firm can emit. It
may charge emission fee which is levied on each unit of a firm’s emissions.
 The market-based approaches– environmental taxes and cap-and-trade – operate
through price mechanism to create an incentive for change.
 The key is to internalizing an externality (both external costs and benefits) is to
ensure that those who create the externalities include them while making decisions.
 One method of ensuring internalization of negative externalities is imposing
pollution taxes. (Pigouvian taxes). By ‘making the polluter pay’, pollution taxes seek
to internalize external costs into the price of a product or activity.
 Pollution taxes are difficult to determine and administer due to difficulty to discover
the right level of taxation, problems associated with inelastic nature of demand for
the good and the problem of possible capital flight.
 Tradable emission permits are marketable licenses to emit limited quantities of
pollutants and can be bought and sold by polluters. The high polluters have to buy
more permits and the low polluters receive extra revenue from selling their surplus
permits.
 The system is administratively cheap and simple, allows flexibility and reward
efficiency and provides strong incentives for innovation.
 Subsidy is a market-based policy and involves the government paying part of
the cost to the firms in order to promote the production of goods having positive
externalities.
 Merit goods such as education, health care etc are socially desirable and have
substantial positive externalities. Left to the market, merit goods are likely to be
underproduced and under- consumed so that social welfare will not be maximized.
 The possible government responses to under-provision of merit goods are regulation,
legislation, subsidies, direct government provision and a combination of government
provision and market provision.
 Demerit goods are goods which impose significant negative externalities on the
society as a whole and are believed to be socially undesirable. The production and
consumption of demerit goods are likely to be more than optimal under free markets.
 Steps taken by government to limit demerit goods include complete ban of the
good, legislations, persuasion and advertising campaigns, limiting access to the
good, especially by vulnerable groups.
 In the case of non excludable pure public goods where entry fees cannot be charged,
direct provision by governments through the use of general government tax revenues
is the only option.
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 A very commonly followed method in the case of excludable public good is to grant
licenses to private firms to build a facility and then the government regulates the
level of the entry fee chargeable from the public.
 Due to strategic and security reasons, certain goods are produced and consumed as
public goods and services despite the fact that they can be produced or consumed
as private goods.
 Price controls may take the form of either a price floor (a minimum price buyers are
required to pay) or a price ceiling (a maximum price sellers are allowed to charge
for a good or service).
 When prices of certain essential commodities rise excessively government may resort
to controls in the form of price ceilings (also called maximum price) for making a
resource or commodity available to all at reasonable prices.
 With the objective of ensuring stability in prices and distribution, governments often
intervene in grain markets through building and maintenance of buffer stocks.
 Government failure occurs when intervention is ineffective causing wastage of
resources expended for the intervention and/or when intervention produces fresh
and more serious problems. This creates inefficiency and leads to a misallocation of
scare resources.
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UNIT 3 – THE PROCESS OF BUDGET MAKING: SOURCES OF REVENUE, EXPENDITURE

MANAGEMENT AND MANAGEMENT OF PUBLIC DEBT
1. INTRODUCTION
Governments all over the world have to perform manifold functions from
protecting their territories, maintaining law and order, provision of public goods
and implementation of comprehensive plans for economic and social welfare of its
citizens. To execute these functions efficiently, the government requires adequate
financial resources. Budget is a powerful policy instrument in the hands of
government to regulate and to restructure a country's economic priorities.
The need for budgeting arises from the need to efficiently allocate limited resources
to ensure maximum social welfare.
In simple terms, a budget is a statement that presents the details of ‘where the
money comes from’ and ‘where the money goes to’.
The budget includes projections for the economy and its various sectors such as
agriculture, industry, and services. The budget also contains estimates of the
government’s accounts for the next fiscal year called budgeted estimates.
Apart from the union budget, state and the local bodies have their own budgetary
processes for the next financial year. However, the focus of this unit will be the union
budget only.
2. THE PROCESS OF BUDGET MAKING

The finances of the government of India have traditionally been controlled by the Ministry
of Finance. The budget is prepared by the Ministry of Finance in consultation with NITI
Aayog and other relevant ministries. The budget must be presented and approved by
both houses of parliament before the beginning of the fiscal year (April 1 to March 31).
Despite the fact that the term ‘budget’ has not been used in the Indian Constitution,
the process of making it is generally referred to as budgeting. Article112 of the
constitution provides that in respect of every financial year the ‘president shall
cause to be laid before both the houses of parliament a statement of the estimated
receipts and expenditure of the government of India for that year, referred to as the
“Annual Financial Statement’’.
The budgetary procedures are -
(i) Preparation of the budget
(ii) Presentation and enactment of the budget and
(iii) Execution of the budget.
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The budget process mainly consists of two types of activities:

1. The administrative process, wherein the budget along with the accompanying
documents are prepared in consultation with various stakeholders;
2. The legislative process wherein the budget is passed by the parliament after
discussions.
Despite the fact that the union budget is presented on1st February (or any other
suitable date as decided by the government), the process of budget preparation
commences in August-September of the previous year.
The budget is presented in the Parliament in such form as the Finance Ministry may
decide after considering the suggestions (if any) of the Estimates Committee. Broadly,
the budget documents depict information relating to receipts and expenditure for
two years. They are:
(i) Budget estimates (BE) of receipts and expenditure in respect of current and
ensuing financial year
(ii) For the current year through Revised Estimates (RE); and
(iii) Actuals of the year preceding the current year
The budget speech of the Finance Minister is usually in two parts.

• Part A of the budget speech gives an outline of the prevailing macro economic
situation of the country and the budget estimates for the next financial year.
Elaborating the priorities of the government, the minister presents a broad
framework of the total funds raised by the government via taxes or borrowings,
proposed government expenditure allocations for different sectors and fresh
schemes for different sectors.
• Part B of the budget speech details the progress the government has made
on various developmental measures, the direction of future policies and the
government’s tax proposals for the upcoming financial year including variations
in the current taxation system.
The Annual Financial Statement shows the receipts and expenditure of
government in three separate parts under which government accounts are
maintained, namely:
1. Consolidated Fund of India
2. Contingency Fund of India, and the
3. Public Account.
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The list of budget documents presented to the parliament, besides the finance
minister’s budget speech, is given below:
(a) Annual Financial Statement (AFS)
(b) Demands for Grants (DG)
(c) Finance Bill
(d) Statements mandated under FRBM Act:
(i) Macro -Economic Framework Statement
(ii) Medium-Term Fiscal Policy cum Fiscal Policy Strategy Statement
The budget is discussed in two stages in the Lok Sabha.

1. First, there is the general discussion on the budget as a whole.
2. After the general discussion on the budget proposals and voting on demands
for grants have been completed, the government introduces the Appropriation
Bill.
The Finance Bill seeking to give effect to the government’s taxation proposals is
introduced in Lok Sabha immediately after the presentation of the general budget.
The Parliament has to pass the Finance Bill within 75 days of its introduction.
On the last day of the days allotted for discussion on the demands for grants, the
speaker puts all the outstanding demands for grants to the vote of the house. This
process is known as ‘Guillotine’. It is a device for bringing the debate on financial
proposals to an end within a specified time.
After the Finance Bill has been passed by the Lok Sabha, it is transmitted to the
Rajya Sabha for Its recommendations. The bill being a money bill, Rajya Sabha
has to return it within a period of 14 days, with or without recommendations. The
recommendations of Rajya Sabha may be accepted or rejected by the Lok Sabha.
An important budgetary reform was the merger of railway budget with the general
budget from the budget for financial year 2017-18.
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BUDGET
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3. SOURCES OF REVENUE
The Department of Revenue exercises control in respect of matters relating to all the
direct and indirect union taxes through two statutory boards, namely,
1. the Central Board of Direct Taxes (CBDT) and
2. the Central Board of Indirect Taxes and Customs (CBIC).
Government receipts are classified under two categories:
1. Revenue receipts which consists of tax revenue and non tax revenue.
2. Capital receipts which consists of debt receipts and non debt capital receipts
The broad sources of revenue are:

1. Corporation tax
2. Taxes on income
3. Wealth tax
4. Customs duties
5. Union excise duties
6. Goods and services tax including GST compensation cess
7. Taxes on union territories
Non-tax revenues comprise the following:

1. Interest receipts,
2. Dividends and profits from public sector enterprises and surplus transfers from
Reserve Bank of India
3. Other Non-tax revenues and
4. Receipts of union territories
Capital Receipts include:

1. Non debt capital receipts which include
(a) Recoveries of loans and advances
(b) Miscellaneous capital receipts (disinvestments and others)
2. Debt capital receipts which include
(a) Market loans for different purposes
(b) Short term /Treasury bill borrowings
(c) Securities issued against small savings,
(d) State provident fund (Net)
(e) Net external debts
(f) Other receipts (Net)
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4. PUBLIC EXPENDITURE MANAGEMENT

A prudent and well designed public expenditure management is essential for any
government to ensure that the level of aggregate public expenditure is consistent
with a sustainable macroeconomic framework.
Public expenditure management is the process that allows governments to be fiscally

responsible.
The economic costs of unproductive public expenditures can be extensive .and may
have far reaching effects such as:
• larger deficits
• higher levels of taxation,
• lower economic growth,
• fewer resources available for use elsewhere, and
• greater debt burden in the future.
The Department of Expenditure of the Ministry of Finance is the nodal department

for overseeing the public financial management system in the central government
and matters connected with state finances. It is responsible for
• the implementation of the recommendations of the Finance Commission and
the Central Pay Commission,
• monitoring of audit comments/observations, and
• preparation of central government accounts.
• Additionally, it also assists central ministries/departments in
• controlling the costs and prices of public services,
• reviewing systems and procedures to optimize outputs and outcomes of public
expenditure.
The total expenditure through budget (both current and capital) of various ministries
and departments is composed of central expenditure and transfers. In Expenditure
budget, the Central government expenditure is classified into six broad categories as
below:
A. Centre’s Expenditure:
• Establishment Expenditure of the Centre;
• Central sector schemes, and
• Other central expenditures including those on CPSEs and Autonomous
Bodies
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B. Centrally Sponsored Schemes and other Transfers:

The transfers include
• Centrally sponsored schemes
• Finance Commission transfers and
• Other transfers to states
5. PUBLIC DEBT MANAGEMENT

In emerging market and developing economies, the government is generally the
largest borrower. Government debt from internal and external sources contracted in
the Consolidated Fund of India is defined as Public Debt.
The overall objective of the central government’s debt management policy is to “meet
the central government’s financing needs at the lowest possible long term borrowing
costs and also to keep the total debt within sustainable levels. Additionally, it aims
at supporting development of a well-functioning and vibrant domestic bond market”.
The institutions responsible for public debt management are:

1. Reserve Bank of India – domestic marketable debt i.e., dated securities, treasury
bills and cash management bills.
2. Ministry of Finance (MOF); – external debt
3. Ministry of Finance; Budget Division and Reserve Bank of India – Other liabilities
such as small savings, deposits, reserve funds etc.
The responsibility of managing the domestic debt of the central government and of
28 state governments and two union territories is entrusted with the Internal Debt
Management Department (IDMD) of the Reserve Bank of India.
The RBI acts as the debt manager for marketable internal debt. While treasury bills
are issued to meet short term cash requirements of the government, dated securities
are issued to mobilise longer term resources to finance the fiscal deficit. From 1997
onwards, the Reserve Bank also provides short-term credit up to three months to
state governments banking with it in the form of Ways and Means Advances (WMA)
to bridge temporary mismatches in cash flows.
External debt (bilateral and multilateral loans) is managed by the Department of
Economic Affairs in the Ministry of Finance (MoF). Most of the external debt is sourced
from multilateral agencies (International Bank for Reconstruction and Development,
Asian Development Bank, etc.). There is no sovereign borrowing from international
capital markets.
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The Fiscal Responsibility and Budget Management (FRBM) was passed in 2003 to provide
a legislative framework for reduction of deficit and thereby debt of the central
government to a sustainable level. The objectives of the act are:
• inter-generational equity in fiscal management,
• long run macroeconomic stability,
• better coordination between fiscal and monetary policy, and
• transparency in fiscal operation of the government.
The sheer size of India’s public debt can be understood from the following table:
Debt Position of the Government of India (in ` crores)
As on 31st March 2023 As on 31st March 2024

Internal debt and other liabilities 147,77,724.43 164,23,983.04
External debt# 4,83,397.69 5,22,683.81
Total 152,61,122.12 169,46,666.85
The Reserve Bank has been proactively engaged in the development of the government
securities (G-sec) market including broadening of investor participation. As part of
continuing efforts to increase retail participation in G-sec, ‘RBI Retail Direct’ facility
was announced on February 5, 2021:
• for improving the ease of access by retail investors through online access to the
primary and secondary government securities market
• to provide the facility to open their government securities account (‘Retail
Direct’) with the Reserve Bank.
BUDGET CONCEPTS
Type of budgets
Balanced budget: (Revenue= Expenditure).
Unbalanced budget:
• A surplus budget: public revenue exceeds public expenditure.
• A deficit budget: government receipts are less than the government expenditure
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Capital Receipts:
Capital receipts are those receipts that lead to a reduction in the assets or an increase
in the liabilities of the government. Examples include recoveries of loans, earnings from
disinvestment and debt.
Revenue Receipts:
Revenue receipts can be defined as those receipts which neither create any liability nor
cause any reduction in the assets of the government. There are two sources of revenue
receipts for the government — tax revenues and non-tax revenues.
Revenue Expenditure:
Revenue expenditure is expenditure incurred for purposes other than creation of physical
or financial assets of the central government.
Capital Expenditure:
There are expenditures of the government which result in creation of physical or financial
assets or reduction in financial liabilities.
Budgetary Deficit or Overall Deficit
Revenue Deficit
Revenue deficit = Revenue expenditure – Revenue receipts
Fiscal Deficit
Fiscal deficit = Total Expenditure –Total Receipts excluding borrowing
Primary Deficit
Primary deficit = Fiscal deficit – Net Interest liabilities
Finance Bill
The Bill produced immediately after the presentation of the union budget detailing the
Imposition, abolition, alteration or regulation of taxes proposed in the budget.
Outcome budget
The outcome budget establishes a direct link between budgetary allocations of schemes
and its annual performance targets measured through output and outcome indicators.
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The outcome budget is a progress card on what various ministries and departments have
done with the outlays in the previous annual budget.
Guillotine
The parliament has very limited time for examining the expenditure demands of all the
ministries. So, once the prescribed period for the discussion on demands for grants is
over, the speaker of Lok Sabha puts all the outstanding demands for grants, whether
discussed or not, to the vote of the house. This process is popularly known as 'Guillotine'.
Cut Motions
Motions for reduction to various demands for grants are made in the form of cut motions
seeking to reduce the sums sought by government on grounds of economy or difference
of opinion on matters of policy or just in order to voice a grievance.
Consolidated Fund of India

All revenues received, loans raised and all moneys received by the government in
repayment of loans are credited to the Consolidated Fund of India and all expenditures
of the government are incurred from this fund.
Contingency Fund of India

A fund placed at the disposal of the President to enable him/her to make advances to the
executive/Government to meet urgent unforeseen expenditure.
Public Account
Under provisions of Article 266(1) of the Constitution of India, public account is used in
relation to all the fund flows where government is acting as a banker. Examples include
Provident Funds and Small Savings.
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Question 1
Define the concept of market failure. Describe the different sources/reasons of market failure.
Answer
Market fai
Pending Question
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183
1. The difference between the budget deficit of a government and its debt service
payments is
(a) Fiscal deficit (b) Budget deficit
(c) Primary deficit (d) None of the above
The following hypothetical figures relate to country A

` Crores
Revenue receipts 20,000
Recovery of loans 1,500
Borrowing 15,000
Other Receipts 5,000
Expenditure on revenue account 24,500
Expenditure on capital account 26,000
Interest payments 2,000
2. The revenue deficit for country A is

(a) 5,000 (a) 24,000
3. Fiscal deficit of country A is

(a) 14,000 (b) 24,000
4. Primary deficit of Country A is

(a) 26,000 (b) 26,500
(c) 22,000 (d) 24,500
5. In NITI Aayog, NITI stands for

(a) National Initiative for Transforming India
(b) National Institution for Transforming India
(c) National Institute for Technology and Innovation
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6. The Appropriation Bill is intended to

(a) reduce unnecessary expenditure on the part of the government
(b) give authority to government to incur expenditure from and out of the
Consolidated Fund of India
(c) give authority to government to incur expenditure from the revenue receipts
only
(d) be passed before the budget is taken for discussion
7. Public debt management aims at

(a) An efficient budgetary policy to avail of domestic debt facilities
(b) Raising loans from international agencies at lower rates of interest
(c) Raising the required amount of funding at the desired risk and cost levels
(d) Management of public expenditure to reduce public debt
8. The railway budget is

(a) Part of the general budget, but is presented by the railway minister
(b) Part of the general budget from the budget for financial year 2017-18.
(c) Part of the general budget from the budget for financial year 2021-22
(d) Part of the general budget but presented on the next day of the general budget
9. Outcome budgeting
(a) shares information about the money allocated for various purposes in a budget
(b) establishes a direct link between budgetary allocations and performance
targets measured through output and outcome indicators
(c) establishes a direct link between budgetary performance targets and public
account disbursals
(d) shares information about public policies and programmes under the budget
10. Corporate tax

(a) is collected by the union government and can be a capital receipt or revenue
receipt
(b) may be collected by the respective states and fall under revenue receipts
(c) may be collected either by the centre or states and fall under revenue receipts
(d) is collected by the union government and is a revenue receipt
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11. Government borrowings from foreign governments and institutions

(a) Capital receipt (b) Revenue receipt
(c) Accounts for fiscal deficit
(d) Any of the above depending on the purpose of borrowing
The following table relates to the revenue and expenditure figures of a hypothetical
economy
In ` lakh Crores
(a) Recovery of loans 5.1
(b) Salaries of govt. servants 41.1
(c) Capital Expenditure 45.0
(d) Interest payments 1.3
(e) Payments towards subsidies 3.2
(f) Other receipts (mainly from disinvestment) 11.6
(g) Tax revenue (net of states’ share) 26.3
(h) Non-tax revenue 12.3
(i) Borrowings and other liabilities 6.8
(j) States’ share in tax revenue 11.9
12. The capital receipts are

(a) 23.5 (b) 19.7
(c) 11.3 (d) None of the above
13. Revenue deficit is

(a) 23.6 (b) 13.0
(c) 7.0 (d) 2.6
14. The non–debt capital receipts of this country is

(a) 45.1 (b) 16.7
(c) 15.8 (d) None of the above
15. A budget is said to be unbalanced when

(a) when government’s revenue exceeds government’s expenditure
(b) when government’s expenditure exceeds government’s revenue
(c) either budget surplus of budget deficit occurs
(d) All the above
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16. Fiscal deficit refers to

(a) the excess of government’s revenue expenditure over revenue receipts
(b) The excess of total expenditure over total receipts excluding borrowings
(c) Primary deficit - interest payments
(d) None of these
17. Budget of the government generally impacts

(a) the resource allocation in the economy
(b) redistribution of income and enhance equity
(c) stability in the economy by measures to control price fluctuations
(d) all the above
18. Which of the following is a statement submitted along with the budget as a
requirement of FRBM Act
(a) Annual Financial Statement
(b) Macro -Economic Framework Statement
(c) Medium-Term Fiscal Policy cum Fiscal Policy Strategy Statement
19. Government borrowing is treated as capital receipt because

(a) It is mainly used for creating assets by government
(b) It creates a liability for the government
(c) Both (a) and (b) above are correct
(d) None of the above is correct
20. ‘Retail Direct ‘scheme is

(a) Initiated by the Reserve Bank of India
(b) facilitate investment in government securities by individual investors.
(c) Direct sale of goods and services by government departments
(d) Both (a) and (b) are correct
21. Non-debt capital receipts

(a) do not add to the assets of the government and therefore not treated as capital receipts
(b) are those that do not create any future repayment burden for the government
(c) are those that create future liabilities for the government
(d) facilitate capital investments at low cost
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22. Which of the following is a capital receipt?

(a) Licence fee received
(b) Sale proceeds from disinvestment
(c) Assistance from Japan for covid vaccine
(d) Dividend from a public sector enterprise
23. Grants given by the central government to state governments is

(a) A revenue expenditure as it is meant to meet the current expenditure of the
states
(b) A revenue expenditure as it does neither creates any asset, nor reduces any
liability of the government
(c) A capital expenditure because it increase the capital base of the states
(d) It is a grant and so does not come under revenue expenditure or capital
expenditure.
24. Short-term credit from the Reserve Bank to state governments to bridge temporary
mismatches in cash flows is known as
(a) RBI credit to states (b) Commercial credit of RBI
(c) Ways and Means Advances (WMA) (d) Short term facility
ANSWERS:
1 (c) 2 (c) 3 (b) 4 (c) 5 (b) 6 (b)

7 (c) 8 (b) 9 (b) 10 (d) 11 (a) 12 (a)
13 (c) 14 (b) 15 (d) 16 (d) 17 (d) 18 (d)
19 (b) 20 (d) 21 (b) 22 (b) 23 (b) 24 (c)
Question AND SUMMARY - NO
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UNIT 3 – GOVERNMENT INTERVENTION TO CORRECT MARKET FAILURE
Question 1
Explain the intervention strategies of government to bring about efficient market outcomes or
to control Market power.
Answer
Freely functioning market produce externalities because producers and consumers need
to consider only their private costs and benefit and not the costs imposed on or benefits
accrued to others. Governments have numerous methods to reduce the effects of negative
externalities and to promote positive externalities. Government regulation can deal with
the inefficient that arise from negative externalities.
Market power tends to restrict output and leads to deadweight loss. Because of the
social costs imposed by monopoly, governments intervene by establishing rules and
regulation designed to promote competition and prohibit actions that are likely to restrain
competition. These legislation differ from country to country. For example, in India, we
have the Competition Act, 2002 (as amended by the Competition (Amendment) Act, 2007)
to promote and sustain competition in markets.
Such legislations generally aim at prohibiting contracts, combinations and collusions
among producers or traders which are in restraint of trade and other anticompetitive
actions such as predatory pricing.
On the contrary, some of the regulatory responses of government to incentive failure tend
to create and protect monopoly position of firms that have developed unique innovations.
For example, patent and copyright laws grant exclusive rights of products or processes to
provide incentive for invention and innovation.
Policy options for limiting market power also include price regulation in the form of
setting maximum price that firms can charge.
Other measures include:
• Market liberalization by introducing competition in previously monopolistic sectors
such as energy, telecommunication etc.
• Controls on merger and acquisitions if there is possible market domination
• Price capping and price regulation based on the firm’s marginal costs, average costs,
past prices, or possible inflation and productivity growth
• Profit or rate of return regulation
• Performance targets and performance standards
• Patronage to consumer associations
• Tough investigation into cartelization and fair practices such as collusion and
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predatory pricing
• Restrictions on monopsony power of firms
• Reduction in import control and
• Nationalization
Explain government intervention in case of Negative Production Externality (Pollution)

Government may pass laws to alleviate the effect of negative externalities. Government
stipulated environment standards are rules that protect the environment by specifying
actions by producers and consumers. For example, India has enacted the Environment
(Protection) Act, 1986. The government may, through legislation, fix emission standard
which is legal limit on how much pollutant a firm can emit. The set standard ensures
that the firm produces efficiently. If the firm exceeds the limit, it can invite monetary
penalties or/and criminal liabilities. The firms have pollution-abatement mechanism to
ensure adherence to the emission standards. This means additional expenditure to the
firm leading to rise in the firm’s average cost. New firms will find it profitable to enter
the industry only if the price of the product is greater than the average cost of production
plus abatement expenditure.
Due to negative production externalities, marginal social cost is greater than marginal
private cost. The free market outcome would be to produce a socially non-optimal output
level ‘Q’ at the level of equality between marginal private cost and marginal private
benefit. (Since externalities are not taken into account, marginal private benefit would
be contemplated as marginal social benefit). When externalities are present, the welfare
loss to the society or dead weight loss would be the shaded area ‘ABC’. The tax imposed
by government (equivalent to the vertical distance AA1) would shift the cost curve up by
the amount of tax, price will rise to ‘P1’ and a new equilibrium is established at point ‘B’,
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where the marginal social cost is equal to marginal social benefit. Output level ’Q1’ is
socially optimal and eliminates the whole of welfare loss on account of.
What are the problems in administering an efficient pollution tax?
Answer
1) Pollution taxes are difficult to determine and administer ,because it is difficult to
Discover right level of taxation
2) The method of taxing polluters involves use of complex and costly administrative
procedures
3) This method does not provide any genuine solution to the problem
4) In case of inelastic products producer can easily shift the tax burden on consumers
5) Pollution taxes also have negative impact on employment and investment, as
produces may get discouraged and may shift production units to other countries .
Explain Cap and trade (Market based approach)

The second approach to establishing prices is tradable emissions permits (also known as
cap-and-trade). These are marketable licenses to emit limited quantities of pollutants
and can be bought and sold by polluters. Under this method, each firm has permits
specifying the number of units of emissions that the firm is allowed to generate. A firm that
generates emissions above what is allowed by the permit is penalized with substantial
monetary sanctions. These permits are transferable, and therefore different pollution
levels are possible across the regulated entities. Permits are allocated among firms,
with the total number of permits so chosen as to achieve the desired maximum level
of emissions. By allocating fewer permits than the free pollution level, the regulatory
agency creates a shortage of permits which then leads to a positive price for permits.
This establishes a price for pollution, just as in the tax case. The high polluters have to
buy more permits, which increases their costs, and makes them less competitive and less
profitable.
Advantages:
(1) The system allows flexibility and reward efficiency
(2) It is administratively cheap and simple to implement and ensures that pollution is
minimised in the most cost-effective way
(3) It also provides strong incentives for innovation.
(4) Consumers may benefit if the extra profits made by low pollution firms are passed
on to them in the form of lower prices.
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Disadvantages:
(1) They do not in reality stop firms from polluting the environment;
(2) They only provide an incentive to them to do so.
(3) Price level increase of inelastic goods.
Question 2
Role of Government in case of Positive Externalities.
(Effect of Subsidy on output )
Answer
On the other hand subsidies involve government paying part of the cost to the firms in
order to promote the production of goods having positive externalities. This is in fact a
market-based policy as subsidies to producers would lower their cost of production. A
subsidy on a good which has substantial positive externalities would reduce its cost and
consequently price, shift the supply curve to the right and increase its output. A higher
output that would equate marginal social benefit and marginal social cost is socially
optimal. The effect of a subsidy is shown in the following figure:
Subsidy equal to the benefit of externality (S=E) is granted by government to the producer.
The output level post subsidy is Q* which equates marginal social benefit with marginal
social cost. This is socially optimum level of output.
Question 3
Explain Government intervention in case of Merit goods?
Answer
Merit goods are goods which are deemed to be socially desirable and therefore the
government deems that its consumption should be encouraged. Substantial positive
externalities are involved in the consumption of merit goods. Left to the market, only
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private benefit and private costs would be reflected in the price paid by consumers.
This means, compared to what is socially desirable, people would consume inadequate
quantities. Example of merit goods includes education, health care, welfare service,
housing, fire protection waste management, public libraries, museum and public parks.
Merit goods can be provided through the market, but are likely to be under-produced
and under-consumed through the market mechanism so that social welfare will not be
maximized.
CONSUMPTION OF MERIT GOODS AT ZERO PRICE

When merit goods are directly provided free of cost by government, there will be
substantial demand for the same. As can be seen from the following diagram, when
people are required to pay the free market price, people would consume only OQ quantity
of healthcare. If provided free at zero prices, the demand OD far exceeds supply.
Consumption of Merit Goods at Zero Price
Question 4
Explain Government intervention in case of Demerit goods.
(Determining Minimum price of demerit goods)
Answer
The consumption of demerit goods imposed significant negative externalities on the
society as a whole and therefore the private costs incurred by individual consumers are
less than the social costs experienced by the society. The production and consumption
of demerit goods are likely to be more than optimal under free markets. The price that
consumers pay for a packet of cigarettes is market determined and does not account for
the social costs that arise due to externalities. In other words, the marginal social cost
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will exceed the market price and overproduction and overconsumption will occur, causing
misallocation of society’s scarce resources. However, it should be kept in mind that all
goods with negative externalities are not essentially demerit goods e.g. Production of
steel causes pollution, but steel is not a
socially undesirable good. It is found that generally consumers overvalue demerit goods
because of imperfect information and they are not the best judges of welfare with respect
to such goods. The government should therefore intervene in the marketplace to discourage
their production and consumption. Following steps are taken by the government to curb
excess production of demerit goods:
 Government may enforce complete ban on a demerit good. e.g. Intoxicating drugs.
In such cases, the possession, trading or consumption of the good is made illegal.
 Through negative advertising campaigns which emphasize the dangers associated
with consumption of demerit goods.
 Through legislations that prohibit the advertising or promotion of demerit goods in
whatsoever manner.
 Strict regulations of the market for the good may be put in place so as to limit access
to the good, especially by vulnerable groups such as children and adolescents.
 Regulatory controls in the form of spatial restrictions e.g. smoking in public places,
sale of tobacco to be away from schools, and time restrictions under which sale at
particular times during the day is banned.
The government can also impose high taxes on producing or purchasing the good making
them very costly and unaffordable to many is perhaps the most commonly used method
for reducing the consumption of a demerit good.
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PRICE INTERVENTION: NON MARKET PRICING

MINIMUM SUPPORT PRICE (MSP) (PRICE FLOOR)
(1) Government usually intervenes in many primary markets which are subject to
extreme as well as unpredictable fluctuations in price.
(2) For example in India, in the case of many crops the government has initiated the
Minimum Support Price (MSP) programme as well as procurement by government
agencies at the set support prices
(3) The objective is to guarantee fixed and assured incomes to farmers. In case the
market price falls below the MSP, then the guaranteed MSP will prevail.
Market Outcome of Minimum Support Price
MAXIMUM PRICE (PRICE CEILING)

(1) When prices of certain essential commodities rise excessively, government may resort
to controls in the form of price ceilings (also called maximum price) for making a
resource or commodity available to all at reasonable prices.
(2) For example: maximum prices of food grains and essential items are set by
government during times of scarcity. A price ceiling which is set below the prevailing
market clearing price will generate excess demand over supply.
Market Outcome of Price Ceiling
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Question 5
Do you think government intervention in market will help enhance social welfare? Substantiate
your argument.
Answer
Yes, government intervention in market will help enhance social welfare.
Government plays a vital role in creating the basic framework within which fair and open
competitive markets can exist. It is indispensable that government establishes the ‘rule
of law’, and in this process, creates and protects property rights, ensures that contracts
are upheld and sets up necessary institution for proper functioning of markets.
Policy options for limiting market power also include price regulation in the form of
setting maximum prices that firms can charge. Price regulation is most often used for
natural monopolies that can produce the entire output of the market at a cost that is
lower than what it would be if there were several firms.
Following measures adopted by the government to achieve desired distributional effects:
 A progressive direct tax system ensures that those who have greater ability to pay
contribute more towards defraying the expenses of government and that the tax
burden is distributed fairly among the population.
 Indirect taxes can be differential: for example, the commodities which are primarily
consumed by richer income group, such as luxuries, are taxed heavily and the
commodities the expenditure on which form a larger proportion of the income of
the lower income group, such as necessities, are taxed light.
 A carefully planned policy of public expenditure helps in redistributing income
from the rich to the poorer sections of the society. This is done through spending
programmes targeted on welfare measures for the disadvantaged, such as:
 Poverty alleviation programmes
 Free or subsidized medical care, education, housing, essential commodities
etc. to improve the quality of living of poor
 Infrastructure provision on a selective basis
 Various social security schemes under which people are entitled to old-age
pensions, unemployment relief, sickness allowance etc.
 Subsidized production of product of mass consumption
 Public production and/or grant of subsidies to ensure sufficient supply of
essential goods
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UNIT – 4: FISCAL POLICY
4.1 INTRODUCTION
Fiscal policy is the deliberate policy of the government under which it uses the
instruments of taxation, public expenditure and public borrowing to influence
both the pattern of economic activity and level of aggregate demand, output and
employment. Fiscal policy is in the nature of a demand-side policy.
The significance of fiscal policy as a strategy for achieving certain socio economic
objectives was not recognized or widely acknowledged before 1930 due to the faith in
the limited role of government advocated by the then prevailing laissez-faire approach.
4.2 OBJECTIVES OF FISCAL POLICY

The most common objectives of fiscal policy are:
 Achievement and maintenance of full employment,
 maintenance of price stability,
 acceleration of the rate of economic development, and
 equitable distribution of income and wealth,
Governments may directly as well as indirectly influence the way resources are used
in an economy. Fiscal policy is a powerful tool for managing the economy because
of its ability to influence the total amount of output produced viz. gross domestic
product. The ability of fiscal policy to influence output by affecting aggregate
demand makes it a potential instrument for stabilization of the economy.
4.3 TYPES OF FISCAL POLICY

(a) Expansionary Fiscal Policy:
Expansionary fiscal policy is designed to stimulate the economy during the
contractionary phase of a business cycle or when there is an anticipation of a
business cycle contraction.
 The government may cut all types of taxes, direct and indirect, leaving
the taxpayers with extra money to spend so that there is more purchasing
power and more demand for goods and services. Consequently aggregate
demand, output and employment increase.
 An increase in government expenditure (discussed in detail below) will
pump money into the economy and increase aggregate demand. This in
turn will increase output and employment.
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 A combination of increase in government spending and decrease in

personal income taxes and/or business taxes.
(b) Contractionary fiscal policy:

Contractionary fiscal policy is designed to restrain the levels of economic activity
of the economy during an inflationary phase or when there is anticipation of a
business-cycle expansion which is likely to induce inflation.
Contractionary fiscal policy works through:

 Decrease in government spending: With decrease in government spending,
the total amount of money available in the economy is reduced which in
turn has the effect of reducing the aggregate demand.
 Increase in personal income taxes and/or business taxes: An increase
in personal income taxes reduces disposable incomes leading to fall in
consumption spending and aggregate demand. An increase in taxes on
business profits reduces the surpluses available to businesses, and as
a result, firms’ investments shrink causing aggregate demand to fall.
Increased taxes also dampen the prospects of profits of potential entrants
who will respond by holding back fresh investments.
 A combination of decrease in government spending and increase in
personal income taxes and/or business taxes.
4.4 THE INSTRUMENTS OF FISCAL POLICY
4.4.1 Government Expenditure as an Instrument of Fiscal Policy-

Government may spend money on performance of its large and ever-growing
functions and also for deliberately bringing in stabilization.
During a recession, it may initiate a fresh wave of public works, such as
construction of roads, irrigation facilities, sanitary works, ports, electrification
of new areas etc. Government expenditure involves employment of labour
as well as purchase of multitude of goods and services. These expenditures
directly generate incomes to labour and suppliers of materials and services.
Additionally, a programme of public investment will strengthen the general
confidence of businessmen and consequently their willingness to invest. Primary
employment in public works programmes will induce secondary and tertiary
employment, and before long the economy is put on an expansion track.
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Public expenditure is also used as a policy instrument to reduce the severity of

inflation and to bring down the prices.
4.4.2 Taxes as an Instrument of Fiscal Policy

Taxes form the most important source of revenue for governments. Taxation
policies are effectively used for establishing stability in an economy.
During inflation, new taxes can be levied and the rates of existing taxes are
raised to reduce disposable incomes and to wipe off the surplus purchasing
power. However, excessive taxation usually stifles new investments and
therefore the government has to be cautious about a policy of tax increase.
4.4.3 Public Debt as an Instrument of Fiscal Policy

A rational policy of public borrowing and debt repayment is a potent weapon
to fight inflation and deflation. Public debt may be internal or external; when
the government borrows from its own people in the country, it is called internal
debt. On the other hand, when the government borrows from outside sources,
the debt is called external debt. Public debt takes two forms namely, market
loans and small savings.
4.4.4 Budget as an Instrument of Fiscal Policy

Government’s budget is widely used as a policy tool to stimulate or contract
aggregate demand as required.
A government’s budget can either be balanced, surplus or deficit.

 A balanced budget results when expenditures in a year equal its tax
revenues for that year. Such a budget will have no net effect on aggregate
demand since the leakages from the system in the form of taxes collected
are equal to the injections in the form of expenditures made.
 A budget surplus that occurs when the government collects more than
what it spends, though sounds like a highly attractive one, has in fact a
negative net effect on aggregate demand since leakages exceed injections.
 A budget deficit wherein the government expenditure in a year is greater
than the tax revenue it collects has a positive net effect on aggregate
demand since total injections exceed leakages from the system.
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4.4.5 Fiscal Policy for Long-run Economic Growth:

Fiscal policy influence economic growth through its effects on the incentives
faced by individuals and firms. For example;
1. building a modern infrastructure
2. education, healthcare, nutrition, research and development etc. provide
momentum for long-run economic growth through human capital
formation
3. saving and investment.
4. A well designed tax policy that rewards innovation and entrepreneurship,
5. Tax and spending policies (e.g. subsidies)
6. Increase in environment taxes
7. Subsidies on inputs and support prices to producers (e.g. farmers) generate
higher output.
4.4.6 Fiscal Policy for Reduction in Inequalities of Income and Wealth

Government revenues and expenditure have traditionally been regarded as
important instruments for carrying out desired redistribution of income.
1. A progressive direct tax.
2. Indirect taxes can be differential.
3. poverty alleviation programmes
4. free or subsidized medical care, education, housing, essential commodities
etc. to improve the quality of living of the poor
5. infrastructure provision on a selective basis (e.g. rural roads, water supply
for tribal area)
6. various social security schemes under which people are entitled to old-
age pensions, unemployment relief, sickness allowance etc.
7. subsidized production of products of mass consumption
8. public production and/ or grant of subsidies to ensure sufficient supply of
essential goods, and
9. strengthening of human capital for enhancing employability etc.
4.4.7 Limitations of Fiscal Policy

1. lags
(a) Recognition lag
(b) Decision lag
(c) Implementation lag
(d) Impact lag
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2. Fiscal policy changes may at times be badly timed.

3. Difficulties in instantly changing governments’ spending and taxation
policies.
4. practically difficult to reduce government spending on various items such
as defence and social security
5. Public works cannot be adjusted easily.
6. Supply-side economists are of the opinion that certain fiscal measures
will cause disincentives.
7. Deficit financing increases the purchasing power people.
8. Increase is government borrowing creates perpetual burden.
4.4.8 Crowding Out

Some economists are of the opinion that government spending would sometimes
substitute private spending and when this happens the impact of government
spending on aggregate demand would be smaller than what it should be. In
such cases, fiscal policy may become ineffective.
Substantial government borrowing in the credit market tends to reduce the
amount of funds available and pushes the interest rates up. Higher interest rates
slow down business investment expenditures and consumption expenditures
that are sensitive to interest rates. An increase in the size of government
spending during recessions will ‘crowd-out’ private spending in an economy.
In other words, when spending by government in an economy replaces private
spending, the latter is said to be crowded out.
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Question 1
Define the term ‘recessionary gap’ and ‘inflationary gap’. What would be the appropriate
fiscal policy measures to eliminate recessionary gap’ and ‘inflationary gap’? Illustrate your
answer.
Answer
A recessionary gap, is said to exist if the existing level of aggregate production is less than
what would be produced with full employment of resources. It is a measure of output
that is lost when actual national income falls short of potential income, and represents
the difference between the actual aggregate demand and the aggregate demand which
is required to establish the equilibrium at full employment level of income. This gap
occurs during the contractionary phase of business-cycle and results in higher rates of
unemployment. In other words, recessionary gap occurs when the aggregate demand is
not sufficient to create condition of full employment.
The inflationary gap is a situation when the demand for goods and services exceeds
production due to factors such as higher levels of overall employment, increased trade
activities or increased trade activities or increased government expenditure. This can
lead to the real GDP exceeding the potential GDP, resulting in an inflationary gap.
The inflationary gap is so named because the relative increased in real GDP causes an
economy to increase its consumption, which causes price to rise in the long run.
Due to the higher number of funds available within the economy, consumers are more
inclined to purchase goods and services. As the demand for goods and services increases
but production has yet to compensate for the shift, prices rise in order to restore market
equilibrium.
An expansionary fiscal policy is used to address recessionary gap and the problem of
general unemployment on account of business cycles.
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Question 2
List out the factors that limits the effectiveness of fiscal policy? Explain the possible impacts on
private sector? (Limitations)
Answer
Discretionary fiscal policy is the conscious manipulation of government spending and
taxes to influence the economy. However, there are some significant limitation in respect
of choice and implementation of fiscal policy. These limitations are as follows:
1. One of the biggest problems with using discretionary fiscal policy to counteract
fluctuations is the different types of lags involved in fiscal-policy action. There are
significant lags are:
 Recognition lag: The economy is a complex phenomenon and the state of the
macroeconomic variable is usually not easily comprehensible. Just as in case
of any other policy, the government must first recognize the need for a policy
change.
 Decision lag: Once the need for intervention is recognized, the government
has to evaluate the possible alternative policies. Delays are likely to occur to
decide on the most appropriate policy.
 Implementation lag: even when appropriate policy measures are decided on,
there are possible delays in bringing in legislation and implementing them.
 Impact lag: impact lag occurs when the outcomes of a policy are not visible
for some time.
2. Fiscal policy changes may at time be badly timed due to the various lags so that
it is highly possible that an expansionary policy is initiated when the economy is
already on a path of recovery and vice versa.
3. There are difficulties in instantaneously changing government’ spending and taxation
policies.
4. It is practically difficult to reduce government spending on various items such as
defence and social security as well as on huge capital project which are already
midway.
5. Public works cannot be adjusted easily along with movements of the trade cycle
because many huge projects such as highway and dams have long gestation period.
Besides, some urgent public project cannot be postponed for reasons of expenditure
cut to correct fluctuation caused by business cycles.
6. Due to uncertainties, there are difficulties of forecasting when period of inflation
or deflation may set in and also promptly determining the accurate policy to be
undertaken.
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7. There are possible conflicts between different objectives of fiscal policy such that a
policy designed to achieve one goal may adversely affect another. For example, an
expansionary fiscal policy may worsen inflation in an economy.
8. Supply-side economists are of the opinion that certain fiscal measures will cause
disincentives. For example, increase in profits tax may adversely affect the incentives
of firms to invest and an increase in social security benefits may adversely affect
incentives to work and save.
9. Deficit financing increases the purchasing power of people. The production of goods
and services, especially in under developed countries may not catch up simultaneously
to meet the increased demand. This will result in price spiraling beyond control.
10. Increase is government borrowing creates perpetual burden on even future
generations as debts have to be repaid. If the economy lags behind in productive
utilization of borrowed money, sufficient surpluses will not be generated for
servicing debts. External debt burden has been a constant problem for India and
many developing countries.
Question 3
Explain Crowding out effect.
Answer
Crowding out effect is the negative effect fiscal policy may generate when money from
the private sector is crowded out’ to the public sector. In other words, when spending by
government in an economy replaces private spending the latter is said to be crowded
out. For example, if government provided free computers to students, the demand from
students for computers may not be forthcoming. When government increases it’s spending
by borrowing from the loanable funds from market, the demand for loans increases and
this pushes the interest rates up. Private investments are sensitive to interest rates and
therefore some private investment spending is discouraged.
Similarly, when government increases the budget deficit by selling bonds or treasury bills,
the amount of money with the private sector decreases and consequently interest rates
will be pushed. As a result, private investment, especially the ones which are interest-
sensitive, will be reduced.
Question 4
Explain Government Expenditure as an Instrument of Fiscal Policy
Public expenditures are income generating and include all types of government expenditure
such as capital expenditure on public works, relief expenditures, subsidy payments
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of various types, transfer payments and other social security benefits. Government
expenditure is an important instrument of fiscal policy. It includes governments’
expenditure towards consumption, investment, and transfer payments. Government
expenditures include:
1. current expenditures to meet the day to day running of the government,
2. capital expenditures which are in the form of investments made by the government
in capital equipments and infrastructure, and
3. transfer payments i.e. government spending which does not contribute to GDP
because income is only transferred from one group of people to another without
any direct contribution from the receivers.
Government may spend money on performance of its large and ever-growing functions
and also for deliberately bringing in stabilization. During a recession, it may initiate a fresh
wave of public works, such as construction of roads, irrigation facilities, sanitary works,
ports, electrification of new areas etc. Government expenditure involves employment
of labour as well as purchase of multitude of goods and services. These expenditures
directly generate incomes to labour and suppliers of materials and services. Apart from
the direct effect, there is also indirect effect in the form of working of multiplier. The
incomes generated are spent on purchase of consumer goods. The extent of spending by
people depends on their marginal propensity to consume (MPC)
Question 5
Explain Pump Priming and Compensatory Spending.
A distinction is made between the two concepts of public spending during depression,
namely, the concept of ‘pump priming’ and the concept of 'compensatory spending'.
Pump priming involves a one-shot injection of government expenditure into a depressed
economy with the aim of boosting business confidence and encouraging larger private
investment. It is a temporary fiscal stimulus in order to set off the multiplier process. The
argument is that with a temporary injection of purchasing power into the economy through
a rise in government spending financed by borrowing rather than taxes, it is possible
for government to bring about permanent recovery from a slump. Pump priming was
widely used by governments in the post-war era in order to maintain full employment;
however, it became discredited later when it failed to halt rising unemployment and was
held responsible for inflation. Compensatory spending is said to be resorted to when the
government spending is deliberately carried out with the obvious intention to compensate
for the deficiency in private investment.
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Question 6
Explain Public Debt as an Instrument of Fiscal Policy
A rational policy of public borrowing and debt repayment is a potent weapon to fight
inflation and deflation. Public debt may be internal or external; when the government
borrows from its own people in the country, it is called internal debt. On the other hand,
when the government borrows from outside sources, the debt is called external debt.
Public debt takes two forms namely, market loans and small savings.
In the case of market loans, the government issues treasury bills and government
securities of varying denominations and duration which are traded in debt markets. For
financing capital projects, long-term capital bonds are floated and for meeting short-
term government expenditure, treasury bills are issued.
The small savings represent public borrowings, which are not negotiable and are not
bought and sold in the market. In India, various types of schemes are introduced for
mobilising small savings e.g., National Savings Certificates, National Development
Certificates, etc. Borrowing from the public through the sale of bonds and securities
curtails the aggregate demand in the economy. Repayments of debt by governments
increase the availability of money in the economy and increase aggregate demand.
Question 7
Explain Taxes as an Instrument of Fiscal Policy
Taxes form the most important source of revenue for governments. Taxation policies
are effectively used for establishing stability in an economy. Tax as an instrument of
fiscal policy consists of changes in government revenues or in rates of taxes aimed at
encouraging or restricting private expenditures on consumption and investment. Taxes
determine the size of disposable income in the hands of the general public which in
turn determines aggregate demand and possible inflationary and deflationary gaps. The
structure of tax rates is varied in the context of the overall economic conditions prevailing
in an economy. During recession and depression, the tax policy is framed to encourage
private consumption and investment. A general reduction in income taxes leaves higher
disposable incomes with people inducing higher consumption. Low corporate taxes
increase the prospects of profits for business and promote further investment. The extent
of tax reduction and /or increase in government spending required depends on the size of
the recessionary gap and the magnitude of the multiplier.
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Question 8
Explain Budget as an Instrument of Fiscal Policy
Government’s budget is widely used as a policy tool to stimulate or contract aggregate
demand as required. The budget is simply a statement of revenues earned from taxes
and other sources and expenditures made by a nation’s government in a year. The net
effect of a budget on aggregate demand depends on the government’s budget balance.
A government’s budget can either be balanced, surplus or deficit. A balanced budget
results when expenditures in a year equal its revenues for that year. Such a budget will
have no net effect on aggregate demand since the leakages from the system in the form
of taxes collected are equal to the injections in the form of expenditures made. A budget
surplus that occurs when the government collects more than what it spends, though
sounds like a highly attractive one, has in fact a negative net effect on aggregate demand
since leakages exceed injections. A budget deficit wherein the government expenditure in
a year is greater than the tax revenue it collects has a positive net effect on aggregate
demand since total injections exceed leakages from the government sector.
TYPES OF FISCAL POLICY

Expansion fiscal policy:
1. It is adopted during economic recession or depression.
2. Under this policy, the government may lower the tax rates or increase the public
expenditure or do both. These measures are basically intended to simulate the
economy.
3. Through this policy, the government encourages investment, which in turn boosts
output and employment, which further increases aggregate demand, and thereby
economy begins to grow.
4. Expansion fiscal policy will be successful only if there is accommodative monetary
policy.
5. Working of expansionary fiscal policy can be seen the following diagram:
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Contractionary fiscal policy:

1. It is adpoted during inflation (where aggregate demand rises beyond what economy
can produce).
2. Under this policy, the government may increases the tax rates or reduce the public
expendutire or do both. These measures are basiclly intended to restrian the level
of economic activity.
3. Through this policy, th governemt discourages investement, which in turn lowers
the output and employment, which further reduces the aggregate demand, hereby,
economy begins to slow down and inflation is controlled.
4. Working of contractionary fiscal policy can be seen in the following diagram:

5. Inflationary gap refer to the situation whereby scale rise in consumption and
investment enhances aggregate demand beyond what economy can potentially
produce tends to cause extensive price hike. Contractionary fiscal policy aims to
eliminate such inflationary gap.
The Government Spending Multiplier:

Spending multiplier (also known as Keynesian or fiscal policy multiplier) represent the
multiple by which GDP increases or decreases in response to an increase and decrease
in government expenditure and investment, holding the real money supply constant.
Quantitatively, the government spending multiplier is the same as the investment
multiplier. It is the reciprocal of the marginal propensity to save (MPS). Higher the MPS,
lower the multiplier, and lower the MPS, higher the multiplier.

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Where,
MPS stand for marginal propensity to save (MPS); and
MPC is marginal propensity to consume
MPS equal 1 – MPS
Numerical Illustration
Q.1] Illustration1.
Assume that the MPC is equal to 0.6.
(a) What is the value of government spending multiplier?
(b) What impact would a 50 billion increase in government spending have on
equilibrium GDP?
(c) What about a 50 billion decrease in government spending?
Solution:
= 1/(1 – 0.6) = 1/0.4 = 2.5

(b) & (c) Change in GDP = Initial Change in Spending x (1 – MPC)
Q.2] Illustration 2.
If country X has a marginal propensity to consume of 0, what is the value of fiscal
multiplier?
Solution:
Given MPC = 0; MPS = (1-0) = 1
The spending multiplier = 1. There is no multiplier effect
Q.3] Illustration 3.
Average per capita income of country Y rose from 42,300 to 50,000 and the
corresponding figure for per capita consumption rose from 35,400 to 42,500. Find
the spending multiplier of this economy.
Solution:
Spending multiplier = 1/(1-MPC).
MPC = Increase in Consumption / Increase in Income.
= (42,500 – 35,400) / (50,000 – 42,300)
= 0.922
Multiplier = 1/(1 – 0.922) = 1/(0.078) = 12.83
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Question 9
Explain the role fiscal policy in achieving economic stability.
Answer
Fiscal policy involves the use of government spending, taxation and borrowing to influence
both the pattern of economic activity and level of growth of aggregate demand, output
and employment. It includes any design on the part of the government to change the price
level, composition or timing of government expenditure or to alter the burden, structure
or frequency of tax payment. In other words, fiscal policy is designed to influence the
pattern and level of economic activity in a country.
The economy does not always work smoothly. There often occurs fluctuation in the level
of economic activity. At time the economy finds itself in the grip of recession when levels
of national income, output and employment are far below their full potential levels.
During recession, there is lot of idle or un-utilized productive capacity, that is, available
machines and factories are not working to their full capacity. As a result, unemployment
of labour increases along with the existence of excess capital stock.
On the other hand, at time the economy is ‘overheated which means inflation (i.e. rising
price) occurs in the economy. Thus, in a free market economy there is a lot of economy
ic instability. The classical economists believed that an automatic mechanism works
to restore stability in the economy; recession would cure itself and inflation will be
automatically controlled.
Explain Non-discretionary Fiscal policy or Automatic Stabilizer

1. Non-discretionary fiscal policy or Automatic Stabilizer are that part of the structure
of the economy which have built in fiscal mechanism that operates automatically
to reduce expansions and Contractions
2. In Most of the economies changes in the level of taxation and the level of govt
spending tends to occur automatically
3. Any govt programme that automatically tends to reduce fluctuations in GDP is
called as Automatic Stabilizer
4. Automatic Stabilizer have a tendency to increase GDP when it is falling and reduce
GDP when it is rising
5. It involves built in tax and expenditure mechanism that automatically increases
aggregate demand when there is Recession and reduces aggregate demand when
there is Inflation
6. Automatic Stabilizer occurs through automatic adjustments in Public expenditure
and taxes without any govt interference.
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FISCAL POLICY FOR REDUCTION OF INEQUALITES:

1. Fiscal policy can play vital role in redistribution of income so as to ensure social
justice.
2. Fiscal policy has direct (through taxes) as well as indirect impact (through other
fiscal policy measures) on income distribution.
3. Government can use following measures to achieve the desired distribution of
income and wealth:
i. Progressive direct tax system: Higher the income, higher the taxes. Ensure that
taxes are based on ability to pay and tax burden is distributed fairly among
the population.
ii. Indirect taxes can be differential: Commodity mainly consumed by rich can be
taxed heavily (E.g. luxury goods) while those consumed by lower income
groups (E.g. necessities) can be taxed light.
iii. Public expenditure policy: This policy help in redistributing income from the rich
to the poor through spending programmes targeted on welfare measures,
such as :
a. Poverty alleviation programmes.
b. Free or subsidized medical care, education, housing etc.
c. Infrastructure provision on a selective basis.
d. Various social security (old age pension, unemployment benefits etc.)
e. Subsidized production of mass consumption goods.
f. Public production / providing subsidies for supply of essential goods.
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1. Fiscal policy refers to the

(a) use of government spending, taxation and borrowing to influence the level of
economic activity
(b) government activities related to use of government spending for supply of
essential goods
(c) use of government spending, taxation and borrowing for reducing the fiscal
deficits
(d) and (b) above
2. If real GDP is continuously declining and the rate of unemployment in the economy
is increasing, the appropriate policy should be to
(a) Increase taxes and decrease government spending
(b) Decrease both taxes and government spending
(c) Decrease taxes and increase government spending
(d) Either (a) or (c)
3. Which of the following are likely to occur when an economy is in an expansionary

phase of a business cycle?
(A) Rising unemployment rate
(B) Falling unemployment rate
(C) Rising inflation rate
(D) Deflation
(E) Falling or stagnant wage for workers
(F) Increasing tax revenue
(G) Falling tax revenue
(a) A, B and F are most likely to occur
(b) B, C and F are most likely to occur
(c) D, E and F are most likely to occur
(d) A, E and G are most likely to occur
4. During recession the fiscal policy of the government should be directed towards
(a) Increasing the taxes and reducing the aggregate demand
(b) Decreasing taxes to ensure higher disposable income
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(c) Increasing government expenditure and increasing taxes

5. According to Keynesian economics, when we have inflation an effective fiscal policy

should not include
(a) increase corporate taxes. (b) decrease aggregate demand.
(c) Increase government purchases. (d) None of the above is correct
6. Keynesian economists believe that

(a) fiscal policy can have very powerful effects in altering aggregate demand,
employment and output in an economy
(b) when the economy is operating at less than full employment levels and when
there is a need to offer stimulus to demand fiscal policy is of great use
(c) Wages are flexible and therefore business fluctuations would be automatically
adjusted
7. Which of the following may ensure a decrease in aggregate demand during inflation?
(a) decrease in all types of government spending and/ or an increase in taxes
(b) increase in government spending and/ or a decrease in taxes
(c) decrease in government spending and/ or a decrease in taxes
(d) All the above
8. A recession is characterized by
(a) Declining prices and rising employment
(b) Declining unemployment and rising prices
(c) Declining real income and rising unemployment.
(d) Rising real income and rising prices
9. Which one of the following is an example of fiscal policy?

(a) A tax cut aimed at increasing the disposable income and spending
(b) A reduction in government expenditure to contain inflation
(c) An increase in taxes and decrease in government expenditure to control inflation
(d) All the above
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10. Which of the following would illustrate a recognition lag?

(a) The time required to identify the appropriate policy
(b) The time required to identify to pass a legislation
(c) The time required to identify the need for a policy change
(d) The time required to establish the outcomes of fiscal policy
11. An expansionary fiscal policy, taking everything else constant, would in the short-
run have the effect of
(a) a relative large increase in GDP and a smaller increase in price
(b) a relative large increase in price, a relatively smaller increase in GDP
(c) both GDP and price will be increasing in the same proportion
(d) both GDP and price will be increasing in a smaller proportion
12. Which statement (s) is (are) correct about crowding out?

I. A decline in private spending may be partially or completely offset by the
expansion of demand resulting from an increase in government expenditure.
II. Crowding out effect is the negative effect fiscal policy may generate when
money from the private sector is ‘crowded out’ to the public sector.
III When spending by government in an economy increases government spending
would be crowded out.
IV. Private investments, especially the ones which are interest –sensitive, will be
reduced if interest rates rise due to increased spending by government
(a) I and III only (b) I, II, and III
(c) I, II, and IV (d) III only
13. Which of the following policies is likely to shift an economy’s aggregate demand
curve to the right?
(a) Increase in government spending
(b) Decrease in taxes
(c) A tax cut along with increase in public expenditure
(d) All the above
14. Identify the incorrect statement

(a) A progressive direct tax system ensures economic growth with stability because
it distributes the burden of taxes unequally
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(b) A carefully planned policy of public expenditure helps in redistributing income

from the rich to the poorer sections of the society.
(c) There are possible conflicts between different objectives of fiscal policy such
that a policy designed to achieve one goal may adversely affect another
(d) An increase in the size of government spending during recessions may possibly
‘crowd-out’ private spending in an economy.

I. Fiscal policy is said to be contractionary when revenue is higher than spending
i.e., the government budget is in surplus
II. Other things constant, a fiscal expansion will raise interest rates and “crowd
out” some private investment
III. During inflation new taxes can be levied and the rates of existing taxes are
raised to reduce disposable incomes
IV. Classical economists advocated contractionary fiscal policy to solve the
problem of inflation
Of the above statements
(a) I and II are correct (b) I, II and III are correct
(c) Only III is correct (d) All are correct
16. While resorting to expansionary fiscal policy

(a) the government may possibly have a budget surplus as increased expenditure
will bring more output and more tax revenue
(b) the government may run into budget deficits because tax cuts reduce government
income and the government expenditures exceed tax revenues in a given year
(c) it is important to have a balanced budget to avoid inflation and bring in stability
(d) None of the above will happen
17. Contractionary fiscal policy

(a) is resorted to when government expenditure is greater than tax revenues of
any particular year
(b) increase the aggregate demand to sustain the economy
(c) to increase the disposable income of people through tax cuts and to enable
greater demand
(d) is designed to restrain the levels of economic activity of the economy during an
inflationary phase
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18. When government spending is deliberately reduced to bring in stability

(a) the government is resorting to contractionary fiscal policy
(b) the government is resorting to expansionary fiscal policy
(c) trying to limit aggregate demand to sustainable levels
(d) (a) and c) above
19. An increase in personal income taxes

(a) reduces disposable incomes leading to fall in consumption spending and
aggregate demand
(b) is desirable during inflation or when there is excessive levels of aggregate demand
(c) is to compensate the deficiency in effective demand by boosting aggregate
spending
(d) both a) and b) are correct
20. While the government resorts to deliberate fiscal policy it may not attempt to
manipulate
(a) Government expenditures on public works
(b) The rates of personal income taxes and corporate taxes
(c) Government expenditures on goods and services purchased by government
(d) The rate of interest prevailing in the economy
21. Which of the following fiscal remedy would you advice when an economy is facing
recession
(a) the government may cut interest rates to encourage consumption and investment
(b) the government may cut taxes to increase aggregate demand
(c) the government may follow a policy of balanced the budget.
(d) None of the above will work
22. While if governments compete with the private sector to borrow money for securing
resources for expansionary fiscal policy
(a) it is likely that interest rates will go up and firms may not be willing to invest
(b) it is likely that interest rates will go up and the individuals too may be reluctant
to borrow and spend
(c) it is likely that interest rates will go up and the desired increase in aggregate
demand may not be realized
(d) All the above are possible.
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ANSWERS:
1 (a) 2 (c) 3 (b) 4 (b) 5 (c) 6 (d)
7 (a) 8 (c) 9 (d) 10 (c) 11 (a) 12 (c)
13 (d) 14 (a) 15 (b) 16 (b) 17 (d) 18 (d)
19 (d) 20 (d) 21 (b) 22 (d)
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SUMMARY
 Fiscal policy involves the deliberate use of government spending, taxation and
borrowing to influence both the pattern of economic activity and level of growth of
aggregate demand, output and employment.
 Laissez-faire approach advocated limited role of government resulting in non
recognition of the significance of fiscal policy as a strategy for achieving certain
socio economic objectives till 1930.
 Through the use budgetary instruments such as public revenue, public expenditure,
public debt and deficit financing, governments intend to favourably influence the
level of economic activity of a country.
 The objectives of fiscal policy may vary from country to country, but generally
they are: achievement and maintenance of full employment, maintenance of price
stability, acceleration of the rate of economic development and equitable distribution
of income and wealth.
 Since GDP = C + I + G + NX, governments can influence economic activity (GDP), by
controlling G directly and influencing C, I, and NX indirectly, through changes in
taxes, transfer payments and expenditure.
 The Keynesian school is of the opinion that fiscal policy can have very powerful
effects in altering aggregate demand, employment and output in an economy when
the economy is operating at less than full employment levels and when there is a
need to offer a stimulus to demand.
 The tools of fiscal policy are taxes, government expenditure, public debt and the
budget.
 Expansionary fiscal policy is designed to stimulate the economy during the
contractionary phase of a business cycle and is accomplished by increasing aggregate
expenditures and aggregate demand through an increase in all types of government
spending and / or a decrease in taxes.
 Contractionary fiscal policy is designed to restrain the levels of economic activity of
the economy during an inflationary phase by decreasing the aggregate expenditures
and aggregate demand through a decrease in all types of government spending
and/ or an increase in taxes.
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 A recession sets in with a period of declining real income, as measured by real GDP
and a situation of rising unemployment.
 A recessionary gap, also known as a contractionary gap, is said to exist if the existing
levels of aggregate production is less than what would be produced with the full
employment of resources.
 Government expenditure, an important instrument of fiscal policy, generates
incomes and also has indirect effect in the form of working of multiplier.
 Taxes determine the size of disposable income in the hands of general public which
in turn determines aggregate demand and possible inflationary and deflationary
gaps.
 During recession and depression, the tax policy is framed to encourage private
consumption and investment. A general reduction in income taxes and lower
corporate taxes increase aggregate demand and investments respectively.
 During inflation new taxes can be levied and the rates of existing taxes may be
raised to reduce disposable incomes and to wipe off the surplus purchasing power.
 Borrowing from the public through the sale of bonds and securities curtails the
money available for spending which in turn reduces the aggregate demand in the
economy. Repayment of debts increases the availability of money in the economy
and increase aggregate demand.
 Budget is widely used as a policy tool to stimulate or to contract aggregate demand
as required.
 Fiscal Policy also aims to attain long-run economic growth through policies to
stimulate aggregate supply.
 Fiscal policy is a chief instrument available for governments to influence income
distribution and plays a significant role in reducing inequality and achieving equity
and social justice.
 Contractionary fiscal policy is aimed at eliminating inflationary gaps and to trim
down the aggregate demand by decrease in government spending and an increase
in personal income taxes and/or business taxes causing less disposable incomes
and lower incentives to invest.
 Fiscal policy suffers from limitations such as limitations in respect of choice of
appropriate policy, recognition lag, decision lag, implementation lag, impact
lag, inappropriate timing, difficulties of forecasting due to uncertainties, possible
conflicts between different objectives, possibility of generating disincentives,
practical difficulty to reduce government expenditures and the possibility of certain
fiscal measures replacing private spending.
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 An increase in the size of government spending during recessions will ‘crowd-out’

private spending in an economy. In other words, when spending by government in
an economy replaces private spending, the latter is said to be crowded out.
 As a result of crowding out, the effectiveness of expansionary fiscal policy in
stimulating aggregate demand will be diminished to a great extent. This may also
possibly reduce the economy’s prospects of long-run economic growth.
 During deep recessions, crowding-out is less likely to happen as private sector
investment is already minimal and therefore there is only insignificant private
spending to crowd out.
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Speak Your Mind
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r
Chapte
MONEY MARKET
8
UNIT 1 – THE CONCEPT OF MONEY DEMAND
INTRODUCTION
Money may make the world go around, it plays an essential role in causing the things in
life to work as they should; to underlie the fulfilment of the needs of human existence.
And most people in the world probably have handled money, many of them on a daily
basis. But despite its familiarity, probably few people could tell you exactly what money
is, or how it works.
In short, money can be anything that can serve as a
(1) store of value, which means people can save it and use it later—smoothing their
purchases over time;
(2) unit of account, that is, provide a common base for prices; or
(3) medium of exchange, something that people can use to buy and sell from one
another.
FIAT MONEY
Until relatively recently, gold and silver were the main currency people used. Gold and
silver are heavy, though, and over time, instead of carrying the actual metal around and
exchanging it for goods, people found it more convenient to deposit precious metals at
banks and buy and sell using a note that claimed ownership of the gold or silver deposits.
Anyone who wanted to could go to the bank and get the precious metal that backs the
note. Eventually, the paper claim on the precious metal was delinked from the metal.
When that link was broken, fiat money was born. Fiat money is materially worthless, but
has value simply because a nation collectively agrees to ascribe a value to it. In short,
money works because people believe that it will.
DEFINE MONEY AND DESCRIBE ITS NATURE AND CHARACTERISTICS

Money is all the center of every economic transaction and plays a significant role in all
economies. In simple terms money refers to assets which are commonly used and accepted
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as a means of payment or as a medium of exchange or of transferring purchasing power.

For policy purposes, money may be defined as the set of liquid financial assets, the
variation in the stock of which will impact on aggregate economic activity.
Money has generalized purchasing power and is generally acceptable in settlement of
all transactions and in discharge of other kind of business obligations including future
payments.
Anything that would act as a medium of exchange is not necessarily money. For example,
a bill of exchange may also be a medium, but it is not money since it is not generally
accepted as a means of payment. Money is a totally liquid asset as it can be used directly,
instantly, conveniently and without any cost or restriction to make payment.
At the fundamental level, money provides us with a convenient means to access goods
and services. There are some general characteristics that money should possess in order to
make it serve its function as money. Money should be:
 Generally acceptable
 Durable or long lasting
 Effortlessly recognizable
 Difficult to counterfeit i.e. easily reproducible by people
 Relatively scarce, but has elasticity of supply
 Portable or easily transported
 Possessing uniformity, and
 Divisible into smaller parts in usable quantities or fractions without losing value.
EXPLAIN THE FUNCTION PERFORMED BY MONEY:

The following points highlight some of the important functions of money:
1. Medium of Exchange: Money is a convenient medium of exchange or it is an instrument
that facilitates easy exchange of goods and services. Money, though not having any
inherent power to directly satisfy human wants, by acting as a medium of exchange,
it commands purchasing power and its possession enables us to purchase goods
and services to satisfy our wants.
By acting as an intermediary, money increases the ease of trade and reduces the
inefficiency and transaction costs involved in a barter exchange. By decomposing
the single barter transaction of sales and purchase, money eliminates the need for
double coincidence of wants. Money also facilities separation of transaction both in
time and place and this in turn enables us to economize on time and efforts involved
in transactions.
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2. Unit of Account: Money is an explicitly defined unit of value or unit of account. Put
differently, money is a common measure of value’ or ‘common denominator of value’
or money function as a numeracies. We know, Rupee is the unit in India in which the
entire money is denominated.
The monetary unit is the unit of measurement in terms of which the value of all
goods and services is measured and expressed. The value of each good or service is
expressed as price, which is nothing but the number of monetary units for which the
good or service can be exchanged.
It is convenient to trade all commodities in exchange for a single commodity. So
also, it is convenient to measure the price of all commodities in terms of a single
unit, rather than record the relative price of every good in terms of every other good.
3. Standard of deferred payment: Money serves as a unit or standard of deferred payment

i.e. money facilitates recording of deferred promises to pay. Money is the unit in terms
which future payment are contracted or stated. However, variation in the purchasing
power of money due to inflation or deflation, reduce the efficacy of money in this
function.
4. Store Value: Like nearly all other assets, money is a store of value. People prefer
to hold it as an asset, that is, as part of their stock of wealth. This splitting of
purchases and sales in to two transaction involves a separation in the both time and
space. This separation is possible because money can be used as a store of value or
store of means of payment during the intervening time. Again, rather than spending
one’s money at present, one can store it for use at some future time.
‘THE QUANTITY THEORY OF MONEY IS NOT THEORY ABOUT MONEY AT ALL, RATHER IT IS
THEORY OF THE PRICE LEVEL’ ELUCIDATE.
The quantity theory of money, one of the oldest theories in Economics, was first propounded
by Irving Fisher of Yale University in his book ‘The Purchasing Power of Money’ published
in 1911 and later by the neoclassical economist. Both versions of the QTM demonstrate
that there is strong relationship between money and price level and the quantity of
money is the main determinant of the price level or the value of money. In other words,
changes in the general level of commodity prices or changes in the value or purchasing
power of money are determined first and foremost by changes in the quantity of money
in circulation.
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Fisher’s version, also termed as ‘equation of exchanges’ or ‘transaction approach’ is

formally stated as follows:
MV = PT
Where, M= the total amount of money in circulation (on an average) in an economy

V = transaction velocity of circulation i.e. the average number of times across all transaction
a unit of money (say Rupee) is spent in purchasing goods and services
P = average price level (P=MV/T)
T = the total number of transactions.
Later, Fisher extended the equation of exchange to include demand (bank) deposite (M’)
and their velocity (V’) in the total supply of money. Thus, the expanded form of the
equation of exchange becomes:
MV + M’V’ = PT
Where M’ = the total quantity of credit money

V’ = velocity of circulation of credit money.
The total supply of money in the community consists of the quantity of actual money (M)
and its velocity of circulation (V). Velocity of money in circulation (V) and the velocity of
credit money (V’) remain constant. T is a function of national income. Since full employment
prevails, the volume of transaction T is fixed in the short run. Briefly out, the total volume
of transaction (T) multiplied by the price level (P) represents the demand for money. The
demand for money (PT) is equal to the supply of money (MV + M’V’)’. In any given period,
the total value of transaction made is equal to PT and the value of money flow is equal
to MV+M’V’.
Thus from the above discussion it can be clearly concluded that the Quantity Theory of
Money (QTM) states that there is a direct relationship between the quantity of money in
an economy and the level of price of goods and services sold.
EXPLAIN NEO CLASSICAL THEORY OF DEMAND OF MONEY.

The Cambridge approach: In the early 1900s, Cambridge Economists Alfred Marshall, A.C.
Pigou, D.H. Robertson and John Maynard Keynes (then associated with Cambridge) put
forward a fundamentally different approach to quantity theory, known as neoclassical
theory or cash balance approach. The Cambridge version holds that money increases
utility in the following two ways:
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(a) enabling the possibility of split-up of sale and purchase to two different points of
time rather than being simultaneous, and
(b) being a hedge against uncertainty.
While the fist above represents transaction motive, just as Fisher envisaged, the second
points to money’s role as a temporary store of wealth. Since sale and purchase of
commodities by individuals do not take place simultaneously, they need a ‘temporary
adobe’ of purchasing power as a hedge against uncertainty. As such, demand for money
also involves a precautionary motive in Cambridge approach. Since money gives utility in
its store of wealth and precautionary modes, one can say that money is demanded for
itself.
The Cambridge equation is stated as:
Where
Md = is the demand for money
Y = real national income
P = averages price level of currently produced goods and services
PY = nominal income
K = proportion of nominal income (PY) that people want to hold as cash balances
The term ‘k’ in the above equation is called ‘Cambridge k’. The equation above explains
that the demand for money (M) equals k proportion of the total money income.
EXPLAIN KEYNESIAN APPROACH OF DEMAND OF MONEY OR LIQUIDITY THEORY BY KEYNES

Keynesian Approach
↓
Liquidity preference Approach
↓
J.M.Keynes (1936)
↓
General theory of employment Interest money.
[Demand for money both as a medium of exchange & store of value]
Transaction motive
People require money to carry out transaction at all types but most of them receive income
once is a month sometimes once in a week or even daily in case of daily wage earners.
There is a time gap between two successive Income receipts but not between the expenses
incurred on various transaction. Transaction motive is divided in to two parts,
(1) Income motive
(2) Business motive
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Income motive:
It refers to transaction demand for money by wages and salary earners. They receive their
Income once in a month, in few cases weekly or daily. Money is required for these people
to carry out transaction at all kind they may incur regular payment like Rent, electricity,
grossary bill & other payments. Suppose the time interval between Income receipts is a
month. People required to hold money with them to meet the daily payments. Money
held for this purpose gradually decline over the period.
Business motive:
Business firms required to hold money to meet their day to day transaction. The time
interval of a firm may be a month or two or even longer as there is always a time gap
between production and realization of its value. Meanwhile they are required to keep
money for payment of various bills such as electricity, rent, raw material, wages etc. The
amount of money held for transaction motive depends on three factors.
1. Level of income 2. Time interval 3. Price level
Precautionary motive:
It is necessary to be cautious about future which is uncertain. Uncertainity is an important
element in Keynesian precautionary motive and additional amount of money over and
above for a known -requirement is held for contingencies, sudden expenditure, illness,
accident or to grab opportunity of advantageous purchase money may also be required
at a time of temporary unemployment.
Business people hold cash with them to meet any unforeseen expenditure or to take
advantage of favourable market condition when price declines. A firm’s precautionary
demand for money is influenced by political uncertainty. When political conditions are
unstable business firms tend to be more cautious and hold larger amount of cash. The
demand for money for transaction & precautionary motive is directly related to income.
Income Elastic
Demand for money for transaction & precautionary motive
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The combined demand for transaction & precautionary motive is expressed as L1 = F(Y)
The demand for money for these motives is not influenced by rate of interest.
Interest inelastic
Demand for money for transaction & precautionary motive
Demand for money for speculative motive

 Demand for money for speculative motive is related to store of value function of
money.
 Speculative demand is also known as Asset demand for money
 People have the alternative to hold the either cash or financial asset like government
bonds & equities
 Speculative demand also relates to uncertainty
 The cash held under this motive is used to make speculative gain by dealing on
bond whose price fluctuates.
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 If bond prices are expected to rise, businessman will buy bonds on other hand is
bond price are expected to fall, businessman will sell bonds to avoid capital losses.
 However Market interest rate is expected to fall, businessman will buy bonds, if
interest rate is expected to rise they will sell bonds. This implies that bond price and
MRI are inversely related to each other
Market rate interest vs BONDS
BONDS MRI ------- FD
↓ 1000/- x 5% 10%
= 50/- 8% ( ROI rises )
7.5%
5.5%
500x10%
=50/-
 Equal amount of return (i.e.) Rs. 50 will be earned by making a financial investment
of just Rs. 500 hence a Rs.1,000 bond value has declined to Rs. 500
 Keynes assumes that at very high rate interest (low bond price) all other asset
holder will be bulls
 On other hand, at low rate of interest (high bond price) all other asset holder will
be bears
 Speculative demand for money increases as market interest rate fall and vice versa.
Demand for money held under speculative motive is as demand for idle cash balance
L2 = F(r) → Rate of interest
List out the factor that determine the demand for money in the Baumol-Tobin analysis of
transactions demand for money? How does a change in each affect the quantity of money
demanded?
Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction demand
for money, known as Inventory Theoretic Approach, in which money or ‘real cash balance’
was essentially viewed as an inventory held for transaction purposes. Inventory models
assume that there are two media for storing value:
(1) Money and
(2) An interest-bearing alternative financial asset.
There is a fixed cost of making transfers between money and the alternative assets
e.g. broker charges. While relatively liquid financial assets other than money (such
as, bank deposits) offer a positive return, the above said transaction cost of going
between money and these assets justifies holding money.
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Baumol used business inventory approach to analyze the behaviour of individual. Just
as businesses keep money to facilitate their business transactions, people also hold
cash balance which involves an opportunity cost in terms of lost interest. Therefore,
they hold an optimum combination of bonds and cash balance, i.e., an amount that
minimizes the opportunity cost.
Excess cash over and above what is required for transaction during the period under
consideration will be invested in bonds or put in an interest-bearing account. Money
holding on an average will be lower if people hold bonds or other interest yielding
assets.
The higher the income, the higher is the average level or inventory of money holdings.
The level of inventory holding also depends also upon the carrying cost, which is the
interest forgone by holding money and not bonds, net of the cost to the individual
of making a transfer between money and bonds, say for example brokerage fee.
The inventory-theoretic approach also suggests that the demand for money and
bonds depend on the cost of making a transfer between money and bonds e.g. the
brokerage fee. An increase the brokerage fee raises the marginal cost of bond market
transactions demand for money and lowers the average bond holding over the period.
To what extent does Friedman’s Restatement of the Quantity Theory explain the demand for money?
Milton Friedman (1956) extended Keynes’ speculative money demand within the
framework of assets price theory. Friedman treat the demand for money as nothing more
than the application of a more general theory of demand for capital assets.
Demand for money is affected by the same factors as demand for any other assets, namely
1. Permanent income.
2. Relative return on assets. (Which incorporate risk).
Friedman maintains that it is permanent income and not current income that determines
the demand for money. Permanent income which is Friedman’s measure of wealth is the
present expected value of all future income. To Friedman, money is a good as any other
durable consumption good and its demand is a function of a great number of factors.
Fried identifies the following four determinates of the demand for money.
The nominal demand for money:
 Is a function of total wealth, which is represented by permanent income divided by the
discount rate, defined as the average return on the five asset classes in the monetarist
theory world, namely money, bond, equity, physical capital and human capital.
 Is positively related to the price level, P. If the price level rises the demand for
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money increases and vice versa.

 Raises if the opportunity costs of money holding (i.e. returns on bonds and stock)
decline and vice versa.
 Is influenced by inflation, a positive inflation rate reduces the real value of money
balances, thereby increasing the opportunity coast of money holdings.
‘Risk-avoiding behaviour of individual provided the foundation for the liquidity preference and for a
negative relationship between the demand for money and the interest rate’ Elucidate with examples.
‘Liquidity Preference as Behaviour towards Risk’ (1958). Tobin established that the
theory of risk-avoiding behaviour of individuals provided the foundation for the liquidity
preference and for a negative relationship between the demand for money and the
interest rate. The optimal portfolio structure is determined by
1. the risk/reward characteristics of different assets
2. the taste of the individual in maximizing his utility consistent with the existing
opportunities
In his theory which analyzes the individual’s portfolio allocation between money and bond
holdings, the demand for money is considered as a store of wealth. Tobin hypothesized
that an individual would hold a portion of his wealth in the form of money in the portfolio
because the rate of return on holding money was more certain than the rate of return on
holding interest earning assets and entails no capital gains or losses. It is riskier to hold
alternative assets vis-a vis holding interest just money alone because government bonds
and equities are subject to market price volatility, while money is not.
According to Tobin, rational behaviour of a risk-averse individual induces him to hold an
optimally structured wealth portfolio which is comprised of both bond and money. The
overall expected return on the portfolio would be higher if the portfolio were all bonds,
but an investor who is ‘risk-averse’ will be willing to exercise a trade-off and sacrifice
to some extent the higher return for a reduction in risk. Tobin’s theory implies that the
amount of money held as an asset depends on the level of interest rate. An increase in the
interest rate will improve the terms on which the expected return on the portfolio can be
increased by accepting greater risk. In response to the increase in the interest, the individual
will increase the proportion of wealth held in the interest-bearing asset, say bonds, and
will decrease the holding of money. Tobin’s analysis also indicates that uncertainty about
future changes in bond prices, and hence the risk involved in buying bonds, may be a
determinant of money demand. Just as Keynes’ theory, Tobin’s theory implies that the
demand for money as store of wealth depends negatively on the interest rate.
SHORT NOTE ON LIQUIDITY TRAP: (Diagram same as speculative motive)
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Definition:
Liquidity trap is defined as set of points on liquidity preference schedule when the
percentage change in demand for money in response to % change in rate of interest is
infinite.
The inverse relationship between rate of interest and speculative demand for money
transforms in to a different form of relationship, at a very low rate of interest speculative
demand for money becomes perfectly elastic. Keynes considered 2% rate of interest as
the lowest below which market rate of interest would not decline at such low rate of
interest people prefer cash and not securities or any other assets as the risk is far greater
than interest offered. At point C the L2 curve become horizontal straight line, and that
horizontal part of L2 curve shows liquidity trap.
‘There is no unique definition of ‘money’, either as a concept in economic theory or as

measured in practice. Money can be defined for policy purposes as the set of liquid
financial assets, the variation in the stock of which could impact on aggregate economic
activity. As a statistical concept, money could include certain liquid liabilities of a
particular set of financial intermediaries or other issuers’. (Reserve Bank of India Manual
on Financial and Banking Statistics, 2007)
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1. Choose the incorrect statement

(a) Anything that would act as a medium of exchange is money
(b) Money has generalized purchasing power and is generally acceptable in
settlement of all transactions
(c) Money is a totally liquid asset and provides us with means to access goods and
services
(d) Currency which represents money does not necessarily have intrinsic value.
2. Money performs all of the three functions mentioned below, namely

(a) medium of exchange, price control, store of value
(b) unit of account, store of value , provide yields
(c) medium of exchange, unit of account, store of value
(d) medium of exchange, unit of account, income distribution
3. Demand for money is

(a) Derived demand (b) Direct demand
(c) Real income demand (d) Inverse demand
4. Higher the ______________, higher would be ________________of holding cash

and lower will be the ___________
(a) demand for money, opportunity cost, interest rate
(b) price level , opportunity cost, interest rate
(c) real income , opportunity cost, demand for money
(d) interest rate, opportunity cost, demand for money
5. The quantity theory of money holds that

(a) changes in the general level of commodity prices are caused by changes in the
quantity of money
(b) there is strong relationship between money and price level and the quantity of
money is the main determinant of the price
(c) changes in the value of money or purchasing power of money are determined
first and foremost by changes in the quantity of money in circulation
(d) All the above
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6. The Cambridge approach to quantity theory is also known as

(a) Cash balance approach (b) Fisher’s theory of money
(c) Classical approach (d) Keynesian Approach
7. Fisher’s approach and the Cambridge approach to demand for money consider
(a) money’s role in acting as a store of value and therefore, demand for money is
for storing value temporarily.
(b) money as a means of exchange and therefore demand for money is termed as
for liquidity preference
(c) money as a means of transactions and therefore, demand for money is only
transaction demand for money.
8. Real money is
(a) nominal money adjusted to the price level
(b) real national income
(c) money demanded at given rate of interest
(d) nominal GNP divided by price level
9. The precautionary money balances people want to hold

(a) as income elastic and not very sensitive to rate of interest
(b) as income inelastic and very sensitive to rate of interest
(c) are determined primarily by the level of transactions they expect to make in
the future.
(d) are determined primarily by the current level of transactions
10. Speculative demand for money

(a) is not determined by interest rates
(b) is positively related to interest rates
(c) is negatively related to interest rates
(d) is determined by general price level
11. According to Keynes, if the current interest rate is high

(a) people will demand more money because the capital gain on bonds would be
less than return on money
(b) people will expect the interest rate to rise and bond price to fall in the future.
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(c) people will expect the interest rate to fall and bond price to rise in the future.
(d) Either (a) or (b) will happen
12. The inventory-theoretic approach to the transactions demand for money

(a) explains the negative relationship between money demand and the interest rate.
(b) explains the positive relationship between money demand and the interest rate.
(c) explains the positive relationship between money demand and general price
level
(d) explains the nature of expectations of people with respect to interest rates and
bond prices
13. According to Baumol and Tobin’s approach to demand for money, the optimal
average money holding is:
(a) a positive function of income Y and the price level P
(b) a positive function of transactions costs c
(c) a negative function of the nominal interest rate i
(d) All the above
14. ___________ considered demand for money is as an application of a more general

theory of demand for capital assets
(a) Baumol (b) James Tobin
(c) J M Keynes (d) Milton Friedman
15. The nominal demand for money rises if

(a) the opportunity costs of money holdings – i.e. bonds and stock returns, rB and
rE , respectively- decline and vice versa
(b) the opportunity costs of money holdings – i.e. bonds and stock returns, rB and
rE , respectively- rises and vice versa
(c) the opportunity costs of money holdings – i.e. bonds and stock returns, rB and
rE , respectively remain constant
ANSWERS:
1 (a) 2 (c) 3 (a) 4 (d) 5 (d)
6 (a) 7 (c) 8 (a) 9 (a) 10 (c)
11 (c) 12 (a) 13 (d) 14 (d) 15 (a)
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SUMMARY
 Money refers to assets which are commonly used and accepted as a means of
payment or as a medium of exchange or for transferring purchasing power.
 Money is totally liquid, has generalized purchasing power and is generally
acceptable in settlement of all transactions and in discharge of other kinds of
business obligations including future payments.
 The functions of money are: acting as a medium of exchange to facilitate easy
exchanges of goods and services, providing a ‘common measure of value’ or
‘common denominator of value’, serving as a unit or standard of deferred payments
and facilitating storing of value both as a temporary abode of purchasing power
and as a permanent store of value.
 Money should be generally acceptable, durable, difficult to counterfeit, relatively
scarce, easily transported, divisible without losing value and effortlessly recognizable.
 The demand for money is derived demand and is a decision about how much of
one’s given stock of wealth should be held in the form of money rather than as
other assets such as bonds.
 Both versions of the theory of money, namely, the classical approach and the
neoclassical approach demonstrate that there is strong relationship between money
and price level and the quantity of money is the main determinant of the price level
or the value of money.
 Keynes’ theory of demand for money is known as the ‘liquidity preference theory’.
‘Liquidity preference’, is a term that was coined by John Maynard Keynes in his
masterpiece ‘The General Theory of Employment, Interest and Money’ (1936).
 According to Keynes, people hold money (M) in cash for three motives: the
transactions, precautionary and speculative motives.
 The transaction motive for holding cash is directly related to the level of income and
relates to ‘the need for cash for the current transactions for personal and business
exchange.’
 The amount of money demanded under the precautionary motive is to meet unforeseen
and unpredictable contingencies involving money payments and depends on the
size of the income, prevailing economic as well as political conditions and personal
characteristics of the individual such as optimism/ pessimism, farsightedness etc.
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 The speculative motive reflects people’s desire to hold cash in order to be equipped
to exploit any attractive investment opportunity requiring cash expenditure. The
speculative demand for money and interest are inversely related.
 So long as the current rate of interest is higher than the critical rate of interest (rc),
a typical wealth-holder would hold in his asset portfolio only government bonds
while if the current rate of interest is lower than the critical rate of interest, his asset
portfolio would consist wholly of cash.
 Liquidity trap is a situation where the desire to hold bonds is very low and approaches
zero, and the demand to hold money in liquid form as an alternative approaches
infinity. People expect a rise in interest rate and the consequent fall in bond prices
and the resulting capital loss. The speculative demand becomes perfectly elastic
with respect to interest rate and the speculative money demand curve becomes
parallel to the X axis.
 Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction
demand for ‘real cash balance’, known as Inventory Theoretic Approach, in which
money is essentially viewed as an inventory held for transaction purposes.
 People hold an optimum combination of bonds and cash balance, i.e., an amount
that minimizes the opportunity cost.
 The optimal average money holding is: a positive function of income Y, a positive
function of the price level P, a positive function of transactions costs c, and a negative
function of the nominal interest rate i.
 Milton Friedman (1956) extending Keynes’ speculative money demand within the
framework of asset price theory holds that demand for money is affected by the
same factors as demand for any other asset, namely, permanent income and relative
returns on assets.
 The nominal demand for money is positively related to the price level, P; rises if
bonds and stock returns, rb and re, respectively decline and vice versa; is influenced
by inflation; and is a function of total wealth
 The Demand for Money as Behaviour toward ‘aversion to risk’ propounded by Tobin
states that money is a safe asset but an investor will be willing to exercise a trade-
off and sacrifice to some extent, the higher return from bonds for a reduction in risk
 According to Tobin, rational behaviour induces individuals to hold an optimally
structured wealth portfolio which is comprised of both bonds and money and the
demand for money as a store of wealth depends negatively on the interest rate.
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UNIT 2 – CONCEPT OF MONEY SUPPLY
From April 1977, following the recommendations of the Second Working Group on Money
Supply (SWG), the RBI has been publishing data on four alternative measures of money
supply denoted by M1, M2, M3 and M4 besides the reserve money. The respective empirical
definitions of these measures are given below:
 The Monetary aggregates are:
 M1 = Currency and coins with the people + demand deposits of banks (Current
and Saving accounts) + other deposits of the RBI;
 M2 = M1 + savings deposits with post office savings banks,
 M3 = M1 + net time deposits of banks and
 M4 = M3 + total deposits with the Post Office Savings Organization (excluding
National Savings Certificates).
Following the recommendations of the Working Group on Money (1998), the RBI has
started publishing a set of four new monetary aggregates on the basis of the balance
sheet of the banking sector in conformity with the norms of progressive liquidity. The new
monetary aggregates are: (New Monetary aggregates)
NM1 = Currency with the public + Demand deposits with the banking system + ‘Other’
deposits with the RBI.
NM2 = NM1 + time liabilities portion of savings deposit + Certificate of deposit + term
deposits maturing within one year – FCNR ( B ) deposits
NM3 = NM2 + Long-term time deposits of residents + Call/Term funding from financial
institutions
Reserve Money / High Powered Money / Monetary Base

RM = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI
RM = Net RBI credit to the Government + RBI credit to the Commercial sector + RBI’s
Claims on banks + RBI’s net Foreign assets + Government’s Currency liabilities to the
public – RBI’s net non - monetary Liabilities
The central bank also measures macroeconomic liquidity by formulating various ‘liquidity’
aggregates in addition to the monetary aggregates. While the instruments issued by the
banking system are included in ‘money’, instruments, those which are close substitutes of
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money but are issued by the Non-banking financial institutions are also included in liquidity
aggregates.
L1= NM3 + All deposits with the post office savings banks (excluding National Savings
Certificates).
L2= L1 +Term deposits with term lending institutions and refinancing institutions (FIs)
+ Term borrowing by FIs + Certificates of deposit issued by FIs.
L3 = L2+ Public deposits of non-banking financial companies
Explain MONEY MULTIPLIER in detail

The money supply is defined as
M = m x MB
Where M is the money supply, m is money multiplier and MB is the monetary base or high
powered money. From the above equation we can derive the money multiplier (m) as
(Money supply )/
Money Multiplier (m)
(Monetary base)
Definition
Money multiplier is defined as a ratio that relates the changes in the money supply to a given
change in the monetary base. It denotes by how much the money supply will change for a given
change in high-powered money. The multiplier indicates what multiple of the monetary base is
transformed into money supply.
If some portion of the increase in high-powered money finds its way into currency, this
portion does not undergo multiple deposit expansion. In other words, as a rule, an
increase in the monetary base that goes into currency is not multiplied, whereas an
increase in monetary base that goes into supporting deposits is multiplied.
The money multiplier approach to money supply propounded by Milton Friedman and Anna
Schwartz, (1963) considers three factors as immediate determinants of money supply,
namely:
(a) the stock of high-powered money (H)
(b) the ratio of reserves to deposits, e = {ER/D} and
(c) the ratio of currency to deposits , c ={C/D}
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(a) The Behaviour of the Central Bank

The behaviour of the central bank which controls the issue of currency is reflected in
the supply of the nominal high-powered money. Money stock is determined by the
money multiplier and the monetary base is controlled by the monetary authority.
If the behaviour of the public and the commercial banks remains unchanged over
time, the total supply of nominal money in the economy will vary directly with the
supply of the nominal high-powered money issued by the central bank.
(b) The Behaviour of Commercial Banks

By creating credit, the commercial banks determine the total amount of nominal
demand deposits. The behaviour of the commercial banks in the economy is reflected
in the ratio of their cash reserves to deposits known as the ‘reserve ratio’. If the
required reserve ratio on demand deposits increases while all the other variables
remain the same, more reserves would be needed. This implies that banks must
contract their loans, causing a decline in deposits and hence in the money supply. If
the required reserve ratio falls, there will be greater expansions of deposits because
the same level of reserves can now support more deposits and the money supply
will increase.
In actual practice, however, the commercial banks keep only a part or fraction
of their total deposits in the form of cash reserves. However, for the commercial
banking system as a whole, the actual reserves ratio is greater than the required
reserve ratio since the banks keep with them a higher than the statutorily required
percentage of their deposits in the form of cash reserves. The additional units of
high-powered money that goes into ‘excess reserves’ of the commercial banks do
not lead to any additional loans, and therefore, these excess reserves do not lead to
creation of money.
When the costs of holding excess reserves rise, we should expect the level of excess
reserves to fall; when the benefits of holding excess reserves rise, we would expect
the level of excess reserves to rise.
If banks fear that deposit outflows are likely to increase (that is, if expected deposit
outflows increase), they will want more assurance against this possibility and will
increase the excess reserves ratio. Conversely, a decline in expected deposit outflows
will reduce the benefit of holding excess reserves and excess reserves will fall.
241
The public, by their decisions in respect of the amount of nominal currency in hand
(how much money they wish to hold as cash) is in a position to influence the amount
of the nominal demand deposits of the commercial banks. The behaviour of the
public influences bank credit through the decision on ratio of currency to the money
supply designated as the ‘currency ratio’.
In other words, you decide to keep more money in your pocket and less money in your
bank. That means you are converting some of your demand deposits into currency.
If many people like you do so, technically we say there is an increase in currency
ratio. As we know, demand deposits undergo multiple expansions while currency in
your hands does not. Hence, when bank deposits are being converted into currency,
banks can create only less credit money. The overall level of multiple expansion
declines, and therefore, money multiplier also falls. Therefore, we conclude that
money multiplier and the money supply are negatively related to the currency ratio c.
To summarise the money multiplier approach, the size of the money multiplier is
determined by the required reserve ratio (r) at the central bank, the excess reserve
ratio (e) of commercial banks and the currency ratio (c) of the public. The lower these
ratios are, the larger the money multiplier is. In other words, the money supply is
determined by high powered money (H) and the money multiplier (m) and varies
directly with changes in the monetary base, and inversely with the currency and
reserve ratios.
DESCRIBE THE DIFFERENT DETERMINATES OF MONEY SUPPLY IN A COUNTRY.

There are two alternate theories in respect of determination of money supply. According
to the first view, money supply is determined exogenously by the central bank. The
second view holds that the money supply is determined endogenously by changes in the
economic activities which affect people’s desire to hold currency relative to deposits, rate
of interest, etc.
The current practice is to explain the determinates of money supply based on ‘money
multiplier approach, which focuses on the relation between the money stock and money
supply in terms of the monetary base or high-powered money. This approach holds that
total supply of nominal money in the economy is determined by the joint behavior of the
central bank, the commercial banks and the public.
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Following three factors acts as immediate determinants of money supply, namely:

(a) the stock of high-power money (H) which represent the behaviour if the central
bank
(b) the ratio of reserves to deposits, e = {ER/D} which represent the behaviour of
Commercial banks
(c) the ratio of currency to deposits, c={C/D} which represent the behaviour of General public.
(a) The Behaviour of the Central Bank:

The behaviour of the central bank which controls the issue of currency is reflected in
the supply of the nominal high-powered money. Money stock is determined by the
money multiplier and the monetary base is controlled by the monetary authority. If
the behaviour of the public and the commercial bank remains unchanged over time,
the total supply of nominal money in the economy will vary directly with the supply
of the nominal high-powered money issued by the central bank.
(b) The Behaviour of Commercial Banks:

By creating credit, the commercial banks determine the total amount of nominal
demand deposits. The behaviour of the commercial banks in the economy is reflected
in the ration of their cash reserve to deposits known as the ‘reserve ratio’.
(c) The Behaviour of the Public:

The public, by their decision in respect of the amount of nominal currency in hand
(how much money they wish to hold as cash) is in a position to influence the amount
of the nominal demand deposits of the commercial banks. The behaviour of the
public influence bank credit through the decision on ratio of currency to the money
supply designated as the ‘currency ratio’.
When people decide to keep more money in their pocket and less money in their
bank. That means people are converting some of their demand deposits into
currency then technically we say there is increase in currency ratio. As we know,
demand deposits undergo multiple expansions while currency in people’s hands
does not. Hence, when bank deposits are being converted into currency, bank can
create only less credit money. The overall level of multiple expansion declines, and
therefore, money multiplier and the money supply are negatively related to the
currency ration c.
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Credit Multiplier (Explain)

The Credit Multiplier also referred to as the deposit multiplier or the deposit expansion
multiplier, describes the amount of additional money created by commercial bank
through the process of lending the available money it has in excess of the central bank's
reserve requirements. The deposit multiplier is, thus inextricably tied to the bank's reserve
requirement. This measure tells us how much new money will be created by the banking
system for a given increase in the high- powered money. It reflects a bank's ability to
increase the money supply.
The credit multiplier is the reciprocal of the required reserve ratio. If reserve ratio is 20%,
then credit multiplier = 1/0.20 = 5.
1
Credit Multiplier=
(Required Reserve Ratio)
The existence of the credit multiplier is the outcome of fractional reserve
banking.
The deposit multiplier and the money multiplier though closely related are not identical because:
(a) Generally banks do not lend out all of their available money but instead maintain reserves
at a level above the minimum required reserve.
(b) All borrowers do not spend every Rupee they have borrowed. They are likely to convert
some portion of it to cash.
THE SOURCES OF MONEY SUPPLY

The supply of money in the economy depends on:
(a) the decision of the central bank based on the authority conferred on it, and
(b) the supply responses of the commercial banking system of the country to the changes
in policy variables initiated by the central bank to influence the total money supply
in the economy.
Money either has intrinsic value or represents title to commodities that have intrinsic
value or title to other debt instruments. In modern economies, the currency is a
form of money that is issued exclusively by the sovereign (or a central bank as its
representative) and is legal tender. Paper currency is such a representative money,
and it is essentially a debt instrument.
It is a liability of the issuing central bank (and sovereign) and an asset of the holding
public. The central banks of all countries are empowered to issue currency and,
therefore, the central bank is the primary source of money supply in all countries.
The currency issued by the central bank is ‘fiat money’ and is backed by supporting
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reserves and its value is guaranteed by the government.

The currency issued by the central bank is, in fact, a liability of the central bank
and the government. Therefore, in principle, it must be backed by an equal value of
assets mainly consisting of gold and foreign exchange reserves. In practice, however,
most countries have adopted a ‘minimum reserve system’ wherein the central bank
is empowered to issue currency to any extent by keeping only a certain minimum
reserve of gold and foreign securities.
The second major source of money supply is the banking system of the country. The
total supply of money in the economy is also determined by the extent of credit
created by the commercial banks in the country. Banks create money supply in the
process of borrowing and lending transactions with the public. Money so created by
the commercial banks is called 'credit money’.
With the developments in the economy and the evolution of the payments system, the
form and functions of money has changed over time, and it will continue to influence
the future course of currency. The concept of money has experienced evolution from
Commodity to Metallic Currency to Paper Currency to Digital Currency. The changing
features of money are defining new financial landscape of the economy. Further,
with the advent of cutting-edge technologies, digitalization of money is the next
milestone in the monetary history.
Advancement in technology has made it possible for the development of new form
of money viz. Central Bank Digital Currencies (CBDCs).
Recent innovations in technology-based payments solutions have led central banks
around the globe to explore the potential benefits and risks of issuing a CBDC so
as to maintain the continuum with the current trend in innovations. RBI has also
been exploring the pros and cons of introduction of CBDCs for some time and is
currently engaged in working towards a phased implementation strategy, going
step by step through various stages of pilots followed by the final launch, and
simultaneously examining use cases for the issuance of its own CBDC (Digital Rupee
(e`), with minimal or no disruption to the financial system. Currently, we are at the
forefront of a watershed movement in the evolution of currency that will decisively
change the very nature of money and its functions.
Reserve Bank broadly defines CBDC as the legal tender issued by a central bank
in a digital form. It is akin to sovereign paper currency but takes a different form,
exchangeable at par with the existing currency and shall be accepted as a medium
of payment, legal tender and a safe store of value. CBDCs would appear as liability
on a central bank’s balance sheet.
245
The Crypto currencies face significant legislative uncertainties and are not legally
recognized in India as currency. Hence, these are not categorized as money. In a
massive development for crypto traders in India, the Reserve Bank of India (RBI) has
said that banks or other financial entities cannot cite RBI’s 2018 order that barred
them from dealing with virtual cryptocurrencies.
246
Question 1
Calculate Narrow Money (M1) from the following data
Currency with public ` 90000 crore
Demand Deposits with Banking System ` 200000 crore
Time Deposits with Banking System ` 220000 crore
Other Deposits with RBI ` 280000 crore
Saving Deposits of Post office saving banks ` 60000 crore
Answer
M1 = Currency with public + Demand Deposits with Banking System + Other Deposits
with the RBI
= 90000 crore + 200000 crore + 280000 crore = 570000 crore
Question 2
Compute credit multiplier if the required reserved ratio is 10% and 12.5% for every
` 1,00,000 deposited in the banking system. What will be the total credit money created
by the banking system in each case?
Answer
Credit Multiplier is the reciprocal of required reserved ratio.
1
Credit Multiplier =
Required Reserverd Ratio
1
For RRR = 0.10 i.e. 10% the credit multiplier = = 10
0.10
1
For RRR = 0.125i.e. 12.5% the credit multiplier = =8
0.125
1
Credit creation = Initial deposits *
RRR
For RRR 0.10 credit creation will be 1,00,000 × 1/0.10 = Rs. 10,00,000
For RRR 0.125 credit creation will be 1,00,000× 1/0.125= Rs. 8,00,000
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Question 3
Calculate currency with the Public from the following data (` Crore)
1.1 Notes in Circulation 2496611
1.2 Circulation of Rupee Coin 25572
1.3 Circulation of Small Coins 743
1.4 Cash on Hand with Banks 98305
Answer
Currency with the Public (1.1 + 1.2 + 1.3 – 1.4)
= (2496611+25572+743) – 98305
= 2424621
Question 4
Calculate M2 from the following data
(` Crore)
Notes in Circulation 2420964
Circulation of Rupee Coin 25572
Circulation of Small Coins 743
Post Office Saving Bank Deposits 141786
Cash on Hand with Banks 97563
Deposit Money of the Public 1776199
Demand Deposits with Banks 1737692
‘Other’ Deposits with Reserve Bank 38507
Total Post Office Deposits 14896
Time Deposits with Banks 178694
Answer
M2 = M1+ Post Office Saving Bank Deposits
where M1 = (Notes in Circulation + Circulation of Rupee Coin + Circulation of Small
Coins -Cash on Hand with Banks) + Deposit Money of the Public
= (2420964 + 25572 + 743 - 97563) + 1776199 = 4125915
M2 = M1+ Post Office Saving Bank Deposits
= 4125915 +141786 = 4267701
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Question 5
If the required reserve ratio is 10 percent, currency in circulation is ` 400 billion, demand deposits
are ` 1000 billion, and excess reserves total ` 1 billion, find the value of money multiplier.
Answer
r = 10% = 0.10
Currency = 400 billion
Deposits = 1000 billion
Excess Reserves = 1 billion
Money Supply is M = Currency + Deposits = 1400 billion
c = C/D =
400 billion/1000 billion = 0. 4 or depositors hold 40 percent of their money as currency
e = 1billion /1000 billion = 0.001 or banks hold 0.1% of their deposits as excess reserves.
Multiplier
= 1+ 0.4/ 0.1 + 0.001 + 0.4
= 1.5/ 0. 501 =2.79
Therefore, a 1 unit increase in MB leads to a 2.79 units increase in M.
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1. Reserve money is also known as

(a) central bank money (b) base money
(c) high powered money (d) all the above
2. Choose the correct statement from the following

(a) Money is deemed as something held by the public and therefore only currency
held by the public is included in money supply.
(b) Money is deemed as something held by the public and therefore inter-bank
deposits are included in money supply.
(c) Since inter-bank deposits are not held by the public, therefore inter-bank
deposits are excluded from the measure of money supply.
(d) Both (a) and (c) above.
3. Reserve Money is composed of

(a) currency in circulation + demand deposits of banks (Current and Saving
accounts) + Other deposits with the RBI.
(b) currency in circulation + Bankers’ deposits with the RBI + Other deposits with
the RBI.
(c) currency in circulation + demand deposits of banks + Other deposits with the
RBI.
(d) currency in circulation + demand and time deposits of banks + Other deposits
with the RBI.
4. M1 is the sum of
(a) currency and coins with the people + demand deposits of banks (Current and
Saving accounts) + other deposits of the RBI.
(b) currency and coins with the people + demand and time deposits of banks
(Current and Saving accounts) + other deposits of the RBI.
(c) currency in circulation + Bankers’ deposits with the RBI + Other deposits with
the RBI
250
5. Under the’ minimum reserve system’ the central bank is

(a) empowered to issue currency to any extent by keeping an equivalent reserve of
gold and foreign securities.
(b) empowered to issue currency to any extent by keeping only a certain minimum
reserve of gold and foreign securities.
(c) empowered to issue currency in proportion to the reserve money by keeping
only a minimum reserve of gold and foreign securities.
(d) empowered to issue currency to any extent by keeping a reserve of gold and
foreign securities to the extent of ` 350 crores
6. The primary source of money supply in all countries is

(a) the Reserve Bank of India (b) the Central bank of the country
(c) the Bank of England (d) the Federal Reserve
7. The supply of money in an economy depends on

(a) the decision of the central bank based on the authority conferred on it.
(b) the decision of the central bank and the supply responses of the commercial
banking system.
(c) the decision of the central bank in respect of high powered money.
(d) both (a) and (c) above.
8. Banks in the country are required to maintain deposits with the central bank
(a) to provide the necessary reserves for the functioning of the central bank
(b) to meet the demand for money by the banking system
(c) to meet the central bank prescribed reserve requirements and to meet
settlement obligations.
(d) to meet the money needs for the day to day working of the commercial banks
9. If the behaviour of the public and the commercial banks is constant, then
(a) the total supply of nominal money in the economy will vary directly with the
supply of the nominal high-powered money issued by the central bank
(b) the total supply of nominal money in the economy will vary directly with the
rate of interest and inversely with reserve money
(c) the total supply of nominal money in the economy will vary inversely with the
supply of high powered money
(d) all the above are possible
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10. Under the fractional reserve system

(a) the money supply is an increasing function of reserve money (or high powered
money) and the money multiplier.
(b) the money supply is an decreasing function of reserve money (or high powered
money) and the money multiplier.
(c) the money supply is an increasing function of reserve money (or high powered
money) and a decreasing function of money multiplier.
(d) none of the above as the determinants of money supply are different
11. The money multiplier and the money supply are

(a) positively related to the excess reserves ratio e.
(b) negatively related to the excess reserves ratio e.
(c) not related to the excess reserves ratio e.
(d) proportional to the excess reserves ratio e.
12. The currency ratio represents

(a) the behaviour of central bank in the issue of currency.
(b) the behaviour of central bank in respect cash reserve ratio.
(c) the behaviour of the public.
(d) the behaviour of commercial banks in the country.
13. The size of the money multiplier is determined by

(a) the currency ratio (c) of the public,
(b) the required reserve ratio (r) at the central bank, and
(c) the excess reserve ratio (e) of commercial banks.
(d) all the above
14. _____________tells us how much new money will be created by the banking
system for a given increase in the high-powered money.
(a) The currency ratio
(b) The excess reserve ratio (e)
(c) The credit multiplier
(d) The currency ratio (c)
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15. The money multiplier will be large

(a) for higher currency ratio (c), lower required reserve ratio (r) and lower excess
reserve ratio (e)
(b) for constant currency ratio (c), higher required reserve ratio (r) and lower excess
reserve ratio (e)
(c) for lower currency ratio (c), lower required reserve ratio (r) and lower excess
reserve ratio (e)
16. The ratio that relates the change in the money supply to a given change in the
monetary base is called the
(a) required reserve ratio. (b) money multiplier.
(c) deposit ratio. (d) discount rate.
17. For a given level of the monetary base, an increase in the required reserve ratio will
denote
(a) a decrease in the money supply.
(b) an increase in the money supply.
(c) an increase in demand deposits.
(d) Nothing precise can be said
18. For a given level of the monetary base, an increase in the currency ratio causes the
money multiplier to _____ and the money supply to _____.
(a) decrease; increase (b) increase; decrease
(c) decrease; decrease (d) increase; increase
19. If commercial banks reduce their holdings of excess reserves

(a) the monetary base increases. (b) the monetary base falls.
(c) the money supply increases. (d) the money supply falls
ANSWERS:
1 (d) 2 (c) 3 (b) 4 (a) 5 (b) 6 (b)
7 (b) 8 (c) 9 (a) 10 (a) 11 (b) 12 (c)
13 (d) 14 (c) 15 (c) 16 (b) 17 (a) 18 (c)
19 (c)
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SUMMARY
 The measures of money supply vary from country to country, from time to time and
from purpose to purpose.
 The high-powered money and the credit money broadly constitute the most common
measure of money supply, or the total money stock of a country.
 High powered money is the source of all other forms of money. The second major
source of money supply is the banking system of the country. Money created by the
commercial banks is called 'credit money’.
 Measurement of money supply is essential from a monetary policy perspective
because it enables a framework to evaluate whether the stock of money in the
economy is consistent with the standards for price stability, to understand the
nature of deviations from this standard and to study the causes of money growth.
 The stock of money always refers to the total amount of money at any particular
point of time i.e. it is the stock of money available to the ‘public’ as a means of
payments and store of value and does not include inter-bank deposits.
 The monetary aggregates are:
 M1 = Currency and coins with the people + demand deposits of banks (Current
and Saving accounts) + other deposits of the RBI;
 M2 = M1 + savings deposits with post office savings banks,
 M3 = M1 + net time deposits of banks and
 M4 = M3 + total deposits with the Post Office Savings Organization (excluding
National Savings Certificates).
 Following the recommendations of the Working Group on Money (1998), the RBI
has started publishing a set of four new monetary aggregates as: Reserve Money
= Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the
RBI, NM1 = Currency with the public + Demand deposits with the banking system +
‘Other’ deposits with the RBI, NM2 = NM1 +Short-term time deposits of residents
(including and up to contractual maturity of one year),NM3 = NM2 + Long-term
time deposits of residents + Call/Term funding from financial institutions
 The Liquidity aggregates are:
 L1 = NM3 + All deposits with the post office savings banks (excluding National
Savings Certificates).
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 L2 = L1 +Term deposits with term lending institutions and refinancing institutions

(FIs) + Term borrowing by FIs + Certificates of deposit issued by FIs.
 The Reserve money, also known as central bank money, base money or high powered
money determines the level of liquidity and price level in the economy.
 The money multiplier approach showing relation between the money stock and
money supply in terms of the monetary base or high-powered money holds that
total supply of nominal money in the economy is determined by the joint behaviour
of the central bank, the commercial banks, and the public.
 M = m X MB; Where M is the money supply, m is money multiplier and MB is the
monetary base or high powered money. It shows the relationship between the
reserve money and the total money stock.
 The money multiplier is a function of the currency ratio which depends on the
behaviour of the public, excess reserves ratio of the banks and the required reserve
ratio set by the central bank.
 The additional units of high-powered money that goes into ‘excess reserves’ of the
commercial banks do not lead to any additional loans, and therefore, these excess
reserves do not lead to the creation of deposits.
 When the required reserve ratio falls, there will be greater multiple expansions for
demand deposits.
 Excess reserves ratio e is negatively related to the market interest rate i. If interest
rate increases, the opportunity cost of holding excess reserves rises, and the desired
ratio of excess reserves to deposits falls.
 An increase in time deposit-demand deposit ratio (TD/DD) means that greater
availability of free reserves for banks and consequent enlargement of volume of
multiple deposit expansion and monetary expansion.
 When the Reserve Bank lends to the governments under WMA /OD it results in the
generation of excess reserves (i.e., excess balances of commercial banks with the
Reserve Bank).
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UNIT 3 - MONETARY POLICY
OPERATING PROCEDURES AND INSTRUMENTS

Quantitative tools –
The tools applied by the policy that impact money supply in the entire economy, including
sectors such as manufacturing, agriculture, automobile, housing, etc.
Reserve Ratio
Banks are required to keep aside a set percentage of cash reserves or RBI approved
assets.
Reserve ratio is of two types:

Cash Reserve Ratio (CRR) – Banks are required to set aside this portion in cash with the
RBI. The bank can neither lend it to anyone nor can it earn any interest rate or profit on
CRR.
Statutory Liquidity Ratio (SLR) – Banks are required to set aside this portion in liquid assets
such as gold or RBI approved securities such as government securities. Banks are allowed
to earn interest on these securities, however it is very low.
Open Market Operations (OMO)

In order to control money supply, the RBI buys and sells government securities in the
open market. These operations conducted by the Central Bank in the open market are
referred to as Open Market Operations.
When the RBI sells government securities, the liquidity is sucked from the market, and the
exact opposite happens when RBI buys securities. The latter is done to control inflation.
The objective of OMOs are to keep a check on temporary liquidity mismatches in the
market, owing to foreign capital flow.
Qualitative tools
Unlike quantitative tools which have a direct effect on the entire economy’s money supply,
qualitative tools are selective tools that have an effect in the money supply of a specific
sector of the economy.
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Margin requirements – The RBI prescribes a certain margin against collateral, which in turn
impacts the borrowing habit of customers. When the margin requirements are raised by
the RBI, customers will be able to borrow less.
Moral suasion – By way of persuasion, the RBI convinces banks to keep money in government
securities, rather than certain sectors.
Selective credit control – Controlling credit by not lending to selective industries or

speculative businesses.
MARKET STABILISATION SCHEME (MSS) -

Policy Rates
Bank rate – The interest rate at which RBI lends long term funds to banks is referred to
as the bank rate. However, presently RBI does not entirely control money supply via the
bank rate. It uses Liquidity Adjustment Facility (LAF) – repo rate as one of the significant
tools to establish control over money supply.
Bank rate is used to prescribe penalty to the bank if it does not maintain the prescribed
SLR or CRR.
Liquidity Adjustment Facility (LAF) – RBI uses LAF as an instrument to adjust liquidity and
money supply. The following types of LAF are:
Repo rate: Repo rate is the rate at which banks borrow from RBI on a short-term
basis against a repurchase agreement. Under this policy, banks are required to provide
government securities as collateral and later buy them back after a pre-defined time.
Reverse Repo rate: It is the reverse of repo rate, i.e., this is the rate RBI pays to banks in
order to keep additional funds in RBI. It is linked to repo rate in the following way:
Reverse Repo Rate = Repo Rate – 1
Marginal Standing Facility (MSF) Rate: MSF Rate is the penal rate at which the Central Bank
lends money to banks, over the rate available under the rep policy. Banks availing MSF
Rate can use a maximum of 1% of SLR securities.
MSF Rate = Repo Rate + 1MSF Rate = Repo Rate + 1
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Question 1
Explain the objective of monetary policy in an economy. Assess the instruments and targets of
monetary policy of the Reserve Bank of India.
Answer
Monetary policy encompasses all actions of the central bank which are aimed at directly
controlling the money supply and indirectly at regulating the demand for money. Monetary
policy is in the nature of ‘demand-side’ macroeconomic policy and works by stimulating
or discouraging investment and consumption spending on goods and services.
Following are some of the important objective of the Monetary Policy:

The most commonly pursued objectives of monetary policy of the central banks across
the world are maintenance of price stability (or controlling inflation) and achievement of
high level of economy’s growth and maintenance of full employment.
 To regulate the issue of bank notes and the keeping of reserves with a view to
securing monetary stability in India and generally to operate the currency and credit
system of the country to its advantage.
 To promote rapid economic growth, and price stability (inflation /deflation)
 To maintain a robust debt management,
 To sustain a moderate structure of interest rates to encourage investments,
 To maintain exchange rate stability and external balance of payment equilibrium
 To ensure an adequate flow of credit to the productive sectors
 To create an efficient market for government securities.
Question 2
Explain Operating Procedures & Instruments / target of monetary policy of the Reserve Bank of India:
Answer
The operating framework relates to all aspects of implementation of monetary policy. It
primarily involves three major aspects, namely,
1. Choosing the operating target,
2. Choosing the intermediate target, and
3. Choosing the policy instruments.
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The operating target refers to the variable (for e.g. inflation) that monetary policy can
influence with its actions. The intermediate target (e.g. economic stability) is a variable
which the central bank can hope to influence to a reasonable degree through the operating
target and which displays a predictable and stable relationship with the goal variables.
The monetary policy instruments are the various tools that a central bank can use to
influence money market and credit conditions and pursue its monetary policy objectives.
The day-to-day implementation of monetary policy by central bank can act directly,
using its regulatory power, or indirectly, using its influence on money market conditions
as the issuer of reserve money (currency in circulation and deposit balances with the
central bank).
In general, the direct instrument comprise of:

(a) The required cash reserve ratio and liquidity reserve ratios prescribed from time to
time.
(b) directed credit which takes the form of prescribed targets for allocation of credit to
preferred sectors (for e.g. Credit to priority sectors), and
(c) Administered interest rates wherein the deposit and lending rates are prescribed by
the central bank.
The indirect instruments mainly consist of:

(a) Repos
(b) Open market operations
(c) Standing facilities, and
(d) Market-based discount window
The inflation target is to be set by the Government of India, in consultation with the
Reserve Bank, once in every five years. Accordingly,
 The Central Government has notified 4 per cent Consumer Price Index (CPI) inflation
as the target for the period from August 5, 2016 to March 31, 2021 with the upper
tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.
 The RBI is mandated to publish a Monetary Policy Report every six months, explaining
the sources of inflation and the forecasts of inflation for the coming period of six to
eighteen months.
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Operating Procedures & Instruments

↓
Quantitative
Measures
Operating Intermediate
Target Target
↓ ↓
Inflation Economic
stability
As per 2021 (June):
Bank rate : 4.25%
CRR : 4%
SLR : 18%
REPO : 4%
Reverse repo : 3.35%
MSF : 4.25%
Instruments:
CRR:
CRR refers to fraction of Total NDTL (Net demand and time liability) of commercial bank
which it should maintain as cash deposits with RBI. CRR is mandatory Reserve for all
commercial bank. Bank have to pay monetary penalty to they don’t maintain CRR. CRR
is applicable only to commercial bank & not applicable to NBFC. RBI may not give any
interest on CRR. Currently CRR is 4%.
Statutory Liquidity Ratio:

SLR is a percentage of NDTL that every commercial bank has to keep with itself either
in cash, gold or government dated securities. Currently SLR is 18%. As per 2021 during
inflation, SLR increases, and during deflation SLR decreases.It is Mandatory to maintain
SLR with RBI, Failure to maintain will attract Monetary penalty , Not applicable to NBFC
Liquidity Adjustment Facilities:

LAF started in year 2000. ( RBI is Bankers Bank), LAF is a window available with central
bank known as discount window which provides financial accommodation to commercial
banks, it helps at the time of Liquidity shortage and control short term Interest rate,
through Repo and. Reverse repo auction
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1. Repo Auction: It is a rate at which commercial bank borrows money from central
bank by keeping some security mortgage which could be repurchased @ later stage.
At present rate is 4%
2. Reverse Repo: It is a percentage that central bank borrows from commercial bank by
keeping security as mortgage currently it is 3.35%
Marginal Standing Facility:

MSF started in the year 2011. MSF refers to the facility under which schedule commercial
bank can borrow additional amount up to 1% of NDTL for overnight purpose (24 hrs). MSF
will be activated when commercial banks have exhausted all borrowings option currently
it is 4.25%, minimum amount 1Cr & in multiples of that.
Market stabilization scheme:

MSS started in the year 2004 it is a program started by RBI & government, to absorb
additional liquidity from the market due to huge foreign inflow of fund and the process
is called as sterilization. later under this scheme Govt borrows money from RBI which
helps to absorb additional liquidity from the system, which controls inflation and brings
Exchange rate Stability
Bank rate:
Bank rate is also known as rediscount rate. It is rate at which central bank rediscount the
bill of commercial bank. Currently bank rate acts as a penalty interest rate. Currently it is
4.25%, it has been dis continued due to introduction of LAF.
Open market operation:

It is a general term used for market operation. It is an deliberate attempt for buying &
selling government bonds in the open market. It will lead to either absorption or injection
of liquidity. During inflation Selling of bonds will take place and during period of low
growth Purchase of bonds will take place .
Question 3
A central bank is a ‘bankers’ bank.’ Elucidate the statement with illustrations.
Answer
A central bank is a ‘bankers’ bank.’ It provides liquidity to bank when the latter face
shortage of liquidity. This facility is provided by the central bank through its discount
window. The scheduled commercial banks can borrow from the discount window against
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the collateral of securities like commercial bills, government securities, treasury bills, or
other eligible papers.
This type of support earlier look the form of refinance of loans given by commercial bank
to various sectors (e.g. Export, agriculture etc.). By varying the terms and conditions of
encourage/discourage lending to particular sectors. In line with the financial sector reforms,
the system of sector-specific refinance schemes (expect export credit refinance scheme)
was withdrawn. From June 2000, the RBI has introduced Liquidity Adjustment Facility (LAF).
The Liquidity Adjustment Facility (LAF) is a facility extended by the Reserve Bank of
India to the scheduled commercial banks (excluding RRBs) and primary dealers to avail
of liquidity in case of requirement (or park excess funds with the RBI in case of excess
liquidity) on an overnight basis against the collateral of government securities including
state government securities.
Currently, the RBI provides financial accommodation to the commercial banks through
repo/reverse repos under the Liquidity Adjustment facility (LAF).
The Reserve Bank of India, being a bankers’ bank, also acts as a lender of last resort.
The Marginal standing Facility (MSF) announced by the Reserve Bank of India (RBI) in its
Monetary Policy, 2011-12 refers to the facility under which scheduled commercial banks
can borrow additional amount of overnight money from the Liquidity Ratio (SLR) portfolio
up to a limit (a fixed per cent of their net demand and time liabilities deposits (NDTL)
liable to change every year) at a penal rate of interest.
Question 4
Explain Bank lending Channel and balance sheet channel
Answer
Two distinct credit channels- the Bank lending channel and the balance sheet channel-
also allow the effects of monetary policy actions to spread through the real economy.
Credit channel operates by altering access of firms and households to bank credit. Most
business and people mostly depend on bank for borrowing money.“An open market
operation” that leads first to a contraction in the supply of bank reserves and then to a
contraction in bank credit requires banks to cut back on their lending. This, in turn makes
the firms that are especially dependent on banks loans to cut back on their investment
spending. Thus, there is decline in the aggregate output and employment following a
monetary contraction.
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Balance sheet channel

Now we shall look into how the balance sheet channel works. Logically, as a firm’s cost
of credit rises, the strength of its balance sheet deteriorates. A direct effect of monetary
policy on the firm’s balance sheet comes through an increase in interest rates leading
to an increase in the payments that the firm must make to repay its floating rate debts.
An indirect effect occurs when the same increase in interest rates works to reduce the
capitalized value of the firm’s long-lived assets. Hence, a policy-induced increase in
the short-term interest rate not only acts immediately to depress spending through the
traditional interest rate channel, it also acts, possibly with a time-lag, to raise each
firm’s cost of capital through the balance sheet channel. These together aggravate the
decline in output and employment.
A policy-induced increase in the short-term nominal interest rates makes debt instruments
more attractive than equities in the eyes of investors leading to a fall in equity prices. If
stock prices fall after a monetary tightening, it leads to reduction in household financial
wealth, leading to fall in consumption, output, and employment.
Question 5
Explain policy rate
Answer
In India, the fixed repo rate quoted for sovereign securities in the overnight segment of
Liquidity Adjustment Facility (LAF) is considered as the policy rate. (It may be noted that
India has many other repo rates in operation). The RBI uses the single independent ‘policy
rate’ which is the repo rate (in the LAF window) for balancing liquidity. The policy rate is in
fact, the key lending rate of the central bank in a country. A change in the policy rate gets
transmitted through the money market to the entire the financial system and alters all
other short term interest rates in the economy, thereby influencing aggregate demand – a
key determinant of the level of inflation and economic growth. If the RBI wants to make it
more expensive for banks to borrow money, it increases the repo rate. Similarly, if it wants
to make it cheaper for banks to borrow money, it reduces the repo rate.
Short note on Monetary Policy Committee (MPC)

An important landmark in India’s monetary history is the constitution of an empowered
six-member Monetary Policy Committee (MPC) in September, 2016 consisting of the RBI
Governor (Chairperson), the RBI Deputy Governor in charge of monetary policy, one official
nominated by the RBI Board and the remaining three central government nominees
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representing the Government of India who are persons of ability, integrity and standing,
having knowledge and experience in the field of Economics or banking or finance or
monetary policy.
The MPC shall determine the policy rate required to achieve the inflation target. Accordingly,
fixing of the benchmark policy interest rate (repo rate) is made through debate and
majority vote by this panel of experts. With the introduction of the Monetary Policy
Committee, the RBI will follow a system which is more consultative and participative
similar to the one followed by many of the central banks in the world. The new system
is intended to incorporate:
 diversity of views,
 specialized experience,
 independence of opinion ,
 representativeness , and
 accountability.
The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating
the monetary policy. The views of key stakeholders in the economy and analytical work
of the Reserve Bank contribute to the process for arriving at the decision on the policy
repo rate.
The Financial Markets Operations Department (FMOD) operationalises the monetary
policy, mainly through day-to-day liquidity management operations. The Financial
Markets Committee (FMC) meets daily to review the liquidity conditions so as to ensure
that the operating target of monetary policy is kept close to the policy repo rate.
Question 6
Explain Monetary Policy Frame work agreement or Inflation targeting by RBI.
Answer
The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016, for giving
a statutory backing to the Monetary Policy Framework Agreement and for setting up
a Monetary Policy Committee (MPC). The Monetary Policy Framework Agreement is an
agreement reached between the Government of India and the Reserve Bank of India
(RBI) on the maximum tolerable inflation rate that the RBI should target to achieve price
stability. The amended RBI Act (2016) provides for a statutory basis for the implementation
of the ‘flexible inflation targeting framework’.
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Announcement of an official target range for inflation is known as inflation targeting.

The Expert Committee under Urijit Patel to revise the monetary policy framework, in its
report in January, 2014 suggested that RBI abandon the ‘multiple indicator’ approach
and make inflation targeting the primary objective of its monetary policy. The inflation
target is to be set by the Government of India, in consultation with the Reserve Bank,
once in every five years. Accordingly,
 The Central Government has notified 4 per cent Consumer Price Index (CPI) inflation
as the target for the period from August 5, 2016 to March 31, 2021 with the upper
tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.
 The RBI is mandated to publish a Monetary Policy Report every six months, explaining
the sources of inflation and the forecasts of inflation for the coming period of six to
eighteen months.
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1. Which of the following is the function of monetary policy?

(a) regulate the exchange rate and keep it stable
(b) regulate the movement of credit to the corporate sector
(c) regulate the level of production and prices
(d) regulate the availability, cost and use of money and credit
2. The main objective of monetary policy in India is _______:

(a) reduce food shortages to achieve stability
(b) economic growth with price stability
(c) overall monetary stability in the banking system
(d) reduction of poverty and unemployment
3. The monetary transmission mechanism refers to

(a) how money gets circulated in different sectors of the economy post monetary
policy
(b) the ratio of nominal interest and real interest rates consequent on a monetary
policy
(c) the process or channels through which the evolution of monetary aggregates
affects the level of product and prices
4. A contractionary monetary policy-induced increase in interest rates

(a) increases the cost of capital and the real cost of borrowing for firms
(b) increases the cost of capital and the real cost of borrowing for firms and
households
(c) decreases the cost of capital and the real cost of borrowing for firms
(d) has no interest rate effect on firms and households
5. During deflation
(a) the RBI reduces the CRR in order to enable the banks to expand credit and
increase the supply of money available in the economy
(b) the RBI increases the CRR in order to enable the banks to expand credit and
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(c) the RBI reduces the CRR in order to enable the banks to contract credit and
(d) the RBI reduces the CRR but increase SLR in order to enable the banks to
contract credit and increase the supply of money available in the economy
6. Which of the following statements is correct?

(a) The governor of the RBI in consultation with the Ministry of Finance decides the
policy rate and implements the same
(b) While CRR has to be maintained by banks as cash with the RBI, the SLR requires
holding of approved assets by the bank itself
(c) When repo rates increase, it means that banks can now borrow money through
open market operations (OMO)
7. RBI provides financial accommodation to the commercial banks through repos/

reverse repos under
(a) Market Stabilisation Scheme (MSS)
(b) The Marginal Standing Facility (MSF)
(c) Liquidity Adjustment Facility (LAF).
(d) Statutory Liquidity Ratio (SLR)
8. ______________is a money market instrument, which enables collateralised short

term borrowing and lending through sale/purchase operations in debt instruments.
(a) OMO (b) CRR
(c) SLR (d) Repo
9. In India, the term ‘Policy rate’ refers to

(a) The bank rate prescribed by the RBI in its half yearly monetary policy statement
(b) The CRR and SLR prescribed by RBI in its monetary policy statement
(c) the fixed repo rate quoted for sovereign securities in the overnight segment of
Liquidity Adjustment Facility (LAF)
(d) the fixed repo rate quoted for sovereign securities in the overnight segment of
Marginal Standing Facility (MSF)
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10. Reverse repo operation takes place when

(a) RBI borrows money from banks by giving them securities
(b) banks borrow money from RBI by giving them securities
(c) banks borrow money in the overnight segment of the money market
(d) RBI borrows money from the central government
11. The Monetary Policy Framework Agreement is on

(a) the maximum repo rate that RBI can charge from government
(b) the maximum tolerable inflation rate that RBI should target to achieve price
stability.
(c) the maximum repo rate that RBI can charge from the commercial banks
(d) the maximum reverse repo rate that RBI can charge from the commercial banks
12. An open market operation is an instrument of monetary policy which involves buying
or selling of ________from or to the public and banks
(a) bonds and bills of exchange (b) debentures and shares
(c) government securities (d) none of these
13. Which statement (s) is (are) true about Monetary Policy Committee?
I. The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016, for
giving a statutory backing to the Monetary Policy Framework Agreement and
for setting up a Monetary Policy Committee
II. The Monetary Policy Committee shall determine the policy rate through debate
and majority vote by a panel of experts required to achieve the inflation target.
III. The Monetary Policy Committee shall determine the policy rate through
consensus from the governor of RBI
IV. The Monetary Policy Committee shall determine the policy rate through debate
and majority vote by a panel of bankers chosen for eth purpose
(a) I only (b) I and II only
(c) III and IV (d) III only
ANSWERS:
1 (d) 2 (b) 3 (c) 4 (b) 5 (a) 6 (b)
7 (c) 8 (d) 9 (c) 10 (a) 11 (b) 12 (c)
13 (b)
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SUMMARY
 Monetary policy refers to the use of monetary policy instruments which are at the
disposal of the central bank to regulate the availability, cost and use of money and
credit so as to promote economic growth, price stability, optimum levels of output
and employment, balance of payments equilibrium, stable currency or any other
goal of government's economic policy.
 The monetary policy framework which has three basic components, viz. the objectives
of monetary policy, the analytics of monetary policy which focus on the transmission
mechanism, and the operating procedure which focuses on the operating targets
and instruments.
 Though multiple objectives are pursued, the most commonly pursued objectives of
monetary policy of the central banks across the world has become maintenance of
price stability (or controlling inflation) and achievement of economic growth.
 The process or channels through which the evolution of monetary aggregates
affects the level of production and price level is known as ‘monetary transmission
mechanism’ i.e how they impact real variables such as aggregate output and
employment.
 There are mainly four different mechanisms, namely, the interest rate channel, the
exchange rate channel, the quantum channel, and the asset price channel.
 A contractionary monetary policy-induced increase in interest rates increases the
cost of capital and the real cost of borrowing for firms and households who respond
by cut back on their investment and consumption respectively.
 The exchange rate channel works through expenditure switching between domestic
and foreign goods on account of appreciation / depreciation of the domestic
currency with its impact on net exports and consequently on domestic output and
employment.
 Two distinct credit channels- the bank lending channel and the balance sheet
channeloperate by altering access of firm and household to bank credit and by the
effect of monetary policy on the firm’s balance sheet respectively.
 Asset prices generate important wealth effects that impact, through spending,
output and employment.
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 The operating framework of monetary policy relates to all aspects of implementation

namely, choosing the operating target, choosing the intermediate target, and
choosing the policy instruments.
 The day-to-day implementation of monetary policy by central banks through
various instruments is referred to as ‘operating procedures’.
 Monetary policy instruments are the various tools that a central bank can use
to influence money market and credit conditions and pursue its monetary policy
objectives. There are direct instruments and indirect instruments.
 The Cash Reserve Ratio (CRR) refers to the fraction of the total net demand and time
liabilities (NDTL) of a scheduled commercial bank in India which it should maintain
as cash deposit with the Reserve Bank irrespective of its size or financial position.
 The Statutory Liquidity Ratio (SLR) is what the scheduled commercial banks in India
are required to maintain as a stipulated percentage of their total Demand and Time
Liabilities (DTL) / Net DTL (NDTL) in Cash, Gold or approved investments in securities.
 On the basis of the recommendations of Narsimham Committee on banking sector
reforms the RBI introduced Liquidity Adjustment Facility (LAF) under which RBI
provides financial accommodation to the commercial banks through repos/reverse
repos.
 Repurchase Options or in short Repo, is defined as ‘an instrument for borrowing
funds by selling securities with an agreement to repurchase the securities on a
mutually agreed future date at an agreed price which includes interest for the funds
borrowed’.
 In India, the fixed repo rate quoted for sovereign securities in the overnight segment
of Liquidity Adjustment Facility (LAF) is considered as the ‘policy rate’ .
 Repo or repurchase option is a collaterised lending because banks borrow money
from Reserve bank of India to fulfil their short term monetary requirements by
selling securities to RBI with an explicit agreement to repurchase the same at
predetermined date and at a fixed rate. The rate charged by RBI for this transaction
is called the ‘repo rate’.
 Reverse Repo is defined as an instrument for lending funds by purchasing securities
with an agreement to resell the securities on a mutually agreed future date at an
agreed price which includes interest for the funds lent.
 The Marginal Standing Facility (MSF) refers to the facility under which scheduled
commercial banks can borrow additional amount of overnight money from the
central bank over and above what is available to them through the LAF window by
dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit.
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 Under the Market Stabilisation Scheme (MSS) the Government of India borrows from
the RBI (such borrowing being additional to its normal borrowing requirements) and
issues treasury-bills/dated securities.
 Bank Rate refers to “the standard rate at which the Reserve Bank is prepared to buy
or re-discount bills of exchange or other commercial paper eligible for purchase
under the Act.
 OMOs is a general term used for market operations conducted by the Reserve Bank
of India by way of sale/ purchase of Government securities to/ from the market with
an objective to adjust the rupee liquidity conditions in the market on a regular basis.
 The Monetary Policy Committee (MPC) consisting of six members shall determine
the policy rate to achieve the inflation target through debate and majority vote by
a panel of experts.
 The Monetary Policy Framework Agreement is an agreement reached between the
Government of India and the Reserve Bank of India (RBI) to keep the Consumer Price
Index CPI) inflation rate between 2 to 6 per cent.
 Choice of a monetary policy action is rather complex in view of the surrounding
uncertainties and the need for exercising trade-offs between growth and inflation
concerns. Additional complexities arise in the case of an emerging market like India
where inflation is influenced by factors such as international petroleum prices and
food prices.
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Speak Your Mind
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r
Chapte
INTERNATIONAL
9 TRADE
UNIT 1: THEORIES OF INTERNATIONAL TRADE
1. INTRODUCTION
International trade is the exchange of goods and services as well as resources
between countries. It involves transactions between residents of different countries.
If there is a point on which most economists agree, it is that trade among nations
makes the world better off.
International trade reduces production cost and improves living standards of people.
The foreign producer also benefits by making more sales than it could selling solely
in its own market and by earning foreign exchange (currency) that can be used by
itself or others in the country to purchase foreign-made products. International
trade is an integral part of international relations and has become an important
engine of growth in developed as well as developing countries.
Benefits of International Trade

(i) International trade is a powerful stimulus to economic efficiency and contributes
to economic growth and rising incomes. The wider market made possible owing
to trade induces companies to reap the quantitative and qualitative benefits of
division of labour.
(ii) Efficient deployment of productive resources to their best use is a direct economic
advantage of foreign trade. Greater efficiency in the use of natural, human,
industrial and financial resources ensures productivity gains. Since international
trade also tends to decrease the likelihood of domestic monopolies, it is always
beneficial to the community.
(iii) Trade provides access to new markets and new materials and enables sourcing
of inputs and components internationally at competitive prices. This reflects in
innovative products at lower prices and wider choice in products and services
for consumers. It also enables nations to acquire foreign exchange reserves
necessary for imports which are crucial for sustaining their economies.
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(iv) International Trade necessitates increased use of automation, supports

technological change, stimulates innovations, and facilitates greater investment
in research and development and productivity improvement in the economy.
(v) Trade also provides greater stimulus to innovative services in banking, insurance,
logistics, consultancy services etc.
(vi) For emerging economies, improvement in the quality of output of goods and
services, superior products, finer labour and environmental standards etc.
enhance the value of their products and enable them to move up the global
value chain.
(vii) Opening up of new markets results in broadening the productive base and
facilitates export diversification so that new production possibilities are opened
up.
(viii) Trade can also contribute to human resource development, by facilitating
fundamental and applied research and exchange of know-how and best
practices between trade partners.
(ix) Trade strengthens bonds between nations by bringing citizens of different
countries together in mutually beneficial exchanges and, thus, promotes
harmony and cooperation among nations.
Despite being a dynamic force, which has an enormous potential to generate
overall economic gains, liberal global trade and investments are often criticised
as detrimental to national interests. The major arguments put forth against
trade openness are:
(i) International trade is often not equally beneficial to all nations. Potential unequal
market access and disregard for the principles of a fair trading system may even
amplify the differences between trading countries, especially if they differ in their
wealth.
(ii) Economic exploitation is a likely outcome when underprivileged countries
become vulnerable to the growing political power of corporations operating
globally. The domestic entities can be easily outperformed by financially
stronger transnational companies.
(iii) Substantial environmental damage and exhaustion of natural resources in a
shorter span of time could have serious negative consequences on the society
at large.
(iv) Trade cycles and the associated economic crises occurring in different countries
are also likely to get transmitted rapidly to other countries.
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(v) Risky dependence of underdeveloped countries on foreign nations impairs

economic autonomy and endangers their political sovereignty. Such reliance
often leads to widespread exploitation and loss of cultural identity. Substantial
dependence may also have severe adverse consequences in times of wars and
other political disturbances.
(vi) Too much export orientation may distort actual investments away from the
genuine investment needs of a country.
(vii) Finally, there is often a lack of transparency and predictability in respect of
many aspects related to trade policies of trading partners. There are also many
risks in trade which are associated with changes in governments’ policies of
participating countries, such as imposition of an import ban, high import tariffs
or trade embargoes.
2. IMPORTANT THEORIES OF INTERNATIONAL TRADE

You might have noticed that many goods and services are imported by us because
they are simply not produced in our country for various reasons and therefore not
available domestically. However, we do import many things which can be produced
or are being produced within our country. Why do we do so? Is it beneficial to engage
in international trade? The theories of international trade which we discuss in the
following sections provide answers to these and other related questions.
 The Mercantilists’ View of International Trade

Mercantilism, which is derived from the word mercantile, “trade and commercial
affairs”.
Mercantilism according to Microsoft Encarta Dictionary (2009), is the economic
policy trending in Europe from the 16th to the 18th centuries, where the
government used power to control industry and trade with the theoretical
belief that national power is achieved and sustained by having constant large
quantities of exports over imports. Nations’ human and material resources
are unevenly endowed, distributed and developed. This allows flow of labour,
raw materials, capital and finished products across national boundaries and
markets; thus resulting in “mercantilism” as the earliest international economic
system that proposes massive and aggressive export over import to accumulate
wealth, to have favourable balance of payment and trade and to be still
relevant in today’s economy.
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 The Theory of Absolute Advantage

Adam Smith, the father of economics, thought that the basis of international
trade was absolute cost advantage. According to his theory, trade between
two countries would be mutually beneficial if one country could produce one
commodity at absolute advantage (over the other commodity) and the other
countries could, in turn, produce another commodity at an absolute advantage
over the first. In other words, the principle of absolute advantage refers to
the ability of a party (an individual, or firm, or country) to produce a greater
quantity of a good, product, or service than competitors, using the same amount
of resources. Adam Smith first described the principle of absolute advantage in
the context of international trade, using labour as the only input. Since absolute
advantage is determined by a simple comparison of labour productivity, it is
possible for a nation to have no absolute advantage in anything; in that case,
according to the theory of absolute advantage, no trade will occur with the
other nation. It can be contrasted with the concept of comparative advantage
which refers to the ability to produce specific goods at a lower opportunity cost.
Assumptions of the Absolute Advantage Theory:
• Trade between the two countries.
• He took into consideration a two-country and two-commodity framework
for his analysis.
• There is no transportation cost.
• Smith assumed that the costs of the commodities were computed by
the relative amounts of labour required in their respective production
processes.
• He assumed that labour was mobile within a country but immobile
between countries.
• He implicitly assumed that any trade between the two countries considered
would take place if each of the two countries had an absolutely lower cost
in the production of one of the commodities.
 The Theory of Comparative Advantage

In one of the most important concepts in economics, David Ricardo observed
that trade was driven by comparative rather than absolute costs (of producing
a good). One country may be more productive than others in all goods, in
the sense that it can produce any good using fewer inputs (such as capital
and labour) than other countries require to produce the same good. Ricardo’s
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insight was that such a country would still benefit from trading according to its
comparative advantage—exporting products in which its absolute advantage
was greatest, and importing products in which its absolute advantage was
comparatively less (even if still positive). Even a country that is more efficient
(has absolute advantage) in everything it makes would benefit from trade.
Consider an example:
Country A: One hour of labour can produce either three kilograms of steel or
two shirts.
Country B: One hour of labour can produce either one kilogram of steel or one
shirt.
Country A is more efficient in both products.

Now suppose Country B offers to sell Country A two shirts in exchange for 2.5
kilograms of steel.
To produce these additional two shirts, Country B diverts two hours of work
from producing (two kilograms) of steel.
Country A diverts one hour of work from producing (two) shirts. It uses that
hour of work to instead produce three additional kilograms of steel.
Overall, the same number of shirts is produced: Country A produces two fewer
shirts, but Country B produces two additional shirts.
However, more steel is now produced than before: Country A produces three
additional kilograms of steel, while Country B reduces its steel output by two
kilograms.
The extra kilogram of steel is a measure of the gains from trade.
Though a country may be twice as productive as its trading partners in making

clothing, if it is three times as productive in making steel or building aeroplanes,
it will benefit from making and exporting these products and importing clothes.
Its partner will gain by exporting clothes—in which it has a comparative but
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not absolute advantage—in exchange for these other products. The notion
of comparative advantage also extends beyond physical goods to trade in
services—such as writing computer code or providing financial products.
Because of comparative advantage, trade raises the living standards of both

countries.
Douglas Irwin (2009) calls comparative advantage “good news” for economic
development.
“Even if a developing country lacks an absolute advantage in any field, it will
always have a comparative advantage in the production of some goods,” and
will trade profitably with advanced economies.
3 The Heckscher-Ohlin Theory of Trade

Differences in comparative advantage may arise for several reasons. In the early
20th century, Swedish economists Eli Heckscher and Bertil Ohlin identified the role
of labour and capital,so-called factor endowments, as a determinant of advantage.
The Heckscher-Ohlin proposition maintains that countries tend to export goods

whose production uses intensively the factor of production that is relatively abundant
in the country.
Countries well endowed with capital—such as factories and machinery—should

export capitalintensive products, while those well endowed with labour should
export labour-intensive products. Economists today think that factor endowments
matter, but that there are also other important influences on trade patterns.
The increase in competition coming from foreign firms puts pressure on profits,
forcing less efficient firms to contract and making room for more efficient firms.
Expansion and new entry bring with them better technologies and new product
varieties. Likely the most important is that trade enables greater selection across
different types of goods (say refrigerators). This explains why there is a lot of intra-
industry trade (for example, countries that export household refrigerators may
import industrial coolers), which is something that the factor endowment approach
does not encompass.
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There are clear efficiency benefits from trade that results in more products—not only
more of the same products, but greater product variety. An even greater benefit may
be the more efficient investment spending that results from firms having access to
a wider variety and quality of intermediate and capital inputs (think lithium battery
manufacturing by China rather than manufacturing electrical cars). By enhancing
overall investment and facilitating innovation, trade can bring sustained higher
growth.
Indeed, economic models used to assess the impact of trade typically neglect
influences involving technology transfer and pro-competitive forces such as the
expansion of product varieties. That is because these influences are difficult to
model, and results that do incorporate them are subject to greater uncertainty.
Where this has been done, however, researchers have concluded that the benefits
of trade reforms—such as reducing tariffs and other nontariff barriers to trade—are
much larger than suggested by conventional models.
The table 4.1.3 presents, though not exhaustive, a comparison of the theory of
comparative costs and modern theory.
Comparison of Theory of Comparative Costs and Modern Theory

Theory of Comparative Costs Modern Theory
The basis is the difference between Explains the causes of differences in
ountries is comparative costs comparative costs as differences in
factor endowments
Based on labour theory of value Based on money cost which is more

realistic.
Considered labour as the sole factor of Widened the scope to include labour and
production and presents a one-factor capital as important factors of production.
(labour) model This is 2-factor model and can be
extended to more factors.
Treats international trade as quite International trade is only a special case
distinct from domestic trade of inter-regional trade.
Studies only comparative costs of the Considers the relative prices of the
goods concerned factors which influence the comparative
costs of the goods
Attributes the differences in comparative Attributes the differences in comparative
advantage to differences in productive advantage to the differences in factor
efficiency of workers endowments.
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Does not take into account the factor Considers factor price differences as
price differences the main cause of commodity price
differences
Does not provide the cause of Explains the differences in comparative
differences in comparative advantage. advantage in terms of differences in
factor endowments.
Normative; tries to demonstrate the Positive; concentrates on the basis of
gains from international trade trade
 Globalization and New International Trade Theory

The revolution that swept through the theory of international trade in the
first half of the 1980s-the rise of the so-called new trade theory’-left many
of the insights of traditional trade theory intact. In particular, introducing
imperfect competition and increasing returns into the picture does not alter
the fundamental point that trade is a positive-sum game, generally carried
on to countries’ mutual benefit. Indeed, the new trade theory adds to the
positive sum: by enlarging markets, international trade increases competition
and allows greater exploitation of economies of scale, both of which represent
gains over and above those due to comparative advantage.
The new trade theory suggests that in practice many traded goods are
produced by industries that are both oligopolistic and subject to external
economies (e.g., because of economies of scale in the production of nontraded
intermediates). Thus instead of a picture of an international economy that is
at a Pareto optimum, the new trade theory offers a picture of one in which
markets normally lead to suboptimal results.
American economist and journalist Paul Krugman received the 2008 Nobel
Prize for Economics for his work in economic geography and in identifying
international trade patterns. In the late 1970s, Paul Krugman noticed that
the accepted model that economists used to explain patterns of international
trade did not fit the data. The Heckscher-Ohlin model predicted that trade
would be based on such factors as the ratio of capital to labor, with “capital-
rich” countries exporting capital-intensive goods and importing labor-intensive
goods from “laborrich” countries. But Krugman noticed that most international
trade takes place between countries with roughly the same ratio of capital
to labor. The auto industry in capital-intensive Sweden, for example, exports
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cars to capital-intensive America, while Swedish consumers also import cars

from America. This is particularly true in key economic sectors in India such
as electronics, IT, food, and automotive. We have cars made in India, yet we
purchase many cars made in other countries.
Krugman defended free trade. He was passionate and showed deep concern
for the wellbeing of people around the world. One such example is “In Praise
of Cheap Labor, ” published in Slate in 1997. In it, Krugman told of Smokey
Mountain, a huge garbage dump in Manila in which men, women, and children
made a living combing through garbage for valuable items.
Low-wage jobs in multinational companies’ factories in the Philippines,

Bangladesh, and other poor countries, he noted, are much better alternatives.
Because multinational companies hired many of these poor workers, he wrote
that “the result has been to move hundreds of millions of people from abject
poverty to something still awful but nonetheless significantly better.
According to NTT, two key concepts give advantages to countries that import
goods to compete with products from the home country:
 Economies of Scale: As a firm produces more of a product, its cost per
unit keeps going down. So if the firm serves domestic as well as foreign
market instead of just one, then it can reap the benefit of large scale of
production consequently the profits are likely to be higher.
 Network effects refer to the way one person’s value for a good or service
is affected by the value of that good or service to others. The value of
the product or service is enhanced as the number of individuals using it
increases. This is also referred to as the ‘bandwagon effect’. Consumers like
more choices, but they also want products and services with high utility,
and the network effect increases utility obtained from these products
over others. A good example will be Mobile App such as What’s App and
software like Microsoft Windows.
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1. Which of the following does not represent a difference between internal trade and
international trade?
(a) transactions in multiple currencies
(b) homogeneity of customers and currencies
(c) differences in legal systems
2. The theory of absolute advantage states that

(a) national wealth and power are best served by increasing exports and decreasing
imports
(b) nations can increase their economic well-being by specializing in the production
of goods they produce more efficiently than anyone else.
(c) that the value or price of a commodity depends exclusively on the amount of
labour going into its production and therefore factor prices will be the same
(d) differences in absolute advantage explains differences in factor endowments in
different countries
3. Which of the following theories advocates that countries should produce those
goods for which it has the greatest relative advantage?
(a) Modern theory of international trade
(b) The factor endowment theory
(c) The Heckscher-Ohlin Theory
4. Which of the following holds that a country can increase its wealth by encouraging
exports and discouraging imports
(a) Capitalism
(b) Socialism
(c) Mercantilism
(d) Laissez faire
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5. Given the number of labour hours to produce cloth and grain in two countries, which
country should produce grain?
Labour cost (hours) for production of one unit
Country A Country B
Cloth 40 80
Grain 80 40
(a) Country A (b) Country B
(c) Neither A nor B (d) Both A and B
6. According to the theory of comparative advantage

(a) trade is a zero-sum game so that the net change in wealth or benefits among
the participants is zero.
(b) trade is not a zero-sum game so that the net change in wealth or benefits
among the participants is positive
(c) nothing definite can be said about the gains from trade
(d) gains from trade depends upon factor endowment and utilization
7. Given the number of labour hours to produce wheat and rice in two countries and
that these countries specialise and engage in trade at a relative price of 1:1 what
will be the gain of country X?
Wheat Rice
Country X 10 20
Country Y 20 10
(a) 20 labour hours. (b) 10 labour hours
(c) 30 labour hours (d) Does not gain anything
8. Assume India and Bangladesh have the unit labour requirements for producing
tables and mats shown in the table below. It follows that:
India Bangladesh
Tables 3 8
Mats 2 1
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(a) Bangladesh has a comparative advantage in mats

(b) India has a comparative advantage in tables
(c) Bangladesh has an absolute advantage in mats
(d) All the above are true
9. Comparative advantage refers to

(a) a c ountry’s ability t o produce some g ood or service at the lowest possible
cost compared to other countries
(b) a country’s ability to produce some good or service at a lower opportunity cost
than other countries.
(c) Choosing a productive method which uses minimum of the abundant factor
10. Ricardo explained the law of comparative advantage on the basis of

(a) opportunity costs
(b) the law of diminishing returns
(c) economies of scale
(d) the labour theory of value
ANSWERS:
1 (b) 2 (b) 3 (d) 4 (c) 5 (b) 6 (b)
7 (b) 8 (d) 9 (b) 10 (d)
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SUMMARY
 International trade is the exchange of goods and services as well as resources

between countries and involves greater complexity compared to internal trade.
 Trade can be a powerful stimulus to economic efficiency, contributes to economic

growth and rising incomes, enlarges manufacturing capabilities, ensures benefits
from economies of large-scale production, and enhances competitiveness and
profitability by adoption of cost reducing technology and business practices.
 Efficient deployment of productive resources to their best use, productivity gains,

decrease in the likelihood of domestic monopolies, cost-effective sourcing of inputs
and components internationally, innovative products at lower prices and wider
choice in products and services for consumers are claimed as benefits of trade.
 Enhanced foreign exchange reserves, increased scope for mechanization and
specialisation, research and development, creation of jobs, reduction in poverty,
augmenting factor incomes, raising standards of livelihood, increase in overall
demand for goods and services and greater stimulus to innovative services are other
benefits of trade.
 There are also other possible positive outcomes of trade in the form of prospects
of employment generating investments, improvement in the quality of output,
superior products, labour and environmental standards, broadening of productive
base, export diversification, stability in prices and supply of goods, human resource
development and strengthening of bonds between nations.
 The arguments against trade converge on negative labour market outcomes,

economic exploitation, profit-driven exhaustion of natural resources, shift towards
a consumer culture, risky dependence, shortages resulting in inflation, disregard
for welfare of people, quick transmission of trade cycles, rivalries and risks in trade
associated with changes in governments’ policies of participating countries.
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 Mercantilism advocated maximizing exports in order to bring in more precious metals

and minimizing imports through the state imposing very high tariffs on foreign goods.
 According to Adam Smith’s Absolute Cost Advantage theory, a country will specialize
in the production and export of a commodity in which it has an absolute cost
advantage.
 Ricardo's theory of comparative advantage states that a nation should specialize

in the production and export of the commodity in which its absolute disadvantage
is smaller (this is the commodity of its comparative advantage) and import the
commodity in which its absolute disadvantage is greater (this is the commodity of
its comparative disadvantage).
 Haberler resolved the issue of dependence on labour alone in the case of theory of
comparative advantage when he introduced the opportunity cost concept.
Opportunity cost which is the value of the forgone option.
 The Heckscher-Ohlin theory of trade, also referred to as Factor-Endowment Theory

of Trade or Modern Theory of Trade, states that comparative advantage in cost of
production is explained exclusively by the differences in factor endowments.
 A country tends to specialize in the export of a commodity whose production requires

intensive use of its abundant resources and imports a commodity whose production
requires intensive use of its scarce resources.
 Accordingly, a capital abundant country will produce and export capital-intensive

goods relatively more cheaply and a labour-abundant country will produce and
export labour-intensive goods relatively more cheaply than other country.
 The Factor-Price Equalization Theorem states that international trade equalizes the
factor prices between the trading nations. Therefore, with free trade, wages and
returns on capital will converge across the countries.
 NTT is the latest entrant to explain the rising proportion of world trade between the
developed and bigger developing economies (such as BRICS), which trade in similar
products. These countries constitute more than 50% of world trade.
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UNIT 2: THE INSTRUMENTS OF TRADE POLICY
1. INTRODUCTION
Before we go into the subject matter of this unit, we shall take a quick look at a few
recent developments in India’s international trade strategy.
• After a decade of eschewing free trade deals, India has embarked on an FTA-
signing spree that is quickly transforming the country into one of the most FTA-
engaged countries in the world.
• The reinvigorated Free Trade Agreement rush began with an agreement with
Mauritius on 1 April 2021, followed by fast-track negotiations with the United
Arab Emirates (UAE), Australia, the United Kingdom (UK), Canada and the
European Union (EU).
• On 18 February 2022, a comprehensive economic partnership agreement
(CEPA) with the UAE was concluded within 90 days of the commencement of
negotiations and has been in force since 1 May 2022. In addition, an Economic
Cooperation and Trade Agreement (ECTA) with Australia also concluded on 2
April 2022.
• The next highly-anticipated Free Trade Agreement in the works is with the UK,
which is expected to conclude by Diwali (the festival of lights) in October 2022.
Free Trade Agreement discussions are also on the fast track with Canada, the
EU, as well as with the Gulf Cooperation Council (GCC – Bahrain, Kuwait, Oman,
Qatar, Saudi Arabia and the UAE) and Israel.
As we know, under free trade, buyers and sellers from separate economies voluntarily
trade with minimum of state interference. The free interplay of market forces of
supply and demand decides prices. Protectionism, on the other hand, is a state
policy aimed to protect domestic producers against foreign competition through the
use of tariffs, quotas
and non-tariff trade policy instruments. Trade liberalization refers to opening up of
domestic markets to goods and services from the rest of the world by bringing down
trade barriers.
In unit 1, we have seen that there are clear efficiency benefits from trade in terms
of economic growth, job-creation and welfare. The persuasive academic arguments
for open trade presuppose that fair competition, without distortions, is maintained
between domestic and foreign producers. However, it is a fact that fair competition
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does not always exist and unobstructed international trade also brings in severe
dislocation to many domestic firms and industries on account of difficult adjustment
problems. Therefore, individuals and organizations continue to pressurize
policymakers and regulatory authorities to restrict imports or to artificially boost
up the size of exports.
Historically, as part of their protectionist measures, governments of different

countries have applied many different types of policy instruments, not necessarily
based on their economic merit, for restricting the free flow of goods and services
across national boundaries. While some such measures of government intervention
are simple, widespread, and relatively transparent, others are complex, less apparent
and frequently involve many types of distortions.
In this unit, we shall describe some of the most frequently used forms of interference
with trade. Understanding the uses and implications of the common trade policy
instruments, will enable formulation of appropriate policy responses and more
balanced dialogues on trade policy issues and international trade agreements.
Trade policy encompasses all instruments that governments may use to promote
or restrict imports and exports. Trade policy also includes the approach taken
by countries in trade negotiations. While participating in the multilateral trading
system and/or while negotiating bilateral trade agreements, countries assume
obligations that shape their national trade policies. The instruments of trade policy
that countries typically use to restrict imports and/ or to encourage exports can
be broadly classified into price- related measures such as tariffs and non-price
measures or non-tariff measures (NTMs).
In the following sections, we shall briefly touch upon the different trade policy
measures
adopted by countries to protect their domestic industries.
2. TARIFFS
Tariffs, also known as customs duties, are basically taxes or duties imposed on goods
and services which are imported or exported. Different tariffs are generally applied
to different commodities. It is defined as a financial charge in the form of a tax,
imposed at the border on goods going from one customs territory to another. They
are the most visible and universally used trade measures that determine market
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access for goods. Instead of a single tariff rate, countries have a tariff schedule
which specifies the tariff collected on every particular good and service. Import
duties being pervasive than export duties, tariffs are often identified with import
duties and in this unit, the term ‘tariff’ would refer to import duties.
Tariffs are aimed at altering the relative prices of goods and services imported, so
as to contract the domestic demand and thus regulate the volume of their imports.
Tariffs leave the world market price of the goods unaffected; while raising their
prices in the domestic market.
The main goals of tariffs are to raise revenue for the government, and more
importantly to protect the domestic import-competing industries.
 Forms of Import Tariffs

(i) Specific Tariff: Specific tariff is the fixed amount of money per physical unit
oraccording to the weight or measurement of the commodity imported
or exported. This tariff can vary according to the type of good imported.
Example, a specific tariff of `1000/ may be charged on each imported
bicycle. The disadvantage of specific tariff as an instrument for protection
of domestic producers is that its protective value varies inversely with
the price of the import. For example: if the price of the imported cycle is
` 5,000/- and the rate of tariff is 20%; then, if due to inflation, the price
of bicycle rises to ` 10,000, the specific tariff is still only 10% of the value
of the import. Since the calculation of these duties does not involve the
value of merchandise, customs valuation is not applicable in this case.
(ii) Ad valorem tariff: When the duty is levied as a fixed percentage of the
value of the traded commodity, it is called as valorem tariff. An ad valorem
tariff is levied as a constant percentage of the monetary value of one unit
of the imported good. A 20% ad valorem tariff on any bicycle generates
a ` 1000/ payment on each imported bicycle priced at ` 5,000/ in the
world market; and if the price rises to `10,000, it generates a payment of
` 2,000/. While ad valorem tariff preserves the protective value of tariff on
home producer, it gives incentives to deliberately undervalue the good’s
price on invoices and bills of lading to reduce the tax burden. Nevertheless,
ad valorem tariffs are widely used across the world.
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There are many other variations of the above tariffs, such as:
(a) Mixed Tariffs: Mixed tariffs are expressed either on the basis of the value
of the imported goods (an ad valorem rate) or on the basis of a unit
of measure of the imported goods (a specific duty) depending on which
generates the most income (or least income at times) for the nation. For
example, duty on cotton: 5 per cent ad valorem or ` 3000/per tonne,
whichever is higher.
Compound Tariff or a Compound Duty is a combination of an ad valorem
and a specific tariff. That is, the tariff is calculated on the basis of both the
value of the imported goods (an ad valorem duty) and a unit of measure
of the imported goods (a specific duty). It is generally calculated by adding
up a specific duty to an ad valorem duty. Thus, on an import with quantity
q and price p, a compound tariff collects a revenue equal to tsq + tapq,
where ts is the specific tariff and ta is the ad valorem tariff. For example:
duty on cheese at 5 per cent advalorem plus 100 per kilogram.
(b) Technical/Other Tariff: These are calculated on the basis of the specific
contents of the imported goods i.e. the duties are payable by its components
or related items. For example: ` 3000/ on each solar panel plus ` 50/ per
kg on the battery.
(c) Tariff Rate Quotas: Tariff rate quotas (TRQs) combine two policy instruments:
quotas and tariffs. Imports entering under the specified quota portion are
usually subject to alower (sometimes zero) tariff rate. Imports above the
quantitative threshold of the quota face a much higher tariff.
(d) Most-Favoured Nation Tariffs: MFN tariffs refer to import tariffs which
countries promise to impose on imports from other members of the WTO,
unless the country is part of a preferential trade agreement (such as a free
trade area or customs union).
This means that, in practice, MFN rates are the highest (most restrictive)
that WTO members charge each other. Some countries impose higher
tariffs on countries that are not part of the WTO.
(e) Variable Tariff: A duty typically fixed to bring the price of an imported
commodity up to level of the domestic support price for the commodity.
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(f) Preferential Tariff: Nearly all countries are part of at least one preferential
trade agreement, under which they promise to give another country's products
lower tariffs than their MFN rate. These agreements are reciprocal. A lower
tariff is charged from goods imported from a country which is given preferential
treatment. Examples are preferential duties in the EU region under which a
good coming from one EU country to another is charged zero tariff rate. Another
example is North American Free Trade Agreement (NAFTA) among Canada,
Mexico and the USA where the preferential tariff rate is zero on essentially
all products. Countries, especially the affluent ones also grant ‘unilateral
preferential treatment’ to select list of products from specified developing
countries. The Generalized System of Preferences (GSP) is one such system which
is currently prevailing.
(g) Bound Tariff: Under this, a WTO member binds itself with a legal commitment
not to raise tariff rate above a certain level. By binding a tariff rate, often
during negotiations, the members agree to limit their right to set tariff levels
beyond a certain level. The bound rates are specific to individual products and
represent the maximum level of import duty that can be levied on a product
imported by that member. A member is always free to impose a tariff that is
lower than the bound level. Once bound, a tariff rate becomes permanent and
a member can only increase its level after negotiating with its trading partners
and compensating them for possible losses of trade. A bound tariff ensures
transparency and predictability.
(h) Applied Tariffs: An 'applied tariff' is the duty that is actually charged on imports
on a Most-Favoured Nation (MFN) basis. A WTO member can have an applied
tariff for a product that differs from the bound tariff for that product as long as
the applied level is not higher than the bound level.
(i) Escalated Tariff structure refers to the system wherein the nominal tariff rates
on imports of manufactured goods are higher than the nominal tariff rates on
intermediate inputs and raw materials, i.e. the tariff on a product increases
as that product moves through the value-added chain. For example, a four
percent tariff on iron ore or iron ingots and twelve percent tariff on steel pipes.
This type of tariff is discriminatory as it protects manufacturing industries in
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importing countries and dampens the attempts of developing manufacturing

industries of exporting countries.
This has special relevance to trade between developed countries and developing
countries. Developing countries are thus forced to continue to be suppliers of
raw materials without much value addition.
(j) Prohibitive tariff: A prohibitive tariff is one that is set so high that no imports
can enter.
(k) Import subsidies: Import subsidies also exist in some countries. An import
subsidy is simply a payment per unit or as a percent of value for the importation
of a good (i.e., a negative import tariff).
(l) Tariffs as Response to Trade Distortions: Sometimes countries engage in 'unfair'

foreign-trade practices which are trade distorting in nature and adverse to
the interests of the domestic firms. The affected importing countries, upon
confirmation of the distortion, respond quickly by measures in the form of
tariff responses to offset the distortion. These policies are often referred to
as "trigger-price" mechanisms. The following sections relate to such tariff
responses to distortions related to foreign dumping and export subsidies.
(m) Anti-dumping Duties: An anti-dumping duty is a protectionist tariff that a

domestic government imposes on foreign imports that it believes are priced
below fair market value. Dumping occurs when manufacturers sell goods in a
foreign country below the sales prices in their domestic market or below their
full average cost of the product.
Dumping may be persistent, seasonal, or cyclical. Dumping may also be
resorted to as a predatory pricing practice to drive out established domestic
producers from the market and to establish monopoly position. Dumping is an
international price discrimination favouring buyer of exports, but in fact, the
exporters deliberately forego money in order to harm the domestic producers
of the importing country.
Dumping is unfair and constitutes a threat to domestic producers and

therefore when dumping is found, anti-dumping measures may be initiated
as a safeguard instrument by imposing additional import duties/tariffs so as
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to offset the foreign firm's unfair price advantage. This is justified only if the
domestic industry is seriously injured by import competition, and protection is
in the national interest (that is, the associated costs to consumers would be
less than the benefits that would accrue to producers).
For example: In January 2017, India imposed anti-dumping duties on colour-
coated or pre-painted flat steel products imported into the country from China
and European nations for a period not exceeding six months and for jute and
jute products from Bangladesh and Nepal.
(n) Countervailing Duties: Countervailing duties are tariffs that aim to offset the
artificially low prices charged by exporters who enjoy export subsidies and
tax concessions offered by the governments in their home country. If a foreign
country does not have a comparative advantage in a particular good and a
government subsidy allows the foreign firm to be an exporter of the product, then
the subsidy generates a distortion from the free-trade allocation of resources.
In such cases, CVD is charged in an importing country to negate the advantage
that exporters get from subsidies to ensure fair and market-oriented pricing
of imported products and thereby protecting domestic industries and firms.
For example, in 2016, in order to protect its domestic industry, India imposed
12.5% countervailing duty on Gold jewellery imports from ASEAN.
 Effects of Tariffs
A tariff levied on an imported product affects both the exporting country and
the importing country.
(i) Tariff barriers create obstacles to trade, decrease the volume of imports and
exports and therefore of international trade. The prospect of market access of
the exporting country is worsened when an importing country imposes a tariff.
(ii) By making imported goods more expensive, tariffs discourage domestic
consumers from consuming imported foreign goods. Domestic consumers suffer
a loss in consumer surplus because they must now pay a higher price for the
good and also because compared to free trade quantity, they now consume
lesser quantity of the good.
(iii) Tariffs encourage consumption and production of the domestically produced
import substitutes and thus protect domestic industries.
(iv) Producers in the importing country experience an increase in well-being as a
result of imposition of tariff. The price increase of their product in the domestic
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market increases producer surplus in the industry. They can also charge
higher prices than would be possible in the case of free trade because foreign
competition has reduced.
(v) The price increase also induces an increase in the output of the existing firms
and possibly addition of new firms due to entry into the industry to take
advantage of the new high profits and consequently an increase in employment
in the industry. (vi) Tariffs create trade distortions by disregarding comparative
advantage and prevent countries from enjoying gains from trade arising from
comparative advantage. Thus, tariffs discourage efficient production in the rest
of the world and encourage inefficient production in the home country.
(vii) Tariffs increase government revenues of the importing country by the value
of the total tariff it charges. Trade liberalization in recent decades, either
through government policy measures or through negotiated reduction through
the WTO or regional and bilateral free trade agreements, has diminished the
importance of tariff as a tool of protection. Currently, trade policy is focusing
increasingly on not so easily observable forms of trade barriers usually called
non-tariff measures (NTMs). NTMs are thought to have important restrictive
and distortionary effects on international trade. They have become so invasive
that the benefits due to tariff reduction are practically offset by them.
 NON–TARIFF MEASURES (NTMS)

From the discussion above, we have learnt that tariffs constitute the visible
barriers to trade and have the effect of increasing the prices of imported
merchandise. By contrast, the non- tariff measures which have come into
greater prominence than the conventional tariff barriers, constitute the hidden
or 'invisible' measures that interfere with free trade.
Non-tariff measures (NTMs) are policy measures, other than ordinary customs
tariffs, that can potentially have an economic effect on international trade in
goods, changing quantities traded, or prices or both (UNCTAD, 2010). Non-
tariff measures comprise all types of measures which alter the conditions of
international trade, including policies and regulations that restrict trade and
those that facilitate it. NTMs consist of mandatory requirements, rules, or
regulations that are legally set by the government of the exporting, importing,
or transit country.
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It should be kept in mind that NTMs are not the same as non-tariff barriers
(NTBs). NTMs are sometimes used as means to circumvent free-trade rules and
favour domestic industries at the expense of foreign competition. In this case
they are called non-tariff barriers (NTBs). In other words, non-tariff barriers
are discriminatory non-tariff measures imposed by governments to favour
domestic over foreign suppliers. NTBs are thus a subset of NTMs that have a
'protectionist or discriminatory intent'. Compared to NTBs, non-tariff measures
encompass a broader set of measures.
According to WTO agreements, the use of NTMs is allowed under certain

circumstances. Examples of this include the Technical Barriers to Trade (TBT)
Agreement and the Sanitary and Phytosanitary Measures (SPS) Agreement, both
negotiated during the Uruguay Round. However, NTMs are sometimes used as
a means to circumvent free-trade rules and favour domestic industries at the
expense of foreign competition. In this case they are called nontariff barriers
(NTBs). It is very difficult, and sometimes impossible, to distinguish legitimate
NTMs from protectionist NTMs, especially because the same measure may be
used for several reasons.
Depending on their scope and/or design NTMs are categorized as:

I. Technical Measures: Technical measures refer to product-specific
properties such as characteristics of the product, technical specifications
and production processes. These measures are intended for ensuring
product quality, food safety, environmental protection, national security
and protection of animal and plant health.
II. Non-technical Measures: Non-technical measures relate to trade
requirements; for example; shipping requirements, custom formalities,
trade rules, taxation policies, etc. These are further distinguished as:
(a) Hard measures (e.g. Price and quantity control measures),
(b) Threat measures (e.g. Anti-dumping and safeguards) and
(c) Other measures such as trade-related finance and investment
measures.
Furthermore, the categorization also distinguishes between:

(i) Import-related measures which relate to measures imposed by the
importing country, and
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(ii) Export-related measures which relate to measures imposed by the

exporting country itself.
(iii) In addition, to these, there are procedural obstacles (PO) which are
practical problems in administration, transportation, delays in testing,
certification etc which may make it difficult for businesses to adhere to a
given regulation.
 Technical Measures
I. Sanitary and Phytosanitary (SPS) Measures: SPS measures are applied
to protect human, animal or plant life from risks arising from additives,
pests, contaminants, toxins or disease-causing organisms and to protect
biodiversity.
These include ban or prohibition of import of certain goods, all measures

governing quality and hygienic requirements, production processes, and
associated compliance assessments. For example; prohibition of import of
poultry from countries affected by avian flu, meat and poultry processing
standards to reduce pathogens, residue limits for pesticides in foods etc.
II. Technical Barriers To Trade (TBT): Technical Barriers to Trade (TBT) which
cover both food and non-food traded products refer to mandatory
‘Standards and Technical Regulations’ that define the specific characteristics
that a product should have, such as its size, shape, design, labelling /
marking / packaging, functionality or performance and production
methods, excluding measures covered by the SPS Agreement. The specific
procedures used to check whether a product is really conforming to these
requirements (conformity assessment procedures e.g. testing, inspection
and certification) are also covered in TBT. This involves compulsory quality,
quantity and price control of goods before shipment from the exporting
country.
Just as SPS, TBT measures are standards-based measures that countries

use to protect their consumers and preserve natural resources, but these
can also be used effectively as obstacles to imports or to discriminate
against imports and protect domestic products. Altering products and
production processes to comply with the diverse requirements in export
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markets may be either impossible for the exporting country or would

obviously raise costs, hurting the competitiveness of the exporting country.
Some examples of TBT are: food laws, quality standards, industrial
standards, organic certification, eco-labelling, and marketing and label
requirements.
 Non-technical Measures
These include different types of trade protective measures which are put into
operation to neutralize the possible adverse effects of imports in the market of
the importing country. Following are the most commonly practiced measures in
respect of imports:
(i) Import Quotas: An import quota is a direct restriction which specifies that
only a certain physical amount of the good will be allowed into the country
during a given time period, usually one year. Import quotas are typically
set below the free trade level of imports and are usually enforced by
issuing licenses. This is referred to as a binding quota; a nonbinding quota
is a quota that is set at or above the free trade level of imports, thus
having little effect on trade.
Import quotas are mainly of two types: absolute quotas and tariff-
rate quotas. Absolute quotas or quotas of a permanent nature limit
the quantity of imports to a specified level during a specified period of
time and the imports can take place any time of the year. No condition
is attached to the country of origin of the product. For example: 1000
tonnes of fish import which can take place any time during the year from
any country. When country allocation is specified, a fixed volume or value
of the product must originate in one or more countries. Example: A quota
of 1000 tonnes of fish that can be imported any time during the year, but
where 750 tonnes must originate in country A and 250 tonnes in country
B. In addition, there are seasonal quotas and temporary quotas.
With a quota, the government, of course, receives no revenue. The profits

received by the holders of such import licenses are known as ‘quota rents’.
While tariffs directly interfere with prices that can be charged for an
imported good in the domestic market, import quota interferes with the
market prices indirectly. Obviously, an import quota always raises the
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domestic price of the imported good. The license holders are able to buy
imports and resell them at a higher price in the domestic market and
they will be able to earn a ‘rent’ on their operations over and above the
profit they would have made in a free market.
The welfare effects of quotas are similar to that of tariffs. If a quota is set
below free trade level, the amount of imports will be reduced. A reduction
in imports will lower the supply of the good in the domestic market and
raise the domestic price. Consumers of the product in the importing
country will be worse-off because the increase in the domestic price of
both imported goods and the domestic substitutes reduces consumer
surplus in the market. Producers in the importing country are better-
off as a result of the quota. The increase in the price of their product
increases producer surplus in the industry. The price increase also induces
an increase in output of existing firms (and perhaps the addition of new
firms), an increase in employment, and hence an increase in profit.
(ii) Price Control Measures: Price control measures (including additional taxes
and charges) are steps taken to control or influence the prices of imported
goods in order to support the domestic price of certain products when the
import prices of these goods are lower. These are also known as 'para-
tariff' measures and include measures, other than tariff measures, that
increase the cost of imports in a similar manner, i.e. by a fixed percentage
or by a fixed amount. Example: A minimum import price established for
sulphur.
(iii) Non-automatic Licensing and Prohibitions: These measures are normally

aimed at limiting the quantity of goods that can be imported, regardless
of whether they originate from different sources or from one particular
supplier. These measures may take the form of nonautomatic licensing,
or complete prohibitions. For example, textiles may be allowed only on
a discretionary license by the importing country. India prohibits import/
export of arms and related material from/to Iraq. Further, India also
prohibits many items (mostly of animal origin) falling under 60 EXIM
codes.
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(iv) Financial Measures: The objective of financial measures is to increase

import costs by regulating the access to and cost of foreign exchange for
imports and to define the terms of payment. It includes measures such as
advance payment requirements and foreign exchange controls denying the
use of foreign exchange for certain types of imports or for goods imported
from certain countries. For example, an importer may be required to pay
a certain percentage of the value of goods imported three months before
the arrival of goods or foreign exchange may not be permitted for import
of newsprint.
(v) Measures Affecting Competition: These measures are aimed at granting

exclusive or special preferences or privileges to one or a few limited group
of economic operators. It may include government imposed special import
channels or enterprises, and compulsory use of national services. For
example, a statutory marketing board may be granted exclusive rights to
import wheat: or a canalizing agency (like State Trading Corporation) may
be given monopoly right to distribute palm oil. When a state agency or
a monopoly import agency sells in the domestic market at prices above
those existing in the world market, the effect will be similar to an import
tariff.
(vi) Government Procurement Policies: Government procurement policies may

interfere with trade if they involve mandates that the whole of a specified
percentage of government purchases should be from domestic firms rather
than foreign firms, despite higher prices than similar foreign suppliers. In
accepting public tenders, a government may give preference to the local
tenders rather than foreign tenders.
(vii) Trade-Related Investment Measures: These measures include rules on

local content requirements that mandate a specified fraction of a final
good should be produced domestically.
(a) requirement to use certain minimum levels of locally made
components, (25 percent of components of automobiles to be
sourced domestically)
(b) restricting the level of imported components, and
(c) limiting the purchase or use of imported products to an amount
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related to the quantity or value of local products that it exports.

(A firm may import only up to 75 % of its export earnings of the
previous year)
(viii) Distribution Restrictions: Distribution restrictions are limitations imposed on

the distribution of goods in the importing country involving additional license
or certification requirements. These may relate to geographical restrictions or
restrictions as to the type of agents who may resell. For example: a restriction
that imported fruits may be sold only through outlets having refrigeration
facilities.
(ix) Restriction on Post-sales Services: Producers may be restricted from

providing after- sales services for exported goods in the importing country.
Such services may be reserved to local service companies of the importing
country.
(x) Administrative Procedures: Another potential obstruction to free trade

is the costly and time-consuming administrative procedures which are
mandatory for import of foreign goods. These will increase transaction
costs and discourage imports. The domestic importcompeting industries
gain by such non- tariff measures. Examples include specifying particular
procedures and formalities, requiring licenses, administrative delay, red-
tape and corruption in customs clearing frustrating the potential importers,
procedural obstacles linked to prove compliance etc.
(xi) Rules of origin: Country of origin means the country in which a good was
produced, or in the case of a traded service, the home country of the
service provider. Rules of origin are the criteria needed by governments
of importing countries to determine the national source of a product.
Their importance is derived from the fact that duties and restrictions in
several cases depend upon the source of imports. Important procedural
obstacles occur in the home countries for making available certifications
regarding origin of goods, especially when different components of the
product originate in different countries.
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(xii) Safeguard Measures: These are initiated by countries to restrict imports

of a product temporarily if its domestic industry is injured or threatened
with serious injury caused by a surge in imports. Restrictions must be for
a limited time and non-discriminatory.
(xiii) Embargos: An embargo is a total ban imposed by government on import

or export of some or all commodities to particular country or regions for
a specified or indefinite period. This may be done due to political reasons
or for other reasons such as health, religious sentiments. This is the most
extreme form of trade barrier.
 EXPORT-RELATED MEASURES
(i) Ban on exports: Export-related measures refer to all measures applied
by the government of the exporting country including both technical and
non-technical measures. For example, during periods of shortages, export
of agricultural products such as onion, wheat etc. may be prohibited to
make them available for domestic consumption. Export restrictions have
an important effect on international markets. By reducing international
supply, export restrictions have been effective in increasing international
prices.
(ii) Export Taxes: An export tax is a tax collected on exported goods and may
be either specific or ad valorem. The effect of an export tax is to raise the
price of the good and to decrease exports. Since an export tax reduces
exports and increases domestic supply, it also reduces domestic prices
and leads to higher domestic consumption.
(iii) Export Subsidies and Incentives: We have seen that tariffs on imports hurt
exports and therefore countries have developed compensatory measures
of different types for exporters like export subsidies, duty drawback, duty-
free access to imported intermediates etc. Governments or government
bodies also usually provide financial contribution to domestic producers
in the form of grants, loans, equity infusions etc. or give some form of
income or price support. If such policies on the part of governments are
directed at encouraging domestic industries to sell specified products or
services abroad, they can be considered as trade policy tools.
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(iv) Voluntary Export Restraints: Voluntary Export Restraints (VERs) refer to a

type of informal quota administered by an exporting country voluntarily
restraining the quantity of goods that can be exported out of that country
during a specified period of time. Such restraints originate primarily from
political considerations and are imposed based on negotiations of the
importer with the exporter. The inducement for the exporter to agree to a
VER is mostly to appease the importing country and to avoid the effects of
possible retaliatory trade restraints that may be imposed by the importer.
VERs may arise when the import-competing industries seek protection
from a surge of imports from particular exporting countries. VERs cause,
as do tariffs and quotas, domestic prices to rise and cause loss of domestic
consumer surplus.
Over the past few decades, significant transformations are happening in
terms of growth as well as trends of flows and patterns of global trade. The
increasing importance of developing countries has been a salient feature
of the shifting global trade patterns. Fundamental changes are taking
place in the way countries associate themselves for international trade
and investments. Trading through regional arrangements which foster
closer trade and economic relations is shaping the global trade landscape
in an unprecedented way. Alongside, the trading countries also have
devised ingenious policies aimed at protecting their economic interests. The
discussions in this unit are in no way comprehensive considering the faster
pace of discovery of such protective strategies. Students are expected to
get themselves updated on such ongoing changes.
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1. A specific tariff is
(a) a tax on a set of specified imported good
(b) an import tax that is common to all goods imported during a given period
(c) a specified fraction of the economic value of an imported good
(d) a tax on imports defined as an amount of currency per unit of the good
2. A tariff on imports is beneficial to domestic producers of the imported good

because
(a) they get a part of the tariff revenue
(b) it raises the price for which they can sell their product in the domestic market
(c) it determines the quantity that can be imported to the country
(d) it reduces their producer surplus, making them more efficient
3. A tax applied as a percentage of the value of an imported good is known as

(a) preferential tariff
(b) ad valorem tariff
(c) specific tariff
(d) mixed or compound tariff
4. Escalated tariff refers to

(a) nominal tariff rates on raw materials which are greater than tariffs on
manufactured products
(b) nominal tariff rates on manufactured products which are greater than tariffs
on raw materials
(c) a tariff which is escalated to prohibit imports of a particular good to protect
domestic industries
5. Voluntary export restraints involve:

(a) an importing country voluntarily restraining the quantity of goods that can be
exported into the country during a specified period of time
(b) domestic firms agreeing to limit the quantity foreign products sold in their
domestic markets
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(c) an exporting country voluntarily restraining the quantity of goods that can be
exported out of a country during a specified period of time
(d) quantitative restrictions imposed by the importing country's government.
6. Anti-dumping duties are

(a) additional import duties so as to offset the effects of exporting firm's unfair
charging of prices in the foreign market which are lower than production costs.
(b) tadditional import duties so as to offset the effects of exporting firm's increased
competitiveness due to subsidies by government
(c) additional import duties so as to offset the effects of exporting firm's unfair
charging of lower prices in the foreign market
(d) Both (a) and (c) above
7. A countervailing duty is
(a) a tariff that aim to offset artificially low prices charged by exporters who enjoy
export subsidies and tax concessions in their home country
(b) charged by importing countries to ensure fair and market-oriented pricing of
imported products
(c) charged by importing countries to protect domestic industries and firms from
unfair price advantage arising from subsidies
(d) All the above
8. Which of the following is an outcome of tariff?

(a) create obstacles to trade and increase the volume of imports and exports
(b) domestic consumers enjoy consumer surplus because consumers must now
pay only a lower price for the good
(c) discourage domestic consumers from consuming imported foreign goods and
encourage consumption of domestically produced import substitutes
(d) increase government revenues of the importing country by more than value of
the total tariff it charges
9. SPS measures and TBTs are

(a) permissible under WTO to protect the interests of countries
(b) may result in loss of competitive advantage of developing countries
(c) increases the costs of compliance to the exporting countries
(d) All the above
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10. Which of the following is not a non-tariff barrier.

(a) Complex documentation requirements
(b) Import quotas on specific goods
(c) Countervailing duties charged by importing country
(d) Pre shipment product inspection and certification requirements
11. Under tariff rate quota

(a) countries promise to impose tariffs on imports from members other than those
who are part of a preferential trade agreement
(b) a country permits an import of limited quantities at low rates of duty but
subjects an excess amount to a much higher rate
(c) lower tariff is charged from goods imported from a country which is given
preferential treatment
12. Non -tariff barriers (NTBs) include all of the following except:
(a) import quotas
(b) tariffs
(c) export subsidies
(d) technical standards of products
ANSWERS:
1 (d) 2 (b) 3 (b) 4 (b) 5 (c) 6 (d)
7 (d) 8 (c) 9 (d) 10 (c) 11 (b) 12 (b)
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SUMMARY
 Trade policy encompasses all instruments that governments may use to promote or
restrict imports and exports.
 Trade policies are broadly classified into price-related measures such as tariffs and
non-price measures or non-tariff measures (NTMs).
 Tariff, also known as customs duty is defined as a financial charge in the form of a
tax, imposed at the border on goods going from one customs territory to another.
Tariffs are the most visible and universally used trade measures.
 A specific tariff is an import duty that assigns a fixed monetary tax per physical unit
of the good imported whereas an ad valorem tariff is levied as a constant percentage
of the monetary value of one unit of the imported good.
 Mixed tariffs are expressed either on the basis of the value of the imported goods
(an ad valorem rate) or on the basis of a unit of measure of the imported goods (a
specific duty), depending on desired yields.
 Compound Tariff or a compound duty is a combination of an ad valorem and a

specific tariff and is calculated on the basis of both the value of the imported goods
(an ad valorem duty) and a unit of measure of the imported goods.
 Tariff rate quotas (TRQs) combine two policy instruments namely quotas and tariffs.
 MFN tariffs are what countries promise to impose on imports from all members of
the WTO, unless the country is part of a preferential trade agreement (such as a free
trade area or customs union).
 Preferential tariff occurs when a country imposes tariffs lower than its MFN rate on
another country's products.
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 The bound tariff rate is specific to individual products and represents the maximum
level of import duty that can be levied on a product imported by that member.
 An 'applied tariff' is the duty that is actually charged on imports on the mostfavoured
nation (MFN) basis.
 Escalated tariff structure refers to the system wherein the nominal tariff rates
on imports of manufactured goods are higher than the nominal tariff rates on
intermediate inputs and raw materials, i.e.the tariff on a product increases as that
product moves through the value-added chain.
 A prohibitive tariff is one that is set so high that no imports will enter.
 Trigger-price mechanisms are quick responses of affected importing countries upon

confirmation of trade distortion to offset the distortion. E.g. Anti-dumping duties.
 Dumping occurs when manufacturers sell goods in a foreign country below the sales
prices in their domestic market or below their full average cost of the product. It
hurts domestic producers.
 Anti-dumping measures are additional import duties so as to offset the foreign

firm's unfair price advantage.
 Countervailing duties are tariffs to offset the artificially low prices charged by
exporters who enjoy export subsidies and tax concessions offered by the governments
in their home country.
 Tariff barriers create obstacles to trade, reduce the prospect of market access, make
imported goods more expensive, increase consumption of domestic goods, protect
domestic industries and increase government revenues
 Non-tariff measures (NTMs) are policy measures, other than ordinary customs
tariffs, that can potentially have an economic effect on international trade in goods,
changing quantities traded or prices or both
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 Technical Barriers to Trade (TBT) are ‘Standards and Technical Regulations’ that
define the specific characteristics that a product should have, such as its size,
shape, design, labelling / marking / packaging, functionality or performance and
production methods, excluding measures covered by the SPS Agreement.
 Non-technical measures relate to trade requirements; for example; shipping

requirements, custom formalities, trade rules, taxation policies, etc.
 SPS measures are applied to protect human, animal or plant life from risks arising
from additives, pests, contaminants, toxins or disease-causing organisms and to
protect biodiversity
 An import quota is a direct restriction which specifies that only a certain physical
amount of the good will be allowed into the country during a given time period,
usually one year.
 The objective of financial measures is to increase import costs by regulating the

access to and cost of foreign exchange for imports and to define the terms of
payment.
 Government procurement policies may interfere with trade if they involve mandates
that the whole of a specified percentage of purchases should be from domestic
firms rather than from foreign firms
 In the case of investments, local content requirements that mandate that a specified
fraction of a final good be produced domestically may act as a trade barrier.
 Rules of origin are the criteria needed by governments of importing countries to

determine the national source of a product.
 Safeguard measures are initiated by countries to temporarily restrict imports of a

product its domestic industry is injured by the surge in imports while an embargo is
a total ban imposed by government on import or export of some or all commodities
to particular country or region for a specified or indefinite period.
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 An export tax is a tax collected on exported goods and may be either specific or ad
valorem. An export subsidy includes financial contribution to domestic producers in
the form of grants, loans, equity infusions or some form of income or price support.
Both distort trade.
 Voluntary Export Restraints (VERs) refer to a type of informal quota administered

by an exporting country voluntarily restraining the quantity of goods that can be
exported out of that country during a specified period of time. It is imposed based on
negotiations to appease the importing country and to avoid the effects of possible
trade restraints.
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UNIT 3: TRADE NEGOTIATIONS
1. INTRODUCTION
The recent years have seen intense bilateral and multilateral negotiations among
different nations in the international arena. India, for example, has already become
part of 19 such concluded agreements and is currently negotiating more than two
dozens of such proposals. Major events in the year 2020, such as Britain’s exit from
the European Union, the new free trade agreement [which is a successor of the North
American Free Trade Agreement (NAFTA)] concluded between Canada, Mexico, and
United States, namely United States–Mexico–Canada Agreement (USMCA) and many
other unpredictable developments in the trade front due to trade war between the
US and China and the global pandemic, make trade negotiations a highly relevant
area of study.
National governments are not the sole stakeholders in a trade negotiation.

Many interest groups, lobbying groups, pressure groups and Non-Governmental
Organizations (NGO) exert their influence on the process. As anyone can guess, the
positions taken by each of the negotiating parties would represent their underlying
agenda of interests. For example, in trade negotiations, when one of the parties
seems to be bargaining for market access through reduction in tariffs, the other (s)
may be clamouring on the issue of possible grant of protection to domestic industries.
Before we go into the discussion on multilateral trade negotiations and the related
institutions, it is relevant to understand the nature of regional as well as free trade
agreements which evolve through negotiations.
2. TAXONOMY OF REGIONAL TRADE AGREEMENTS (RTAS)

Regional Trade Agreements (RTAs) are defined as groupings of countries (not
necessarily belonging to the same geographical region), which are formed with the
objective of reducing barriers to trade between member countries. In other words, a
regional trade agreement (RTA) is a treaty between two or more governments that
define the rules of trade for all signatories. As of 1 February 2021, 339 RTAs were
in force.
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Trade negotiations result in different types of agreements which are shown in the
chart below-
1. Unilateral trade agreements under which an importing country offers trade incentives
in order to encourage the exporting country, to engage in international economic
activities that will improve the exporting country’s economy. E.g. Generalized System
of Preferences.
2. Bilateral Agreements are agreements that set rules of trade between two countries,
two blocs or a bloc and a country. These may be limited to certain goods and services
or certain types of market entry barriers. E.g. EU-South Africa Free Trade Agreement;
ASEAN–India Free Trade Area.
3. Regional Preferential Trade Agreements among a group of countries reduce trade

barriers on a reciprocal and preferential basis for only the members of the group.
E.g. Global System of Trade Preferences among Developing Countries (GSTP)
4. Trading Bloc has a group of countries that have a free trade agreement between
themselves and may apply a common external tariff to other countries. Example:
Arab League (AL), European Free Trade Association (EFTA)
5. Free-trade area is a group of countries that eliminate all tariff and quota barriers
on trade with the objective of increasing exchange of goods with each other. The
trade among the member states flows tariff free, but the member states maintain
their own distinct external tariff with respect to imports from the rest of the world.
In other words, the members retain independence in determining their tariffs with
non-members. Example: The ASEAN–India Free Trade Area (AIFTA) is a free trade
area among the ten member states of the Association of Southeast Asian Nations
(ASEAN) and India. it came into force on 1 August 2005
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6. A customs union is a group of countries that eliminate all tariffs on trade among
themselves but maintain a common external tariff on trade with countries outside
the union (thus, technically violating MFN). The common external tariff which
distinguishes a customs union from a free trade area implies that, generally, the
same tariff is charged wherever a member imports goods from outside the customs
union. The EU is a Customs Union; its 27 member countries form a single territory
for customs purposes. Other examples are Gulf Cooperation Council (GCC), Southern
Common Market (MERCOSUR).
7. Common Market: A Common Market deepens a customs union by providing for the
free flow of output and of factors of production (labour, capital and other productive
resources) by reducing or eliminating internal tariffs on goods and by creating a
common set of external tariffs. The member countries attempt to harmonize some
institutional arrangements and commercial and financial laws and regulations
among themselves. There are also common barriers against non-members (e.g., EU,
ASEAN)
8. Economic and Monetary Union: For a common market, the free transit of goods and
services through the borders increases the need for foreign exchange operations and
results in higher financial and administrative expenses of firms operating within
the region. The next stage in the integration sequence is formation of some form of
monetary union. In an Economic and Monetary Union, the members share a common
currency. Adoption of common currency also makes it necessary to have a strong
convergence in macroeconomic policies. For example, the European Union countries
implement and adopt a single currency.
There has been significant growth in international trade since the end of the
Second World War, mostly due to the multilateral trade system which is both a
political process and a set of political institutions. It is a political process because
it is based on negotiations and bargaining among sovereign governments based
on which they arrive at rules governing trade between or among themselves. The
political institutions that facilitate trade negotiations, and support international
trade cooperation by providing the rules of the game have been the former General
Agreements on Tariffs and Trade (GATT) and the World Trade Organization (WTO).
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3. THE GENERAL AGREEMENT ON TARIFFS AND TRADE (GATT)

The General Agreement on Tariffs and Trade (GATT) covers international trade in
goods. The workings of the GATT agreement are the responsibility of the Council
for Trade in Goods (Goods Council) which is made up of representatives from all
WTO member countries. The Goods Council has 10 committees dealing with specific
subjects (such as agriculture, market access, subsidies, anti-dumping measures, and
so on). Again, these committees consist of all member countries.
Also reporting to the Goods Council are a working party on state trading enterprises,
and the Information Technology Agreement (ITA) Committee.
The GATT lost its relevance by the 1980s because
• it was obsolete to the fast-evolving contemporary complex world trade scenario
characterized by emerging globalisation
• international investments had expanded substantially
• intellectual property rights and trade in services were not covered by GATT
• world merchandise trade increased by leaps and bounds and was beyond its
scope.
• the ambiguities in the multilateral system could be heavily exploited
• efforts at liberalizing agricultural trade were not successful
• there were inadequacies in institutional structure and dispute settlement
system
• it was not a treaty and therefore terms of GATT were binding only insofar as
they are not incoherent with a nation’s domestic rules.
4 THE URUGUAY ROUND AND THE ESTABLISHMENT OF WTO

The need for a formal international organization which is more powerful and
comprehensive was felt by many countries by late 1980s.Having settled the most
ambitious negotiating agenda that covered virtually every outstanding trade policy
issue, the Uruguay Round brought about the biggest reform of the world’s trading
system. Members established 15 groups to work on limiting restrictions in the areas
of tariffs, non-tariff barriers, tropical products, natural resource products, textiles
and clothing, agriculture, safeguards against sudden ‘surges’ in imports, subsidies,
countervailing duties, trade related intellectual property restrictions, trade related
investment restrictions, services and four other areas dealing with GATT itself, such
as, the GATT system, dispute settlement procedures and implementation of the NTB
Codes of the Tokyo Round, especially on anti-dumping. The Round started in Punta
del Este in Uruguay in September 1986 and was scheduled to be completed by
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December 1990. However, due to many differences and especially due to heated
controversies over agriculture, no consensus was arrived at. Finally, in December
1993, the Uruguay Round, the eighth and the most ambitious and largest ever
round of multilateral trade negotiations in which 123 countries participated, was
completed after seven years of elaborate negotiations. The agreement was signed
by most countries on April 15, 1994, and took effect on July 1, 1995. It also marked
the birth of the World Trade Organization (WTO) which is the single institutional
framework encompassing the GATT, as modified by the Uruguay Round.
5. THE WORLD TRADE ORGANIZATION (WTO)

The World Trade Organization (WTO) is the only global international organization
dealing with the rules of trade between nations. At its heart are the WTO agreements,
negotiated and signed by the bulk of the world’s trading nations and ratified in
their parliaments. The goal is to ensure that trade flows as smoothly, predictably,
and freely as possible. The principal objective of the WTO is to facilitate the flow of
international trade smoothly, freely, fairly, and predictably.
The WTO has six key objectives:

1. to set and enforce rules for international trade,
2. to provide a forum for negotiating and monitoring further trade liberalization,
3. to resolve trade disputes,
4. to increase the transparency of decision-making processes,
5. to cooperate with other major international economic institutions involved in
global economic management, and
6. to help developing countries benefit fully from the global trading system.
The objectives of the WTO Agreements as acknowledged in the preamble of the

Agreement creating the World Trade Organization, include “raising standards of
living, ensuring full employment and a large and steadily growing volume of real
income and effective demand, and expanding the production of and trade in goods
and services. The WTO, whose primary purpose is to open trade for the benefit of
all, does its functions by acting as a forum for trade negotiations among member
governments, administering trade agreements, reviewing national trade policies,
assisting developing countries in trade policy issues, through technical assistance
and training programmes and cooperating with other international organizations.
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 The Structure of the WTO

The WTO activities are supported by a Secretariat located in Geneva, headed
by a Director General. It has a three-tier system of decision making. The WTO’s
top-level decision-making body is the Ministerial Conference which can take
decisions on all matters under any of the multilateral trade agreements.
The Ministerial Conference meets at least once every two years. The next
level is the General Council which meets several times a year at the Geneva
headquarters. The General Council also meets as the Trade Policy Review Body
and the Dispute Settlement Body. At the next level, the Goods Council, Services
Council and Intellectual Property (TRIPS) Council report to the General Council.
These councils are responsible for overseeing the implementation of the WTO
agreements in their respective areas of specialisation. The WTO Secretariat
maintains working relations with almost 200 international organisations in
activities ranging from statistics, research, standard-setting, and technical
assistance and training. Numerous specialized committees, working groups and
working parties deal with the individual agreements and other areas such as
the environment, development, membership applications and regional trade
agreements.
The WTO accounting for about 95% of world trade currently has 164 members,
of which 117 are developing countries or separate customs territories. Around
24 others are negotiating membership. The WTO’s agreements have been
ratified in all members’ parliaments.
 The Guiding Principles of World Trade Organization (WTO)

Right from its inception, the WTO has been driven by a number of fundamental
principles which are the foundations of the multilateral trading system.
Following are the major guiding principles:
Trade without discrimination
1. Most-favoured-nation (MFN): treating other people equally Under the
WTO agreements, countries cannot normally discriminate between their
trading partners. Grant someone a special favour (such as a lower customs
duty rate for one of their products) and you have to do the same for all
other WTO members.
This principle is known as most-favoured-nation (MFN) treatment (see
box). It is so important that it is the first article of the General Agreement
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on Tariffs and Trade (GATT), which governs trade in goods. MFN is also a
priority in the General Agreement on Trade in Services (GATS) (Article 2) and
the Agreement on Trade-Related Aspects of Intellectual Property Rights
(TRIPS) (Article 4), although in each agreement the principle is handled
slightly differently. Together, those three agreements cover all three main
areas of trade handled by the WTO.
Some exceptions are allowed. For example, countries can set up a free
trade agreement that applies only to goods traded within the group —
discriminating against goods from outside. Or they can give developing
countries special access to their markets. Or a country can raise barriers
against products that are considered to be traded unfairly from specific
countries. And in services, countries are allowed, in limited circumstances,
to discriminate. But the agreements only permit these exceptions under
strict conditions. In general, MFN means that every time a country lowers
a trade barrier or opens up a market, it has to do so for the same goods
or services from all its trading partners — whether rich or poor, weak or
strong.
2. National treatment: Treating foreigners and locals equally Imported and
locallyproduced goods should be treated equally — at least after the
foreign goods have entered the market. The same should apply to foreign
and domestic services, and to foreign and local trademarks, copyrights
and patents. This principle of “national treatment” (giving others the same
treatment as one’s own nationals) is also found in all the three main WTO
agreements (Article 3 of GATT, Article 17 of GATS and Article 3 of TRIPS),
although once again the principle is handled slightly differently in each of
these.
National treatment only applies once a product, service or item of
intellectual property has entered the market. Therefore, charging customs
duty on an import is not a violation of national treatment even if locally-
produced products are not charged an equivalent tax. 3.5.3 Overview of
the WTO agreements.
Freer trade: gradually, through negotiation

Lowering trade barriers is one of the most obvious means of encouraging
trade. The barriers concerned include customs duties (or tariffs) and
measures such as import bans or quotas that restrict quantities selectively.
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From time to time other issues such as red tape and exchange rate policies
have also been discussed.
The WTO agreements allow countries to introduce changes gradually,
through “progressive liberalization”. Developing countries are usually
given longer to fulfil their obligations.
Predictability: through binding and transparency

Sometimes, promising not to raise a trade barrier can be as important
as lowering one, because the promise gives businesses a clearer view of
their future opportunities. With stability and predictability, investment is
encouraged, jobs are created and consumers can fully enjoy the benefits
of competition — choice and lower prices.
In the WTO, when countries agree to open their markets for goods or
services, they “bind” their commitments. For goods, these bindings amount
to ceilings on customs tariff rates. Sometimes countries tax imports at
rates that are lower than the bound rates. Frequently this is the case in
developing countries. In developed countries, the rates actually charged
and the bound rates tend to be the same.
A country can change its bindings, but only after negotiating with its trading
partners, which could mean compensating them for loss of trade. One of
the achievements of the Uruguay Round of multilateral trade talks was to
increase the amount of trade under binding commitments. In agriculture,
100% of products now have bound tariffs. The result of all this: is a
substantially higher degree of market security for traders and investors.
The system tries to improve predictability and stability in other ways as
well. One way is to discourage the use of quotas and other measures
used to set limits on quantities of imports — administering quotas can
lead to more red-tape and accusations of unfair play. Another is to make
countries’ trade rules as clear and public (“transparent”) as possible.
Many WTO agreements require governments to disclose their policies and
practices publicly within the country or by notifying the WTO. The regular
surveillance of national trade policies through the Trade Policy Review
Mechanism provides a further means of encouraging transparency both
domestically and at the multilateral level.
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Promoting fair competition

The WTO is sometimes described as a “free trade” institution, but that
is not entirely accurate. The system does allow tariffs and, in limited
circumstances, other forms of protection. More accurately, it is a system of
rules dedicated to open, fair, and undistorted competition.
The rules on non-discrimination — MFN and national treatment — are

designed to secure fair conditions of trade. So too are those on dumping
(exporting at below cost to gain market share) and subsidies. The issues
are complex, and the rules try to establish what is fair or unfair, and how
governments can respond, in particular by charging additional import
duties calculated to compensate for damage caused by unfair trade.
Many of the other WTO agreements aim to support fair competition: in

agriculture, intellectual property, services, for example. The agreement on
government procurement (a “plurilateral” agreement because it is signed
by only a few WTO members) extends competition rules to purchases by
thousands of government entities in many countries. And so on.
Encouraging development and economic reform

The WTO system contributes to development. On the other hand,
developing countries need flexibility in the time they take to implement the
system’s agreements. And the agreements themselves inherit the earlier
provisions of GATT that allow for special assistance and trade concessions
for developing countries.
Over three-quarters of WTO members are developing countries and

countries in transition to market economies. During the seven and a half
years of the Uruguay Round, over 60 of these countries implemented trade
liberalization programmes autonomously. At the same time, developing
countries and transition economies were much more active and influential
in the Uruguay Round negotiations than in any previous round, and they
are even more so in the current Doha Development Agenda.
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At the end of the Uruguay Round, developing countries were prepared to

take on most of the obligations that are required of developed countries.
But the agreements did give them transition periods to adjust to the more
unfamiliar and, perhaps, difficult WTO provisions — particularly so for the
poorest, “least-developed” countries. A ministerial decision adopted at the
end of the round says better-off countries should accelerate implementing
market access commitments on goods exported by the least-developed
countries, and it seeks increased technical assistance for them. More
recently, developed countries have started to allow dutyfree and quota-
free imports for almost all products from least-developed countries. On
all of this, the WTO and its members are still going through a learning
process. The current Doha Development Agenda includes developing
countries’ concerns about the difficulties they face in implementing the
Uruguay Round agreements.
WTO Agreements
The WTO agreements cover goods, services and intellectual property and
the permitted exceptions. These agreements are often called the WTO’s
trade rules, and the WTO is often described as “rules-based”, a system
based on rules. (The rules are actually agreements that the governments
negotiated).
Following are the important agreements under WTO. Since a thorough

discussion on the features of each agreement is beyond the scope of this
unit, only the major provisions are given below:
1. Agreement on Agriculture aims at strengthening GATT disciplines
and improving agricultural trade. It includes specific and binding
commitments made by WTO Member governments in the three areas
of market access, domestic support and export subsidies.
2. Agreement on the Application of Sanitary and Phytosanitary (SPS)

Measures establishes multilateral frameworks for the planning,
adoption and implementation of sanitary and phytosanitary
measures to prevent such measures from being used for arbitrary
or unjustifiable discrimination or for camouflaged restraint on
international trade and to minimize their adverse effects on trade.
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3. Agreement on Textiles and Clothing replaced the Multi-Fibre Arrangement

(MFA) which was prevalent since 1974 and entailed import protection
policies. ATC provides that textile trade should be deregulated by
gradually integrating it into GATT disciplines over a 10-year transition
period.
4. Agreement on Technical Barriers to Trade (TBT) aims to prevent standards

and conformity assessment systems from becoming unnecessary
trade barriers by securing their transparency and harmonization with
international standards. Often excessive standards or misuse of standards
in respect of manufactured goods, and safety/environment regulations
act as trade barriers.
5. Agreement on Trade-Related Investment Measures (TRIMs) expands

disciplines governing investment measures in relation to cross-border
investments. It stipulates that countries receiving foreign investments
shall not impose investment measures such as requirements, conditions
and restrictions inconsistent with the provisions of the principle of
national treatment and general elimination of quantitative restrictions.
For example: measures such as local content requirements and trade
balancing requirements should not be applied on investing corporations.
6. Anti-Dumping Agreement seeks to tighten and codify disciplines for

calculating dumping margins and conducting dumping investigations,
etc. in order to prevent anti-dumping measures from being abused or
misused to protect domestic industries.
7. Customs Valuation Agreement specifies rules for more consistent and

reliable customs valuation and aims to harmonize customs valuation
systems on an international basis by eliminating arbitrary valuation
systems.
8. Agreement on Pre-shipment Inspection (PSI) intends to secure

transparency of preshipment inspection wherein a company designated
by the importing country conducts inspection of the quality, volume,
price, tariff classification, customs valuation, etc. of merchandise in the
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territory of the exporting country on behalf of the importing country’s

custom office and issues certificates. The agreement also provides for
a mechanism for the solution of disputes between PSI agencies and
exporters.
9. Agreement on Rules of Origin provides for the harmonization of rules

of origin for application to all non-preferential commercial policy
instruments. It also provides for dispute settlement procedures and
creates the rules of origin committee.
10. Agreement on Import Licensing Procedures relates to simplification

of administrative procedures and to ensure their fair operation so
that import licensing procedures of different countries may not act as
trade barriers.
11. Agreement on Subsidies and Countervailing Measures aims to clarify

definitions of subsidies, strengthen disciplines by subsidy type and to
strengthen and clarify procedures for adopting countervailing tariffs.
12. Agreement on Safeguards clarify disciplines for requirements and

procedures for imposing safeguards and related measures which are
emergency measures to restrict imports in the event of a sudden surge
in imports.
13. General Agreement on Trade in Services (GATS): This agreement

provides the general obligations regarding trade in services, such as
most- favoured-nation treatment and transparency. In addition, it
enumerates service sectors and stipulates that in the service sectors for
which it has made commitments, a member country cannot maintain
or introduce market access restriction measures and discriminatory
measures that are severer than those that were committed during the
negotiations.
14. Agreement on Trade-Related Aspects of Intellectual Property Rights

(TRIPS): This agreement stipulates most-favoured-nation treatment
and national treatment for intellectual properties, such as copyright,
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trademarks, geographical indications, industrial designs, patents, IC

layout designs and undisclosed information. In addition, it requires
member countries to maintain high levels of intellectual property
protection and to administer a system of enforcement of such rights.
It also stipulates procedures for the settlement of disputes related to
the agreement.
15. Trade Policy Review Mechanism (TPRM) provides the procedures for
the trade policy review mechanism to conduct periodical reviews of
members’ trade policies and practices conducted by the Trade Policy
Review Body (TPRB).
16. Plurilateral Trade Agreements: Multilateral negotiations are those

negotiations involving the entire WTO contracting parties. The
Plurilateral trade agreements involve several countries with a
common interest but do not involve all WTO countries. Not all the
plurilateral agreements are negotiated within the WTO framework.
All the above-mentioned agreements entered into by the members

are not static; they are renegotiated from time to time and new
agreements evolve from negotiations. Example: Many agreements
were negotiated under the Doha Development Agenda, launched by
WTO trade ministers in Doha, Qatar, in November 2001.
6. THE DOHA ROUND

The Doha Round, formally the Doha Development Agenda, which is the ninth round
since the Second World War was officially launched at the WTO’s Fourth Ministerial
Conference in Doha, Qatar, in November 2001. The round seeks to accomplish major
modifications of the international trading system through lower trade barriers and
revised trade rules. The negotiations include 20 areas of trade, including agriculture,
services trade, market access for non-agricultural products (NAMA), trade in services,
trade facilitation, environment, geographical indications and certain intellectual
property issues. The most controversial topic in the Doha Agenda was agriculture
trade.
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7. G 20 ECONOMIES: FACILITATING TRADE

While some trade-restrictive measures have been lifted by G20 countries, the report
indicates that the trend has been going in the wrong direction. Export restrictions
contribute to shortages, price volatility, and uncertainty. G20 economies must build
on their collective pledges from the 12th Ministerial Conference and demonstrate
leadership to keep markets open and predictable, so that food and fertilizer in
particular can flow to where they are needed,” said WTO Director-General Ngozi
Okonjo-Iweala, who will be attending the G20 Leaders' Summit in Bali, Indonesia,
on 15-16 November.
The report indicates that supply chains on the whole have thus far proved to
be resilient, despite the war in Ukraine, the continuing impacts of the COVID-19
pandemic, the highest inflation many countries have experienced in decades, and
the impacts of monetary tightening by central banks seeking to limit price increases.
That said, specific industries and regions have been differently impacted.
Overall, the pace of implementation of new export restrictions by WTO members

has increased since 2020, first in the context of the pandemic and subsequently with
the war in Ukraine and the food crisis. Some of these export restrictions have been
gradually lifted, but several still remain in place.
As of mid-October 2022, WTO members still had in place 52 export restrictions on

food, feed and fertilizers, in addition to 27 export restrictions on products essential
to combat COVID-19. Of these, 44% of the export restrictions on food, feed and
fertilizers, and 63% of the pandemic-related export restrictions, were maintained by
G20 economies.
During the review period, G20 economies introduced 66 new trade-facilitating

measures (covering trade worth USD 451.8 billion) and 47 trade-restrictive measures
on goods (with a trade coverage of USD 160.1 billion). These measures were not
related to the pandemic.
At the same time, the accumulated stockpile of G20 import restrictions continued
to grow. By mid-October, 11.6% of G20 imports were affected by trade-restricting
measures implemented since 2009 and still in force.
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Initiations of trade remedy investigations by G20 economies declined sharply during

the review period (17 initiations), after a peak in 2020 that was the highest since
the beginning of the trade monitoring exercise in 2009. Anti-dumping measures
continued to be the most frequent trade remedy action in terms of initiations and
terminations.
Similarly, the implementation of new COVID-19-related trade measures by G20

economies decelerated over the past five months, with four new such measures
recorded on goods and one on services. The number of new COVID-19-related
support measures to mitigate the social and economic impacts of the pandemic also
fell sharply over the past five months.
Since the beginning of the pandemic, 201 COVID-19 trade and trade-related
measures in goods were implemented by G20 economies. Most (61%) were trade
facilitating, while the rest (39%) could be considered trade restrictive.
G20 economies also continued to phase out pandemic-related import and export
measures. By mid-October 2022, 77% of export restrictions had been repealed,
leaving 17 restrictions in place. Although the number of the pandemic-related trade
restrictions in place decreased, their trade coverage remained significant, at USD
122.0 billion.
The WTO trade monitoring reports have been prepared by the WTO Secretariat since
2009. G20 members are: Argentina; Australia; Brazil; Canada; China; the European
Union; France; Germany; India; Indonesia; Italy; Japan; the Republic of Korea; Mexico;
the Russian Federation; Saudi Arabia; South Africa; Türkiye; the United Kingdom; and
the United States.
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1. Which of the following culminated in the establishment of the World Trade Organi-
zation?
(a) The Doha Round (b) The Tokyo Round
(c) The Uruguay Round (d) The Kennedy Round

(a) The GATT was meant to prevent exploitation of poor countries by richer coun-
tries
(b) The GATT dealt with trade in goods only, while, the WTO covers services as well
as intellectual property.
(c) All members of the World Trade Organization are required to avoid tariffs of all
types
(d) All the above
3. The ‘National treatment’ principle stands for

(a) the procedures within the WTO for resolving disagreements about trade policy
among countries
(b) the principle that imported products are to be treated no worse in the domestic
market than the local ones
(c) exported products are to be treated no worse in the domestic market than the
local ones
(d) imported products should have the same tariff, no matter where they are im-
ported from
4. ‘Bound tariff’ refers to

(a) clubbing of tariffs of different commodities into one common measure
(b) the lower limit of the tariff below which a nation cannot be taxing its imports
(c) the upper limit on the tariff that a country can levy on a particular good, ac-
cording to its commitments under the GATT and WTO.
(d) the limit within which the country’s export duty should fall so that there are
cheaper exports
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5. The essence of ‘MFN principle’ is

(a) equality of treatment of all member countries of WTO in respect of matters
related to trade
(b) favour one, country, you need to favour all in the same manner
(c) every WTO member will treat all its trading partners equally without any prej-
udice and discrimination
(d) all the above
6. The World Trade Organization (WTO)

(a) has now been replaced by the GATT
(b) has an inbuilt mechanism to settle disputes among members
(c) was established to ensure free and fair trade internationally.
(d) (b) and c) above
7. The Agreement on Agriculture includes explicit and binding commitments made by

WTO Member governments
(a) on increasing agricultural productivity and rural development
(b) market access and agricultural credit support
(c) market access, domestic support and export subsidies
(d) market access, import subsidies and export subsidies
8. The Agreement on Textiles and Clothing

(a) provides that textile trade should be deregulated gradually and the tariffs
should be increased
(b) replaced the Multi-Fiber Arrangement (MFA) which was prevalent since 1974
(c) granted rights of textile exporting countries to increase tariffs to protect their
domestic textile industries
(d) stipulated that tariffs in all countries should be the same
9. The Agreement on Trade-Related Aspects of Intellectual Property Rights

(a) stipulates to administer a system of enforcement of intellectual property rights.
(b) provides for most-favoured-nation treatment and national treatment for in-
tellectual properties
(c) mandates to maintain high levels of intellectual property protection by all
members
(d) all the above
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10. The most controversial topic in the yet to conclude Doha Agenda is
(a) trade in manufactured goods
(b) trade in intellectual property rights-based goods
(c) trade in agricultural goods
(d) market access to goods from developed countries
11. The WTO commitments

(a) affect developed countries adversely because they have comparatively less
agricultural goods
(b) affect developing countries more because they need to make radical
adjustments
(c) affect both developed and developing countries equally
(d) affect none as they increase world trade and ensure prosperity to all
ANSWERS:
1 (c) 2 (b) 3 (b) 4 (c) 5 (d) 6 (d)
7 (c) 8 (b) 9 (d) 10 (c) 11 (b)
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SUMMARY
 International trade negotiations, especially the ones aimed at formulation of

international trade rules, are complex interactive processes engaged in by countries
having competing objectives.
 Regional Trade Agreements (RTAs) are defined as groupings of countries (not

necessarily belonging to the same geographical region) which are formed with the
objective of reducing barriers to trade between member countries.
 Trade negotiations result in different types of agreements, namely: unilateral trade

agreements, bilateral agreements, regional preferential trade agreements, trading
bloc, free-trade area, customs union, common market and economic and monetary
union.
 The General Agreement on Tariffs and Trade (GATT) provided the rules for most of
the world trade for 47 years, from 1948 to 1994.
 Eight multilateral negotiations known as “trade rounds ”held under the auspices
GATT resulted in substantial international trade liberalization.
 The eighth of the Uruguay Round of 1986-94, was the last and most consequential
of all rounds and culminated in the birth of WTO and a new set of agreements
replacing the General Agreement on Tariffs and Trade (GATT).
 The principal objective of the WTO is to facilitate the flow of international trade
smoothly, freely, fairly and predictably.
 The WTO does its functions by acting as a forum for trade negotiations among
member governments, administering trade agreements, reviewing national
trade policies, cooperating with other international organizations and assisting
developing countries in trade policy issues through technical assistance and training
programmes.
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 The WTO activities are supported by the Secretariat located in Geneva, headed by
a Director General. It has a three-tier system of decision making. The top-level
decisionmaking body is the Ministerial Conference, followed by councils namely, the
General Council and the Goods Council, Services Council and Intellectual Property
(TRIPS) Council.
 The WTO, accounting for about 95% of world trade, currently has 164 members, of
which 117 are developing countries or separate customs territories.
 The major guiding principles of the WTO are trade without discrimination,
mostfavoured-nation treatment (MFN), the national treatment principle (NTP),
free trade, predictability, general prohibition of quantitative restrictions, greater
competitiveness, tariffs as legitimate measures for protection, transparency in decision
making, progressive liberalization, market access and a transparent, effective and
verifiable dispute settlement mechanism.
 The important agreements under WTO are on agriculture, (SPS) measures, textiles and
clothing, technical barriers to trade (TBT), trade-related investment measures (TRIMs),
anti-dumping, customs valuation, pre-shipment inspection (PSI) , rules of origin,
import licensing procedures, subsidies and countervailing measures , safeguards,
trade in services (GATS), intellectual property rights (TRIPS), settlement of disputes
(DSU), trade policy review mechanism (TPRM) and plurilateral trade agreements on
trade in civil aircraft and government procurement.
 The Doha Round, formally the Doha Development Agenda, which is the ninth round
since the Second World War was officially launched at the WTO’s Fourth Ministerial
Conference in Doha, Qatar, in November 2001.
 The major issues related to the WTO are in respect of slow progress of multilateral
negotiations, uncertainties resulting from regional trade agreements, inadequate or
negligible trade liberalisation, and those which are specific to the developing countries,
namely, protectionism and lack of willingness among developed countries to provide
market access, difficulties that they face in implementing the present agreements,
apparent north-south divide, exceptionally high tariffs, tariff escalation, erosion of
preferences and difficulties with regards to adjustments.
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UNIT 4: EXCHANGE RATE AND ITS ECONOMIC EFFECTS
1. INTRODUCTION
Each day we get fascinating news about the currency which fuel our curiosity, such
as Rupee gains 12 paise against US dollar, Dollar Spot/Forward Rates plummet,
Rupee down, Euro holds steady, Pound strengthens etc. Ever wondered what this
jargon mean? We shall try to understand a few fundamentals related to currency
transactions in this unit.
In chapter 3, we examined the demand for and supply of domestic currency. It is not
domestic currency alone that we need. Households, businesses and governments
in India, for example, buy different types of goods and services produced in other
countries. Similarly, residents of the rest of the world buy goods and services from
residents in India. Foreign investors, businesses, and governments invest in our
country, just as our nationals invest in other countries. In the same way, lending, and
borrowing also take place internationally. These and similar other transactions give
rise to an international dimension of money, which involves exchange of one currency
for another. Obviously, this entails market transactions involving the determination
of price of one currency in terms of another.
2. THE EXCHANGE RATE

A foreign currency transaction is a transaction that is denominated in or requires
settlement in a foreign currency, including transactions arising when an enterprise either:
(a) buys or sells goods or services whose price is denominated in a foreign
currency.
(b) borrows or lends funds when the amounts payable or receivable are
denominated in a foreign currency.
(c) becomes a party to an unperformed forward exchange contract; or
(d) otherwise acquires or disposes of assets, or incurs or settles liabilities,
denominated in a foreign currency.
3. THE EXCHANGE RATE REGIMES

Exchange rates are determined by demand and supply. But governments can
influence those exchange rates in various ways. The extent and nature of government
involvement in currency markets define alternative systems of exchange rates.
331
In this section, we will examine somecommon systems and explore some of their
macroeconomic implications.
There are three broad categories of exchange rate systems. In one system, exchange
rates are set purely by private market forces with no government involvement. Values
change constantly as the demand for and supply of currencies fluctuate. In another
system, currency values are allowed to change, but governments participate in
currency markets in an effort to influence those values. Finally, governments may
seek to fix the values of their currencies, either through participation in the market
or through regulatory policy.
An exchange rate regime is the system by which a country manages its currency
with respect to foreign currencies. It refers to the method by which the value of the
domestic currency in terms of foreign currencies is determined. There are two major
types of exchange rate regimes at the extreme ends; namely:
(i) floating exchange rate regime (also called a flexible exchange rate), and
(ii) fixed exchange rate regime
In a free-floating exchange rate system, governments and central banks do not

participate in the market for foreign exchange. The relationship between governments
and central banks on the one hand and currency markets on the other is much
the same as the typical relationship between these institutions and stock markets.
Governments may regulate stock markets to prevent fraud, but stock values
themselves are left to float in the market.
A free-floating system has the advantage of being self-regulating. There is no

need for government intervention if the exchange rate is left to the market. Market
forces also restrain large swings in demand or supply. Suppose, for example, that a
dramatic shift in world preferences led to a sharply increased demand for goods and
services produced in Canada.
This would increase the demand for Canadian dollars, raise Canada’s exchange rate,
and make Canadian goods and services more expensive for foreigners to buy. Some
of the impact of the swing in foreign demand would thus be absorbed in a rising
exchange rate. In effect, a freefloating exchange rate acts as a buffer to insulate an
economy from the impact of international events.
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The primary difficulty with free-floating exchange rates lies in their unpredictability.
Contracts between buyers and sellers in different countries must not only reckon with
possible changes in prices and other factors during the lives of those contracts, they
must also consider the possibility of exchange rate changes. An agreement by an
Indian distributor to purchase a certain quantity of US goods each year, for example,
will be affected by the possibility that the exchange rate between the Indian rupee
and the U.S. dollar will change while the contract is in effect. Fluctuating exchange
rates make international transactions riskier and thus increase the cost of doing
business with other countries.
Managed Float Systems

Governments and central banks often seek to increase or decrease their exchange
rates by buying or selling their own currencies. Exchange rates are still free to
float, but governments try to influence their values. Government or central bank
participation in a floating exchange rate system is called a managed float.
Countries that have a floating exchange rate system intervene from time to time in
the currency market in an effort to raise or lower the price of their own currency.
Typically, the purpose of such intervention is to prevent sudden large swings in the
value of a nation’s currency. Such intervention is likely to have only a small impact,
if any, on exchange rates.
Still, governments or central banks can sometimes influence their exchange rates.
Suppose the price of a country’s currency is rising very rapidly. The country’s
government or central bank might seek to hold off further increases in order to
prevent a major reduction in net exports. An announcement that a further increase
in its exchange rate is unacceptable, followed by sales of that country’s currency by
the central bank in order to bring its exchange rate down, can sometimes convince
other participants in the currency market that the exchange rate will not rise further.
That change in expectations could reduce demand for and increase the supply of the
currency, thus achieving the goal of holding the exchange rate down.
Fixed Exchange Rates

In a fixed exchange rate system, the exchange rate between two currencies is set by
government policy. There are several mechanisms through which fixed exchange
rates may
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be maintained. Whatever the system for maintaining these rates, however, all fixed
exchange rate systems share some important features.
In an open economy, the main advantages of a fixed rate regime are:
(i) A fixed exchange rate avoids currency fluctuations and eliminates exchange
rate risks and transaction costs that can impede international flow of trade
and investments.
International trade and investment are less risky under fixed rate regime as
profits are not affected by the exchange rate fluctuations.
(ii) A fixed exchange rate can thus, greatly enhance international trade and
investment.
(iii) A reduction in speculation on exchange rate movements if everyone believes
that exchange rates will not change.
(iv) A fixed exchange rate system imposes discipline on a country’s monetary
authority and therefore is more likely to generate lower levels of inflation.
(v) The government can encourage greater trade and investment as stability
encourages investment.
(vi) Exchange rate peg can also enhance the credibility of the country’s monetary
-policy.
(vii) However, in the fixed or managed floating exchange rate regimes (where the
market forces are allowed to determine the exchange rate within a band), the
central bank is required to stand ready to intervene in the foreign exchange
market and, also to maintain an adequate amount of foreign exchange reserves
for this purpose.
Basically, the free floating or flexible exchange rate regime is argued to be efficient
and highly transparent as the exchange rate is free to fluctuate in response to the
supply of and demand for foreign exchange in the market and clears the imbalances
in the foreign exchange market without any control of the central bank or the
monetary authority. A floating exchange rate has many advantages:
(i) A floating exchange rate has the greatest advantage of allowing a Central
bank and/or government to pursue its own independent monetary policy.
(ii) Floating exchange rate regime allows exchange rate to be used as a policy tool:
for example, policy-makers can adjust the nominal exchange rate to influence
the competitiveness of the tradable goods sector.
(iii) As there is no obligation or necessity to intervene in the currency markets, the
central bank is not required to maintain a huge foreign exchange reserves.
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However, the greatest disadvantage of a flexible exchange rate regime is that volatile
exchange rates generate a lot of uncertainties in relation to international transactions
and add a risk premium to the costs of goods and assets traded across borders. In
short, a fixed rate brings in more currency and monetary stability and credibility; but
it lacks flexibility. On the contrary, a floating rate has greater policy flexibility; but
less stability.
4. NOMINAL VERSUS REAL EXCHANGE RATES

We have been discussing so far about nominal exchange rate which refers to the rate
at which a person can trade the currency of one country for the currency of another
country. For any country, there are many nominal exchange rates because its currency
can be used to purchase many foreign currencies. While studying exchange rate
changes, economists make use of indexes that average these many exchange rates.
An exchange rate index turns these many exchange rates into a single measure of
the international value of currency.
Nominal Exchange Rates can be used to find the domestic price of foreign goods.
However, trade flows are affected not by nominal exchange rates, but instead, by
real exchange rates. The person or firm buying another currency is interested in what
can be bought with it.
The real exchange rate is the rate at which a person can trade the goods and services
of one country for the goods and services of another. It describes ‘how many’ of a
good or service in one country can be traded for ‘one’ of that good or service in a
foreign country. A country’s real exchange rate is a key determinant of its net exports
of goods and services.
For calculating real exchange rate, in the case of trade in a single good, we must
first use the nominal exchange rate to convert the prices into a common currency.
The real exchange rate (RER) between two currencies is the product of the nominal
exchange rate and the ratio of prices between the two countries. It is calculated as:
(Nominal exchange Rate ) x Domestic price

Real exchange Rate =
Foreign price
Or
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Domestic Price
Real exchange rate = Nominal exchange rate X
Foreign price
Thus, real exchange rate depends on the nominal exchange rate and the prices of
the good in two countries measured in the local currencies.
When studying the economy as a whole, we use price indices which measure the
price of a basket of goods and services. Real exchange rate will then be:
Domestic Price Index

Real exchange rate = Nominal exchange rate X Foreign price Index
Another exchange rate concept, the Real Effective Exchange Rate (REER) is the
nominal effective exchange rate (a measure of the value of a domestic currency
against a weighted average of various foreign currencies) divided by a price deflator
or index of costs. An increase in REER implies that exports become more expensive
and imports become cheaper; therefore, an increase in REER indicates a loss in trade
competitiveness.
5. THE FOREIGN EXCHANGE MARKET

Forex market participants mainly are commercial banks executing orders from
exporters, importers, investment institutions, insurance and retirement funds,
hedgers, and private investors. Commercial banks also perform trading operations
in their own interests and at their own expense. Daily turnover of the largest banks
often exceeds several billions of U.S.
Dollars and many make their main profit by speculative operations with currency.
Brokerage houses are also playing an important role as contractors between large
numbers of banks, funds, commission houses, dealing centers, etc. Commercial
Banks and Brokerage Houses do not only execute currency exchange operations at
prices set by other active players but come out with their own prices as well, actively
influencing the price formation process and the market life. That is why they are
called market makers.
In contrast to the above, passive players cannot set their own quotations and
make trades at quotations offered by active market players. Passive market players
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normally pursue the following aims: payment of export-import contracts, foreign

industrial investments, the opening of branches abroad or the creation of joint
ventures, tourism, speculation on rate difference, hedging of currency risks (insurance
against losses in case of unfavorable price changes), etc.
In the foreign exchange market, there are two types of transactions:
(i) current transactions which are carried out in the spot market and the exchange
involves immediate delivery, and
(ii) future transactions wherein contracts are agreed upon to buy or sell currencies
for future delivery which are carried out in forward and/or futures markets
Exchange rates prevailing for spot trading (for which settlement by and large takes
two days) are called spot exchange rates. The exchange rates quoted in foreign
exchange transactions that specify a future date are called forward exchange rates.
The currency forward contracts are quoted just like spot rate; however, the actual
delivery of currencies takes place at the specified time in future. When a party agrees
to sell euro for dollars on a future date at a forward rate agreed upon, he has ‘sold
euros forward’ and ‘bought dollars forward’. A forward premium is said to occur
when the forward exchange rate is more than a spot exchange rates.
On the contrary, if the forward trade is quoted at a lower rate than the spot rate,
then there is a forward discount. Currency futures, though conceptually similar to
currency forward and perform the same function, they are distinct in their nature
and details concerning settlement and delivery.
While a foreign exchange transaction can involve any two currencies, most
transactions involve exchanges of foreign currencies for the U.S. dollars even when it
is not the national currency of either the importer or the exporter. On account of its
critical role in the forex markets, the dollar is often called a ‘vehicle currency’.
6. DETERMINATION OF NOMINAL EXCHANGE RATE

As you already know, the key framework for analysing prices is the operation of
forces of supply and demand in markets. Usually, the supply of and demand for
foreign exchange in the domestic foreign exchange market determine the external
value of the domestic currency, or in other words, a country’s exchange rate.
Individuals, institutions and governments participate in the foreign exchange market

for a number of reasons. On the demand side, people desire foreign currency to:
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• purchase goods and services from another country

• for unilateral transfers such as gifts, awards, grants, donations or
endowments
• to make investment income payments abroad
• to purchase financial assets, stocks or bonds abroad
• to open a foreign bank account
• to acquire direct ownership of real capital, and
• for speculation and hedging activities related to risk-taking or risk-
avoidance activity
The participants on the supply side operate for similar reasons. Thus, the supply
of foreign currency to the home country results from purchases of home exports,
unilateral transfers to home country, investment income payments, foreign direct
investments and portfolio investments, placement of bank deposits and speculation.
We shall now look into how the foreign exchange markets work. Similar to any
standard market, the exchange market also faces a downward-sloping demand
curve and an upwardsloping supply curve.
Determination of Nominal Exchange Rate
The equilibrium rate of exchange is determined by the interaction of the supply and
demand for a particular foreign currency. In figure 4.4.1, the demand curve (D$) and
supply curve (S$) of dollars intersect to determine equilibrium exchange rate eeq
with Qe as the equilibrium quantity of dollars exchanged.
7. CHANGES IN EXCHANGE RATES

Changes in exchange rates portray depreciation or appreciation of one currency. The
terms, ` currency appreciation’ and ‘currency depreciation’ describe the movements
of the exchange rate. Currency appreciates when its value increases with respect
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to the value of another currency or a basket of other currencies. On the contrary,

currency depreciates when its value falls with respect to the value of another currency
or a basket of other currencies. We shall try to understand this with the help of an
example.
For example, the Rupee dollar exchange rate in the month of January is $1 = ` 70.
and, we find that in the month of April it is $1 = ` 75. What does this indicate? In
April, you will have to exchange a greater amount of Indian Rupees (`75) to get the
same 1 unit of US dollar. As such, the value of the Indian Rupee has gone down or
Indian Rupee has depreciated in its value. Rupee depreciation here means that the
rupee has become less valuable with respect to the U.S. dollar. Simultaneously, if
you look at the value of dollar in terms of Rupees, you find that the value of the
US dollar has increased in terms of the Indian Rupee. One dollar will now fetch `75
instead of `70 earlier. This is called appreciation of the US dollar. You might have
observed that when one currency depreciates against another, the second currency
must simultaneously appreciate against the first.
To put it more clearly:

• Home-currency depreciation (which is the same as foreign-currency appreciation)
takes place when there is an increase in the home currency price of the foreign
currency (or, alternatively, a decrease in the foreign currency price of the home
currency).
The home currency thus becomes relatively less valuable.
• Home-currency appreciation (or foreign-currency depreciation) takes place

when there is a decrease in the home currency price of foreign currency (or
alternatively, an increase in the foreign currency price of home currency). The
home currency thus becomes relatively more valuable.
Under a floating rate system, if for any reason, the demand curve for foreign
currency shifts to the right representing increased demand for foreign currency,
and supply curve remains unchanged, then the exchange value of foreign
currency rises and the domestic currency depreciates in value. This is illustrated
in figure.
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Home-Currency Depreciation under Floating Exchange Rates
The market initially is in equilibrium at point E with equilibrium exchange rate e

eq. An increase in domestic demand for the foreign currency, with supply of dollars
remaining constant, is represented by a rightward shift of the demand curve to D1$.
The equilibrium exchange rate rises to e1. This indicates that more units of domestic
currency (here Indian Rupees) are required to buy one unit of foreign currency (here
dollar) and that the domestic currency (the Rupee) has depreciated.
We shall now examine what happens when there is an increase in the supply of
dollars in the Indian market. This is illustrated in figure
Home-Currency Appreciation under Floating Exchange Rates
An increase in the supply of foreign exchange shifts the supply curve to the right to
S1 $ and as a consequence, the exchange rate declines to e1. It means, that lesser
units of domestic currency (here Indian Rupees) are required to buy one unit of foreign
currency(dollar), and that the domestic currency (the Rupee) has appreciated.
As we are aware, in an open economy, firms and households use exchange rates to
translate foreign prices in terms of domestic currency. Exchange rates also permit
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us to compare the prices of goods and services produced in different countries.

Furthermore, import or export prices could be expressed in terms of the same
currency in the trading contract. This is the reason why exchange rate movements
can affect intentional trade flows.
8. DEVALUATION (REVALUATION) VS DEPRECIATION (APPRECIATION)

Devaluation is a deliberate downward adjustment in the value of a country's
currency relative to another country’s currency or group of currencies or standard.
It is a monetary policy tool used by countries that have a fixed exchange rate or
nearly fixed exchange rate regime and involves a discrete official reduction in the
otherwise fixed par value of a currency. The monetary authority formally sets a new
fixed rate with respect to a foreign reference currency or currency basket. In contrast,
depreciation is a decrease in a currency's value (relative to other major currency
benchmarks) due to market forces of demand and supply under a floating exchange
rate and not due to any government or central bank policy actions.
Revaluation is the opposite of devaluation and the term refers to a discrete official
increase of the otherwise fixed par value of a nation’s currency. Appreciation, on the
other hand, is an increase in a currency's value (relative to other major currencies)
due to market forces of demand and supply under a floating exchange rate and not
due to any government or central bank policy interventions.
9. IMPACTS OF EXCHANGE RATE FLUCTUATIONS ON DOMESTIC ECONOMY

The fact that among the macroeconomic variables, exchange rates are perhaps the
most closely monitored, analysed and manipulated economic measure, highlights
the overwhelming importance of exchange rates in an economy. The unpredictability
of the markets caused by exchange rate fluctuations can profoundly determine a
country’s economic performance. Knowledge about the possible effects of exchange
rate fluctuations enables us to have an understanding of the appropriateness of
exchange rate policy, especially in developing countries. In the discussion that follows,
we shall examine the impact of exchange rate fluctuations on the real economy.
The developments in the foreign exchange markets affect the domestic economy
both directly and indirectly. The direct impact of fluctuations in rates is initially felt
by economic agents who are directly involved in international trade or international
finance.
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(i) Fluctuations in the exchange rate have a significant role in determining the
nature and extent of a country's trade.
(ii) Fluctuations in the exchange rate affect the economy by changing the relative
prices of domestically-produced and foreign-produced goods and services. All
else equal (or other things remaining the same), an appreciation of a country’s
currency raises the relative price of its exports and lowers the relative price of
its imports. Conversely, depreciation lowers the relative price of a country’s
exports and raises the relative price of its imports. When a country’s currency
depreciates, foreigners find that its exports are cheaper and domestic residents
find that imports from abroad are more expensive.
An appreciation has opposite effects i.e foreigners pay more for the country’s
products and domestic consumers pay less for foreign products. For example;
assume that there is devaluation or depreciation of Indian Rupee from $1=`
65/ to $1=` 70/. A foreigner who spends ten dollars on buying Indian goods
will, post devaluation, get goods worth ` 700/ instead of ` 650/ prior to
depreciation. An importer has to pay for his purchases in foreign currency, and,
therefore, a resident of India, who wants to import goods worth $1 will have to
pay ` 70/ instead of ` 65/ prior to depreciation. Importers will be affected most
as they will have to pay more rupees on importing products. On the contrary,
exporters will be benefitted as goods exported abroad will fetch dollars which
can now be converted to more rupees.
(iii) Exchange rate changes affect economic activity in the domestic economy. A
depreciation of domestic currency primarily increases the price of foreign goods
relative to goods produced in the home country and diverts spending from
foreign goods to domestic goods. Increased demand, both for domestic import-
competing goods and for exports, encourages economic activity and creates
output expansion.
Overall, the outcome of exchange rate depreciation is an expansionary impact on
the economy at an aggregate level. The positive effect of currency depreciation,
however, largely depends on whether the switching of demand has taken place
in the right direction and in the right amount, as well as on the capacity of the
home economy to meet that increased demand by supplying more goods.
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(iv) For an economy where exports are significantly high, a depreciated currency
would mean a lot of gain. In addition, if exports originate from labour-intensive
industries, increased export prices will have positive effect on employment and
potentially on wages.
(v) Depreciation is also likely to add to consumer price inflation in the short run,
directly through its effect on prices of imported consumer goods and also due
to increased demand for domestic goods. The impact will be greater if the
composition of domestic consumption baskets consists more of imported goods.
Indirectly, cost push inflation may result through possible escalation in the cost
of imported inputs. In such an inflationary situation, the central bank of the
country will have no incentive to cut policy rates as this is likely to increase the
burden of all types of borrowers including businesses.
(vi) The fiscal health of a country whose currency depreciates is likely to be affected
with rising export earnings and import payments and consequent impact on
current account balance. A widening current account deficit is a danger signal
as far as growth prospects of the overall economy is concerned. If export
earnings rise faster than the imports spending then current account balance
will improve.
(vii) Companies that have borrowed in foreign exchange through external commercial
borrowings (ECBs) but have been careless and did not sufficiently hedge these
loans against foreign exchange risks, would also be negatively impacted as
they would require more domestic currency to repay their loans. A depreciated
domestic currency would also increase their debt burden and lower their profits
and impact their balance sheets adversely. These would signal investors who
will be discouraged from investing in such companies.
(viii) Countries with foreign currency denominated government debts, currency

depreciation will increase the interest burden and cause strain to the exchequer
for repaying and servicing foreign debt. Fortunately, India’s has small proportion
of public debt in foreign currency.
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(ix) Exchange rate fluctuations make financial forecasting more difficult for firms
and larger amounts will have to be earmarked for insuring against exchange
rate risks through hedging.
(x) With growth of investments across international boundaries, exchange rates

have assumed special significance. Investors who have purchased a foreign
asset, or the corporation which floats a foreign debt, will find themselves
facing foreign exchange risk. Exchange rate movements have become the single
most important factor affecting the value of investments at international level.
They are critical to business volumes, profit forecasts, investment plans and
investment outcomes. Depreciating currency hits investor sentiments and has
radical impact on patterns of international capital flows.
(xi) Foreign investors are likely to be indecisive or highly cautious before investing
in a country that has high exchange rate volatility. Foreign capital inflows are
characteristically vulnerable when local currency weakens. Therefore, foreign
portfolio investment flows into debt and equity as well as foreign direct
investment flows are likely to shrink. This shoots up capital account deficits
affecting the country’s fiscal health.
To reduce the fiscal deficit at the end of 2022, Russia and India agreed to switch
to trade settlements in their national currencies. Over the past year, trade
turnover between Moscow and New Delhi has grown significantly and both
intend to increase these volumes during 2023. Meanwhile, Russian exports to
India significantly exceed Indian imports from this country, when the Indian
Rupee has significantly dipped against the US Dollar and the Russian Ruble. We
look at how such variations can be overcome, setting in motion mechanisms for
additional mutual settlement schemes with countries whose currencies may
not be as strong as the Ruble, and look at the 2023 prospects for Russia-India
bilateral trade.
In mid-November last year, India announced plans to double the volume

of trade with Russia, noting that the transition to settlements in national
currencies would only be an additional incentive for this. In late autumn, the
Indian authorities allowed the use of Rupees in international trade settlements.
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An appreciation of currency or a strong currency (or possibly an overvalued currency)

makes the domestic currency more valuable and, therefore, can be exchanged
for a larger amount of foreign currency. An appreciation will have the following
consequences on real economy:
(i) An appreciation of currency raises the price of exports and, therefore, the
quantity of exports would fall. Since imports become cheaper, we may expect
an increase in the quantity of imports. Combining these two effects together,
the domestic aggregate demand falls and, therefore, economic growth is likely
to be negatively impacted.
(ii) The outcome of appreciation also depends on the stage of the business cycle
as well. If appreciation sets in during the recessionary phase, the result would
be a further fall in aggregate demand and higher levels of unemployment. If
the economy is facing a boom, an appreciation of domestic currency would trim
down inflationary pressures and soften the rate of growth of the economy.
(iii) An appreciation may cause reduction in the levels of inflation because imports
are cheaper. Lower price of imported capital goods, components and raw
materials lead to decrease in cost of production which reflects on decrease in
prices. Additionally, decrease in aggregate demand tends to lower demand pull
inflation. Living standards of people are likely to improve due to availability of
cheaper consumer goods.
(iv) With increasing export prices, the competitiveness of domestic industry is

adversely affected and therefore, firms have greater incentives to introduce
technological innovations and capital-intensive production to cut costs to
remain competitive.
(v) Increasing imports and declining exports are liable to cause larger deficits
and worsen the current account. However, the impact of appreciation on
current account depends upon the elasticity of demand for exports and
imports. Relatively inelastic demand for imports and exports may lead to
an improvement in the current account position. Higher the price elasticity of
demand for exports, greater would be the fall in demand and higher will be
the fall in the aggregate value of exports. This will adversely affect the current
account balance.
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(vi) Loss of competitiveness will be insignificant if currency appreciation is because

of strong fundamentals of the economy.
From the discussions in this unit, we understand that all countries would desire
to have steady exchange rates to eliminate the risks and uncertainties associated
with international trade and investments. However, nations may sometimes go for
trade-offs with weaker exchange rate to stimulate exports and aggregate demand,
or a stronger exchange rate to fight inflation.
Learners may keep themselves well-informed on contemporary exchange rate

developments and their implications on the economic welfare of countries.
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1. Based on the supply and demand model of determination of exchange rate, which
of the following ought to cause the domestic currency of Country X to appreciate
against dollar?
(a) The US decides not to import from Country X
(b) An increase in remittances from the employees who are employed abroad to
their families in the home country
(c) Increased imports by consumers of Country X
(d) Repayment of foreign debts by Country X
2. All else equal, which of the following is true if consumers of India develop taste for
imported commodities and decide to buy more from the US?
(a) The demand curve for dollars shifts to the right and Indian Rupee appreciates
(b) The supply of US dollars shrinks and, therefore, import prices decrease
(c) The demand curve for dollars shifts to the right and Indian Rupee depreciates
(d) The demand curve for dollars shifts to the left and leads to an increase in ex-
change rate
3. ‘The nominal exchange rate is expressed in units of one currency per unit of the other
currency. A real exchange rate adjusts this for changes in price levels’. The state-
ments are
(a) wholly correct (b) partially correct
(c) wholly incorrect (d) None of the above
4. Match the following by choosing the term which has the same meaning
(i) floating exchange rate (ii) fixed exchange rate
iii) pegged exchange rate a. depreciation
(iv) devaluation b. revaluation
(v) appreciation c. flexible exchange rate
(a) (i c); (ii d); (iii b); (iv a))
(b) (i b); (ii a); (iii d); (iv c)
(c) (i a ); (ii d ) ; (iii b); (iv c)
(d) (i d); ( ii a); (iii b); (iv c)
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(a) An indirect quote is the number of units of a local currency exchangeable for
one unit of a foreign currency
(b) the fixed exchange rate regime is said to be efficient and highly transparent.
(c) A direct quote is the number of units of a local currency exchangeable for one
unit of a foreign currency
(d) Exchange rates are generally fixed by the central bank of the country
6. Which of the following statements is true?

(a) Home-currency appreciation or foreign-currency depreciation takes place when
there is a decrease in the home currency price of foreign currency
(b) Home-currency depreciation takes place when there is an increase in the home
currency price of the foreign currency
(c) Home-currency depreciation is the same as foreign-currency appreciation and
implies that the home currency has become relatively less valuable.
(d) All the above
7. An increase in the supply of foreign exchange

(a) shifts the supply curve to the right and as a consequence, the exchange rate
declines
(b) shifts the supply curve to the right and as a consequence, the exchange rate
increases
(c) more units of domestic currency are required to buy a unit of foreign exchange
(d) the domestic currency depreciates and the foreign currency appreciates
8. Currency devaluation
(a) may increase the price of imported commodities and, therefore, reduce the in-
ternational competitiveness of domestic industries
(b) may reduce export prices and increase the international competitiveness of
domestic industries
(c) may cause a fall in the volume of exports and promote consumer welfare
through increased availability of goods and services
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9. At any point of time, all markets tend to have the same exchange rate for a given
currency due to
(a) Hedging
(b) Speculation
(c) Arbitrage
(d) Currency futures
10. ‘Vehicle Currency’ refers to

(a) a currency that is widely used to denominate international contracts made by
parties because it is the national currency of either of the parties
(b) a currency that is traded internationally and, therefore, is in high demand
(c) a type of currency used in euro area for synchronization of exchange rates
(d) a currency that is widely used to denominate international contracts made by
parties even when it is not the national currency of either of the parties
ANSWERS:
1 (b) 2 (c) 3 (a) 4 (d) 5 (c) 6 (d)
7 (a) 8 (b) 9 (c) 10 (d)
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SUMMARY
 Exchange rate is the rate at which the currency of one country exchanges for the
currency of another country.
 A direct quote (European Currency Quotation) is the number of units of a local

currency exchangeable for one unit of a foreign currency. For example, ` 65/US$.
 An indirect quote (American Currency Quotation) is the number of units of a foreign

currency exchangeable for one unit of local currency; for example: $ 0.0151 per
rupee.
 In a direct quotation, the foreign currency is the base currency and the domestic
currency is the counter currency. In an indirect quotation, the domestic currency is
the base currency and the foreign currency is the counter currency.
 The rate between Y and Z which is derived from the given rates of another set of two
pairs of currency (say, X and Y, and, X and Z) is called cross rate.
 An exchange rate regime is the system by which a country manages its currency with
respect to foreign currencies.
 There are two major types of exchange rate regimes at the extreme ends; namely
floating exchange rate regime, (also called a flexible exchange rate) and fixed
exchange rate regime.
 Under floating exchange rate regime, the equilibrium value of the exchange rate of a
country’s currency is market determined i.e. the demand for and supply of currency
relative to other currencies determines the exchange rate.
 A fixed exchange rate, also referred to as pegged exchange rate, is an exchange

rate regime under which a country’s government announces, or decrees, what its
currency will be worth in terms of either another country’s currency or a basket of
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currencies or another measure of value, such as gold.
 A central bank may implement soft peg policy under which the exchange rate is
generally determined by the market or a hard peg where the central bank sets a
fixed and unchanging value for the exchange rate.
 A fixed exchange rate avoids currency fluctuations and eliminates exchange rate
risks and transaction costs, enhances international trade and investment and lowers
the levels of inflation. But the central bank has to maintain an adequate amount of
reserves and be always ready to intervene in the foreign exchange market.
 A floating exchange rate allows a government to pursue its own independent monetary
policy and there is no need for market intervention or maintenance of reserves.
However, volatile exchange rates generate a lot of uncertainties with regard to
international transactions.
 The ‘real exchange rate' incorporates changes in prices and describes ‘how many’ of
a good or service in one country can be traded for ‘one’ of that good or service in a
foreign country.
Domestic price Index

 Real exchange rate = Nominal exchange rate X
Foreign price Index
 Real Effective Exchange Rate (REER) is the nominal effective exchange rate (a measure
of the value of a currency against a weighted average of various foreign currencies)
divided by a price deflator or index of costs.
 The wide-reaching collection of markets and institutions that handle the exchange
of foreign currencies is known as the foreign exchange market. Being an over-the-
counter market, it is not a physical place; rather, it is an electronically linked network
bringing buyers and sellers together and has only very narrow spreads.
 On account of arbitrage, regardless of physical location, at any given moment, all

markets tend to have the same exchange rate for a given currency. Arbitrage refers
to the practice of making risk-less profits by intelligently exploiting price differences
of an asset at different dealing places.
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 There are two types of transactions in a forex market: current transactions which are
carried out in the spot market and future transactions involving contracts to buy or
sell currencies for future delivery which are carried out in forward and futures markets.
 Generally, the supply of and demand for foreign exchange in the domestic foreign
exchange market determine the external value of the domestic currency, or in other
words, a country’s exchange rate.
 Changes in exchange rates portray depreciation or appreciation of one currency. The

terms, ‘currency appreciation’ and ‘currency depreciation’ describe the movements of
the exchange rate.
 Currency appreciates when its value increases with respect to the value of another
currency or a basket of other currencies. On the contrary, currency depreciates when its
value falls with respect to the value of another currency or a basket of other currencies.
 Devaluation is a deliberate downward adjustment by central bank in the value of a

country's currency relative to another currency, group of currencies or standard.
 An appreciation of a country’s currency cause changes in import and export prices

will lead to changes in import and export volumes, causing resulting in import
spending and export earnings.
 Exchange rate depreciation lowers the relative price of a country’s exports, raises the
relative price of its imports, increases demand both for domestic import-competing
goods and for exports, leads to output expansion, encourages economic activity,
increases the international competitiveness of domestic industries, increases the
volume of exports and improves trade balance.
 Currency appreciation raises the price of exports, decrease exports; increase imports,
adversely affect the competitiveness of domestic industry, cause larger deficits and
worsens the trade balance.
 Devaluation is a deliberate downward adjustment by central bank in the value of a

country's currency relative to another currency, group of currencies or standard.
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 An appreciation of a country’s currency cause changes in import and export prices

will lead to changes in import and export volumes, causing resulting in import
spending and export earnings.
 Exchange rate depreciation lowers the relative price of a country’s exports, raises the
relative price of its imports, increases demand both for domestic import-competing
goods and for exports, leads to output expansion, encourages economic activity,
increases the international competitiveness of domestic industries, increases the
volume of exports and improves trade balance.
 Currency appreciation raises the price of exports, decrease exports; increase imports,
adversely affect the competitiveness of domestic industry, cause larger deficits &
worsens the trade balance.
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UNIT 5: INTERNATIONAL CAPITAL MOVEMENTS
1. INTRODUCTION
In unit one, our focus was on international trade in goods and services. Lately, we have
observed enormous increase in international movement of capital. This phenomenon
has received a great deal of attention not only from economists and policy-makers,
but also from people in different walks of life- including workers’ organisations and
members of the civil society. In this unit, we shall look into international capital
movements; more precisely, why do capital move across national boundaries and
what are the consequences of such capital movements. We shall also briefly touch
upon the FDI situation in India.
2. TYPES OF FOREIGN CAPITAL

The term 'foreign capital' is a comprehensive one and includes any inflow of capital
into the home country from abroad and therefore, we need to be clear about the
distinction between movement of capital and foreign investment. Foreign capital
may flow into an economy in different ways. Some of the important components of
foreign capital flows are:
(1) Foreign aid or assistance which may be:
(a) Bilateral or direct inter government grants.
(b) Multilateral aid from many governments who pool funds with international
organizations like the World Bank.
(c) Tied aid with strict mandates regarding the use of money or untied aid
where there are no such stipulations
(d) Foreign grants which are voluntary transfer of resources by governments,
institutions, agencies or organizations.
(2) Borrowings which may take different forms such as:

(a) Direct inter government loans
(b) Loans from international institutions (e.g. world bank, IMF, ADB)
(c) Soft loans for e.g. from affiliates of World Bank such as IDA
(d) External commercial borrowing, and
(e) Trade credit facilities
(3) Deposits from non-resident Indians (NRI)
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(4) Investments in the form of :

(i) Foreign portfolio investment (FPI) in bonds, stocks and securities, and
(ii) Foreign direct investment (FDI) in industrial, commercial and similar other
enterprises
A detailed discussion about all types of capital movements is beyond the scope
of this unit and therefore, we shall concentrate only on foreign investments.
3. FOREIGN DIRECT INVESTMENT (FDI)

Foreign direct investment (FDI), according to IMF manual on 'Balance of payments' is
"all investments involving a long-term relationship and reflecting a lasting interest
and control of a resident entity in one economy in an enterprise resident in an economy
other than that of the direct investor”. This typically occurs through acquisition of
more than 10 percent of the shares of the target asset. Direct investment comprises
not only the initial transaction establishing the relationship between the investor
and the enterprise, but also all subsequent transactions between them and among
affiliated enterprises, both incorporated and unincorporated.
According to the IMF and OECD definitions, the acquisition of at least ten percent of
the ordinary shares or voting power in a public or private enterprise by non-resident
investors makes it eligible to be categorized as foreign direct investment (FDI). India
also follows the same pattern of classification. FDI has three components, viz., equity
capital, reinvested earnings and other direct capital in the form of intra-company
loans between direct investors (parent enterprises) and affiliate enterprises.
Foreign direct investors may be individuals, incorporated or unincorporated private

or public enterprises, associated groups of individuals or enterprises, governments or
government agencies, estates, trusts, or other organizations or any combination of
the above-mentioned entities. The main forms of direct investments are: the opening
of overseas companies, including the establishment of subsidiaries or branches,
creation of joint ventures on a contract basis, joint development of natural resources
and purchase or annexation of companies in the country receiving foreign capital.
Direct investments are real investments in factories, assets, land, inventories etc.
and involve foreign ownership of production facilities. The investor retains control
over the use of the invested capital and also seeks the power to exercise control
over decision making to the extent of its equity participation. The lasting interest
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implies the existence of a long-term relationship between the direct investor and the
enterprise and a significant degree of influence by the investor on the management
of the enterprise.
Based on the nature of foreign investments, FDI may be categorized as horizontal,

vertical or conglomerate.
(i) A horizontal direct investment is said to take place when the investor establishes
the same type of business operation in a foreign country as it operates in its
home country, for example, a cell phone service provider based in the United
States moving to India to provide the same service.
(ii) A vertical investment is one under which the investor establishes or acquires a
business activity in a foreign country which is different from the investor’s main
business activity yet in some way supplements its major activity. For example;
an automobile manufacturing company may acquire an interest in a foreign
company that supplies parts or raw materials required for the company.
(iii) A conglomerate type of foreign direct investment is one where an investor makes
a foreign investment in a business that is unrelated to its existing business in
its home country. This is often in the form of a joint venture with a foreign firm
already operating in the industry, as the investor has no previous experience.
Yet another category of investment is ‘two- way direct foreign investments’

which are reciprocal investments between countries. These investments occur
when some industries are more advanced in one nation (for example, the
computer industry in the United States), while other industries are more efficient
in other nations (such as the automobile industry in Japan).
4. FOREIGN PORTFOLIO INVESTMENT (FPI)

Foreign portfolio investment is the flow of what economists call ‘financial capital’
rather than ‘real capital’ and does not involve ownership or control on the part of
the investor. Examples of foreign portfolio investment are the deposit of funds in an
Indian or a British bank by an Italian company, the purchase of a bond (a certificate of
indebtedness) of a Swiss company or the Swiss government by a citizen or company
based in France. Unlike FDI, portfolio capital, in general, moves to investment in
financial stocks, bonds and other financial instruments and is effected largely by
individuals and institutions through the mechanism of capital market.
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These flows of financial capital have their immediate effects on balance of payments
or exchange rates rather than on production or income generation.
Foreign portfolio investment (FPI) is not concerned with either manufacture of

goods or with provision of services. Such investors also do not have any intention
of exercising voting power or controlling or managing the affairs of the company in
whose securities they invest. The sole intention of a foreign portfolio investor is to
earn a remunerative return through investment in foreign securities and is primarily
concerned about the safety of their capital, the likelihood of appreciation in its
value, and the return generated. Logically, portfolio capital moves to a recipient
country which has revealed its potential for higher returns and profitability.
Following international standards, portfolio investments are characterised by lower

stake in companies with their total stake in a firm at below 10 percent. It is also
noteworthy that unlike the FDIs, these investments are typically of short term nature,
and therefore, are not intended to enhance the productive capacity of an economy
by the creation of capital assets.
Portfolio investors will evaluate, on a separate basis, the prospects of each

independent unit in which they might invest and may often shift their capital with
changes in these prospects.
Therefore, portfolio investments are, to a large extent, expected to be speculative.

Once investor confidence is shaken, such capital has a tendency to speedily shift from
one country to another, occasionally creating financial crisis for the host country.
Foreign direct investment (FDI) VS Foreign portfolio investment (FPI)

Foreign Direct Investment (FDI) Foreign Portfolio Investment (FPI)
Investment involves creation of physical Investment is only in financial assets
assets
Has a long term interest and therefore Only short term interest and generally
remain invested for long remain invested for short periods
Relatively difficult to withdraw Relatively easy to withdraw
Not inclined to be speculative Speculative in nature
Often accompanied by technology Not accompanied by technology trans-
transfer fer
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Direct impact on employment of labour No direct impact on employment of la-

and wages bourand wages
Enduring interest in management and No abiding interest in management and
control control
Securities are held with significant de- Securities are held purely as a financial
greeof influence by the investor on the investment and no significant degree
management of the enterprise of influence on the management of the
enterprise
5. Securities are held purely as a financial investment and no significant degree of influence
on the management of the enterprise
As we know, economic prosperity and the relative abundance of capital are
necessary prerequisites for export of capital to other countries. Many economies
and organisations have accumulation of huge mass of reserve capital seeking
profitable use. The primary aim of economic agents being maximisation of their
economic interests, the opportunity to generate profits available in other countries
often entices such entities to make investments in other countries.
The chief motive for shifting of capital between different regions or between different
industries is the expectation of higher rate of return than what is possible in the
home country.
Investment in a host country may be considered as profitable by foreign firms because
of some firm-specific knowledge or assets (such as superior management skills or
an important patent) that enable the foreign firm to gainfully outperform the host
country's domestic firms.
There are many other reasons (as listed below) for international capital movements
which have found adequate empirical support. Investments move across borders on
account of:
 the increasing interdependence of national economies and the consequent trade
relations and international industrial cooperation established among them
 internationalisation of production and investment of transnational corporations
in their subsidiaries and affiliates.
 desire to reap economies of large-scale operation arising from technological
growth
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 lack of feasibility of licensing agreements with foreign producers in view of the

rapid rate of technological innovations
 necessity to retain direct control of production knowledge or managerial skill
(usually found in monopolistic or oligopolistic markets) that could easily and
profitably be utilized by corporations
 desire to procure a promising foreign firm to avoid future competition and the
possible loss of export markets
 risk diversification so that recessions or downturns may be experienced with
reduced severity
 shared common language or common boundaries and possible saving in time
and transport costs because of geographical proximity
 necessity to retain complete control over its trade patents and to ensure
consistent quality and service or for creating monopolies in a global context
 promoting optimal utilization of physical, human, financial and other resources
 desire to capture large and rapidly growing high potential emerging markets
with substantially high and growing population
 ease of penetration into the markets of those countries that have established
import restrictions such as blanket bans, high customs duties or non-tariff
barriers which make it difficult for the foreign firm to sell in the host-country
market by ‘getting behind the tariff wall’.
 lower environmental standards in the host country and the consequent relative
savings in costs
 stable political environment and overall favourable investment climate in the
host country
 higher degree of openness to foreign capital exhibited by the recipient country
and the prevalence of preferential investment systems such as special economic
zones to encourage direct foreign investments
 the strategy to obtain control of strategic raw material or resource so as to
ensure their uninterrupted supply at the lowest possible price; usually a form
of vertical integration
 desire to secure access to minerals or raw material deposits located elsewhere
and earn profits through processing them to finished form (Eg.FDI in petroleum)
 the existence of low relative wages in the host country because of relative
labour abundance coupled with shortage and high cost of labour in capital
exporting countries, especially when the production process is labour intensive.
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 lower level of economic efficiency in host countries and identifiable gaps in

development.
 tax differentials and tax policies of the host country which support foreign direct
investment. However, a low tax burden cannot compensate for a generally
fragile and unattractive FDI environment.
 inevitability of defensive investments in order to preserve a firm’s competitive
position.
 high gross domestic product and high per capita income coupled with their
high rate of growth. There are also other philanthropic objectives such as
strengthening of socio-economic infrastructure, alleviation of poverty and
maintenance of ecological balance of the host country, and
 prevalence of high standards of social amenities and possibility of good quality
of life in the host country.
Host Country Determinants of Foreign Direct Investment

Economic Determinants Policy Framework
Market -seeking FDI: Economic, political, and social stabil-
Market size and per capita income ity Rules regarding entry and opera-
Market growth tions Standards of treatment of for-
Access to regional and global eign affiliates
markets
Country-specific consumer preferenc-
es Structure of markets
Resource - or asset-seeking FDI: Policies on functioning and structure

Raw materials of markets (e.g., regarding competi-
Low -cost unskilled labor tion, mergers)
Availability of skilled labor International agreements on FDI Pri-
Technological, innovative, & other vatization policy
created assets (e.g., brand names) Trade policies and coherence of FDI
Physical infrastructure and trade policies Tax policy
Efficiency -seeking FDI: Business Facilitation
Costs of above physical and human Investment promotion (including im-
resources and assets age building and investmentgenerat-
(including an adjustment for producing activities and investmentfacilita-
tivity) tion services)
Other input costs (e.g., intermediate Investment incentives
products, transport costs) "Hassle costs" (related to corruption
Membership of country in a regional and administrative efficiency)
integration agreement, which could Social amenities (e.g., bilingual
be conducive to forming regional cor- schools, quality of life)
porate networks After-investment services
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Source: International economics (7th ed) International Economics, Dennis R.

Appleyard; Alfred J. Field; Steven L. Cobb (P237)
Factors in the host country discouraging inflow of foreign investments are

infrastructure lags, high rates of inflation, balance of payment deficits, poor literacy
and low labour skills, rigidity in the labour market, bureaucracy and corruption,
unfavourable tax regime, cumbersome legal formalities and delays, difficulties
in contract enforcement, land acquisition issues, small size of market and lack
of potential for its growth, political instability, absence of well-defined property
rights, exchange rate volatility, poor track-record of investments, prevalence of
non-tariff barriers, stringent regulations, lack of openness, language barriers, high
rates of industrial disputes, lack of security to life and property, lack of facilities
for immigration and employment of foreign technical and administrative personnel,
double taxation and lack of a general spirit of friendliness towards foreign investors.
6. MODES OF FOREIGN DIRECT INVESTMENT (FDI)

Foreign direct investments can be made in a variety of ways, such as:
(i) Opening of a subsidiary or associate company in a foreign country,
(ii) Equity injection into an overseas company,
(iii) Acquiring a controlling interest in an existing foreign company,
(iv) Mergers and acquisitions(M&A)
(v) Joint venture with a foreign company.
(vi) Green field investment (establishment of a new overseas affiliate for freshly
starting nproduction by a parent company).
(vii) Brownfield investments (a form of FDI which makes use of the existing
infrastructure by merging, acquiring or leasing, instead of developing a
completely new one. For e.g. in India 100% FDI under automatic route is allowed
in Brownfield Airport projects.
7. BENEFITS OF FOREIGN DIRECT INVESTMENT

The benefits from and concerns about FDI are widely discussed and well documented.
While recognizing the fact that there are also benefits and costs to the home country
from capital outflow, in this unit we focus only on host-country effects of FDI with
particular attention to the developing countries. Following are the benefits ascribed
to foreign investments:
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1. Entry of foreign enterprises usually fosters competition and generates a

competitive environment in the host country. The domestic enterprises are
compelled to compete with the foreign enterprises operating in the domestic
market. This results in positive outcomes in the form of cost-reducing and
quality-improving innovations, higher efficiency and increasing variety of better
products and services at lower prices ensuring wider choice and welfare for
consumers.
2. International capital allows countries to finance more investment than can be

supported by domestic savings. The provision of increased capital to work with
labour and other resources available in the host country can enhance the total
output/GDP (as well as output per unit of input) flowing from the factors of
production.
3. From the perspective of emerging and developing countries, FDI can accelerate
growth and foster economic development by providing the much needed capital,
technological know-how, management skills, marketing methods and critical
human capital skills in the form of managers and technicians. The spill-over
effects of the new technologies usually spread beyond the foreign corporations.
In addition, the new technology can clearly enhance the recipient country's
production possibilities.
4. Competition for FDI among national governments also has helped to promote
political and structural reforms important to attract foreign investors, including
legal systems and macroeconomic policies.
5. Since FDI involves setting up of production base (in terms of factories, power
plants, etc.), it generates direct employment in the recipient country. Subsequent
FDI as well as domestic investments propelled in the downstream and upstream
projects that come up in multitude of other services, generate multiplier effects
on employment and income/GDP.
6. FDI not only creates direct employment opportunities but also, through
backward and forward linkages, generate indirect employment opportunities.
This impact is particularly important if the recipient country is a developing
country with an excess supply of labour caused by population pressure.
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7. Foreign direct investments also promote relatively higher wages for skilled jobs.
More indirect employment will be generated to people in the lower-end services
sector occupations thereby catering to an extent even to the less educated and
unskilled persons engaged in those units.
8. Foreign corporations provide better access to foreign markets. Unlike portfolio

investments, FDI generally entails people-to-people relations and is usually
considered as a promoter of bilateral and international relations. Greater
openness to foreign capital leads to higher national dependence on international
investors, making the cost of discords higher.
9. There is also greater possibility for the promotion of ancillary units resulting in
job creation and skill development for workers.
10. Foreign enterprises possessing marketing information with their global network
of marketing are in a unique position to utilize these strengths to promote
the exports of developing countries. If the foreign capital produces goods
with export potential, the host country is in a position to secure scarce foreign
exchange needed to import capital equipments or materials to assist the
country's development plans or to ease its external debt servicing.
11. If the host country is in a position to implement effective tax measures, the
foreign investment projects also would act as a source of new tax revenue
which can be used for development projects.
12. It is likely that foreign investments enter into industries in which economies of
scale can be realized so that consumer prices may be reduced. Domestic firms
might not always be able to generate the necessary capital to achieve the cost
reductions associated with large-scale production.
13. Increased competition resulting from the inflow of foreign direct investments
facilitates weakening of the market power of domestic monopolies resulting in
a possible increase in output and fall in prices.
14. Since FDI has a distinct advantage over the external borrowings, it is considered to
have a favourable impact on the host country’s balance of payment position, and
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15. Better work culture and higher productivity standards brought in by foreign firms
may possibly induce productivity related awareness and may also contribute to
overall human resources development.
8. POTENTIAL PROBLEMS ASSOCIATED WITH FOREIGN DIRECT INVESTMENT

In the above section, we have seen that a wide variety of benefits may result from
an inflow of foreign direct investment. These gains do not occur in all cases, nor do
they occur in the same magnitude. Despite the arguments in favour of FDI, many are
highly critical of the impact of foreign capital, especially on developing economies.
They argue that foreign entities are highly focused on profits and have an eye on
exploiting the natural resources and are almost always not genuinely interested in
the development needs of host countries. Foreign capital is perceived by the critics
as an instrument of imperialism, perpetrator of dependence and source of inequality
between and within the nations.
Following are the general arguments put forth against the entry of foreign capital:
1) FDIs are likely to concentrate on capital-intensive methods of production and
service so that they need to hire only relatively few workers. Such technology is
inappropriate for a labour-abundant country as it does not support generation
of jobs which is a crucial requirement to address the two fundamental areas of
concern for the less developed countries namely, poverty and unemployment
2) The inherent tendency of FDI flows to move towards regions or states which are
well endowed in terms of natural resources and availability of infrastructure has
the potential to accentuate regional disparity. Foreign capital is also criticized
for accentuating the already existing income inequalities in the host country.
3) In the context of developing countries, it is usually alleged that the inflow of

foreign capital may cause the domestic governments to slow down its efforts to
generate more domestic savings, especially when tax mechanisms are difficult
to implement. If the foreign corporations are able to secure incentives in the
form of tax holidays or similar provisions, the host country loses tax revenues.
4) Often, the foreign firms may partly finance their domestic investments by
borrowing funds in the host country's capital market. This action can raise
interest rates in the host country and lead to a decline in domestic investments
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through ‘crowding-out’ effect. Moreover, suppliers of funds in developing

economies would prefer foreign firms due to perceived lower risks and such
shifts of funds may divert capital away from investments which are crucial for
the development needs of the country.
5) The expected benefits from easing of the balance of payments situation

might remain unrealised or narrowed down due to the likely instability in the
balance of payments and the exchange rate. Obviously, FDI brings in more
foreign exchange, improves the balance of payments and raises the value of
the host country's currency in the exchange markets. However, when imported
inputs need to be obtained or when profits are repatriated, a strain is placed
on the host country's balance of payments and the home currency leading to its
depreciation. Such instabilities jeopardize longterm economic planning. Foreign
corporations also have a tendency to use their usual input suppliers which
can lead to increased imports. Also, large scale repatriation of profits can be
stressful on exchange rates and the balance of payments.
6) Jobs that require expertise and entrepreneurial skills for creative decision
making may generally be retained in the home country and therefore the host
country is left with routine management jobs that demand only lower levels of
skills and ability. The argument of possible human resource development and
acquisition of new innovative skills through FDI may not be realized in reality.
7) High profit orientation of foreign direct investors tend to promote a distorted

pattern of production and investment such that production could get
concentrated on items of elite and popular consumption and on non-essential
items.
8) Foreign entities are usually accused of being anti-ethical as they frequently

resort to methods like aggressive advertising and anticompetitive practices
which would induce market distortions.
9) A large foreign firm with deep pockets may undercut a competitive local
industry because of various advantages (such as in technology) possessed by
it and may even drive out domestic firms from the industry resulting in serious
problems of displacement of labour. The foreign firms may also exercise a high
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degree of market power and exist as monopolists with all the accompanying
disadvantages of monopoly. The high growth of wages in foreign corporations
can influence a similar escalation in the domestic corporations which are not
able to cover this increase with growth of productivity. The result is decreasing
competitiveness of domestic companies which might prove detrimental to the
long-term interests of industrial development of the host country.
10) FDI usually involves domestic companies ‘off –shoring’, or shifting jobs and
operations abroad in pursuit of lower operating costs and consequent higher
profits. This has deleterious effects on employment potential of home country.
11) The continuance of lower labour or environmental standards in host countries

is highly appreciated by the profit seeking foreign enterprises. This is of great
concern because efforts to converge such standards often fail to receive support
from interested parties.
12) At times, there is potential national security considerations involved when

foreign firms function in the territory of the host country, especially when acute
hostilities prevail.
13) FDI may have adverse impact on the host country's commodity terms of trade
(defined as the price of a country's exports divided by the price of its imports).
This could occur if the investments go into production of export-oriented goods
and the country is a large country in the sale of its exports. Thus, increased
exports drive down the price of exports relative to the price of imports.
14) FDI is also held responsible by many for ruthless exploitation of natural
resources and the possible environmental damage.
15) With substantial FDI in developing countries there is a strong possibility

of emergence of a dual economy with a developed foreign sector and an
underdeveloped domestic sector.
16) Perhaps the most disturbing of the various charges levied against foreign direct
investment is that a large foreign investment sector can exert excessive amount
of power in a variety of ways so that there is potential loss of control by host
366
country over domestic policies and therefore the less developed host country’s
sovereignty is put at risk. Mighty multinational firms are often criticized of
corruption issues, unduly influencing policy making and evasion of corporate
social responsibility.
No general assessment can be made regarding whether the benefits of FDI outweigh
the costs. Each country's situation and each firm's investment must be examined in
the light of various considerations and a judgment about the desirability or otherwise
of the investment should be arrived at.
Many safeguards and performance requirements are put in place by developed and
developing countries to improve the ratio of benefits to costs associated with foreign
capital.
A few examples are: domestic content requirements on inputs, reservation of certain
key sectors to domestic firms, requirement of a minimum percent of local employees,
ceiling on repatriation of profits, local sourcing requirements and stipulations for
full or partial export of output to earn foreign exchange.
9. FOREIGN DIRECT INVESTMENT IN INDIA

Foreign Direct Investment (FDI), in addition to being a key driver of economic growth,
has been a significant non-debt financial resource for India's economic development.
Foreign The corporations invest in India to benefit from the country's particular
investment privileges such as tax breaks and comparatively lower salaries. This
helps India develop technological know how and create jobs as well as other
benefits. These investments have been coming into India because of the government's
supportive policy framework, vibrant business climate, rising global competitiveness
and economic influence.
The government has recently made numerous efforts, including easing FDI
regulations in various industries, PSUs, oil refineries, telecom and defence. India's
FDI inflows reached record levels during 2020-21. The total FDI inflows stood at
US$ 81,973 million, a 10% increase over the previous financial year. According to
the World Investment Report 2022, India was ranked eighth among the world's
major FDI recipients in 2020, up from ninth in 2019. Information and technology,
telecommunication and automobile were the major receivers of FDI in FY22.
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With the help of significant transactions in the technology and health sectors,
multinational companies (MNCs) have pursued strategic collaborations with top
domestic business groupings, fuelling an increase in cross-border M&A of 83% to
US$ 27 billion.
10. OVERSEAS DIRECT INVESTMENT BY INDIAN COMPANIES

India is primarily a domestic demand-driven economy, with consumption and
investments contributing to 70% of the economic activity. With an improvement
in the economic scenario and the Indian economy recovering from the Covid-19
pandemic shock, India is relatively well placed than the rest of the world. Despite
major headwinds that continue to pose risks in the short term, the Indian economy
has remained strong owing to robust policy measures in place.
This gives Indian businesses an advantage to make investments abroad and broaden
their operational footprint in such nations. New innovations from abroad would be
brought to India with the help of knowledge spillover, and India itself would contribute
to the growth of other nations. In this manner, a mutual benefit is achieved. In this
regard, there have been several overseas investments made by Indian companies.
Some of the key overseas investments and developments that have taken place in
the recent past are mentioned as follows:
According to data released by the Reserve Bank of India (RBI), overseas direct
investment stood at US$ 1,922.51 million in September 2022.
The critical investments are as follows:
• In June 2022, Tata Steel announced plans to invest 7 million pounds (US$
837.95 billion) for its Hartlepool Tube Mill in North-East England.
• Tata Communications invested US$ 690 million in its wholly-owned subsidiary
in Singapore.
• Jindal Steel and Power invested US$ 366 million in its wholly owned subsidiary
in Mauritius
• Wipro invested US$ 204.96 million in its wholly-owned subsidiary in Cyprus.
• Jindal Saw invested US$ 64.5 million in its wholly-owned subsidiary in the
United Arab Emirates.
• Restaurant Brand Aisa and Lupin Ltd invested US$ 141.34 million and US$
131.25 million in their JVs in Indonesia and the US, respectively.
• Reliance New Energy invested US$ 87.73 million in its wholly owned subsidiary
in Norway.
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• Mohalla Internet Pvt. Ltd. invested US$ 86 million in its fully owned unit in
Mauritius.
• ONGC Videsh invested US$ 83.31 million in a joint-venture in Russia.
• ICICI Bank ties up with Santander in Britain in a pact aimed at facilitating the
banking requirements of corporates operating across both countries.
• ANI Technologies, the promoter of OLA, invested US$ 675 million in its wholly-
owned subsidiary in Singapore.
• Dr Reddy invested US$ 149.99 million in a joint- venture (JV) in the US.
• A total of US$ 168.9 million was invested by Reliance New Energy in a JV and
whollyowned subsidy in Germany and Norway.
• Gail India, energy PSU invested US$ 70.17 million in a JV and wholly-owned
unit in Myanmar and the US.
• ONGC invested US$ 74.15 million during the month in various countries in 5
different ventures.
• In July 2022, Reliance Brands Ltd. signed a distribution agreement with Maison
Valentino, an Italian luxury fashion house, to open its first boutique in Delhi,
followed by a flagship store in Mumbai.
• In July 2022, Reliance Retail Limited entered into a long-term partnership with
Gap Inc. to bring the iconic American fashion brand, Gap, to India.
• In July 2022, Tata Steel signed a Memorandum of Understanding (MoU) with
BHP, a leading global resources company, with the intention to jointly study
and explore lowcarbon iron and steelmaking technology.
• In January 2022, Ola Electric, the ride-hailing company’s electric vehicle (EV)
subsidiary, announced its plans to establish Ola Futurefoundry, a global hub for
advanced engineering and vehicle design in the UK, investing US$ 100 million
over the next 5 years.
• In January, Essar Group of India announced that it had created a joint venture
with Progressive Energy of the UK to invest US$ 1.34 billion in a hydrogen
manufacturing plant at its Essar Stanlow refinery complex.
• In January, Hindalco Ltd’s US subsidiary, Novelis, announced its plans to invest
US$ 365 million in a state-of-the-art vehicle recycling facility in North America.
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1. Which of the following statements is incorrect?

(a) Direct investments are real investments in factories, assets, land, inventories
etc. and involve foreign ownership of production facilities.
(b) Foreign portfolio investments involve flow of ‘financial capital’ .
(c) Foreign direct investment (FDI) is not concerned with either manufacture of
goods or with provision of services.
(d) Portfolio capital moves to a recipient country which has revealed its potential
for higher returns and profitability.
2. Which of the following is a component of foreign capital?

(a) Direct inter government loans
(b) Loans from international institutions (e.g. World Bank, IMF, ADB)
(c) Soft loans for e.g. from affiliates of World Bank such as IDA
(d) All the above
3. Which of the following would be an example of foreign direct investment from Coun-
try X?
(a) A firm in Country X buys bonds issued by a Chinese computer manufacturer.
(b) A computer firm in Country X enters into a contract with a Malaysian firm for
the latter to make and sell to it processors
(c) Mr. Z a citizen of Country X buys a controlling share in an Italian electronics firm
4. Which of the following types of FDI includes creation of fresh assets and production
facilities in the host country?
(a) Brownfield investment (b) Merger and acquisition
(c) Greenfield investment (d) Strategic alliances
5. Which is the leading country in respect of inflow of FDI to India?

(a) Mauritius (b) USA
(c) Japan (d) USA
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6. An argument in favour of direct foreign investment is that it tends to

(a) promote rural development
(b) increase access to modern technology
(c) protect domestic industries
(d) keep inflation under control
7. Which of the following is a reason for foreign direct investment?

(a) secure access to minerals or raw materials
(b) desire to capture of large and rapidly growing emerging markets
(c) desire to influence home country industries
8. A foreign direct investor

(a) May enter India only through automatic route
(b) May enter India only through government route
(c) May enter India only through equity in domestic enterprises
(d) Any of the above
9. Foreign investments are prohibited in

(a) Power generation and distribution (b) Highways and waterways
(c) Chit funds and Nidhi company (d) Airports and air transport
10. Which of the following statement is false in respect of FPI?

(a) portfolio capital in general, moves to investment in financial stocks, bonds and
other financial instruments
(b) is effected largely by individuals and institutions through the mechanism of
capital market
(c) is difficult to recover as it involves purely long-term investments and the
investors have controlling interest
(d) investors also do not have any intention of exercising voting power or controlling
or managing the affairs of the company.
ANSWERS:
1 (c) 2 (d) 3 (c) 4 (c) 5 (a) 6 (b)
7 (d) 8 (d) 9 (c) 10 (c)
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SUMMARY
 Foreign capital may flow into an economy in different ways, such as foreign aid,
grants, borrowings, deposits from non-resident Indians, investments in the form of
foreign portfolio investment (FPI) and foreign direct investment (FDI)
 Foreign direct investment is defined as a process whereby the resident of one country
(i.e. home country) acquires ownership of an asset in another country (i.e. the host
country) and such movement of capital involves ownership, control as well as
management of the asset in the host country.
 Direct investments are real investments in factories, assets, land, inventories etc.
and have three components, viz., equity capital, reinvested earnings and other direct
capital in the form of intra-company loans. FDI may be categorized as horizontal,
vertical or conglomerate.
 Foreign portfolio investment is the flow of ‘financial capital’ with stake in a firm
at below 10 percent, and does not involve manufacture of goods or provision of
services, ownership management or control of the asset on the part of the investor.
 The main reasons for foreign direct investment are profits, higher rate of return,
possible economies of large-scale in operation, risk diversification, retention of trade
patents, capture of emerging markets, lower host country environmental and labour
standards, bypassing of non-tariff and tariff barriers, cost–effective availability of
needed inputs and tax and investment incentives.
 Foreign direct investment takes place through opening of a subsidiary or associate

company, equity injection, acquiring a controlling interest, mergers and acquisitions
(M&A), joint venture and green field investment.
 Benefits of foreign direct investment include positive outcomes of competition such

as cost- reducing and quality-improving innovations, higher efficiency, huge variety
of better products and services at lower prices, welfare for consumers, multiplier
effects on employment, output and income, relatively higher wages, better access
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to foreign markets, control of domestic monopolies and improvement of balance of

payments position.
 Potential problems of foreign direct investment include use of inappropriate

capitalintensive methods in a labour-abundant country, increase in regional disparity,
crowding-out of domestic investments, diversion of capital resulting in distorted
pattern of production and investment, instability in the balance of payments and
exchange rate and indiscriminate repatriation of the profits.
 FDIs are also likely to indulge in anti-ethical market distortions, off–shoring or

shifting of jobs, overexploitation of natural resources causing environmental damage,
exercising monopoly power, decrease in competitiveness of domestic companies,
potentially jeopardizing national security and sovereignty, worsening commodity
terms of trade and causing emergence of a dual economy.
 FDI in India (Inbound FDI), mostly a post reform phenomenon, is a major source
of non-debt financial resource for economic development. The government has, at
different stages, liberalized FDI by increasing sectoral caps, bringing in more activities
under automatic route and easing conditions for foreign investment.
 Overseas direct investments by Indian companies (Outbound FDI), made possible

by progressive relaxation of capital controls and simplification of procedures, have
undergone substantial changes in terms of size, geographical spread and sectoral
composition. Outward Foreign Direct Investment (OFDI) from India stood at US$ 1.86
billion in the month of June 2016.
373
Speak Your Mind
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375
r
Chapte
INDIAN ECONOMY
10
1. STATUS OF INDIAN ECONOMY: PRE INDEPENDENCE PERIOD (1850 -1947)

Between the first and the seventeenth century AD, India is believed to have had
the largest economy of the ancient and the medieval world. It was prosperous and
self-reliant and is believed to have controlled between one third and one fourth
of the world's wealth. The economy consisted of self-sufficient villages as well as
cities which were centres of commerce, pilgrimage and administration. Compared
to villages, cities presented more opportunities for diverse occupations, trades and
gainful economic activities.
Simple division of labour intertwined with attributes such as race, class, and gender
was the basis of the structure of the villages and acted as a built-in mechanism of
economic and social differentiation. Though agriculture was the dominant occupation
and the main source of livelihood for majority of people, the country had a highly
skilled set of artisans and craftsmen who produced manufactures, handicrafts and
textiles of superior quality and fineness for the worldwide market.
Box.1 Ancient Economic Philosophy of India

The earliest known treatise on ancient Indian economic philosophy is ‘Arthashastra’
the pioneering work attributed to Kautilya (Chanakya) (321–296 BCE)Arthashastra is
recognized as one of the most important works on statecraft in the genre of political
philosophy. It is believed to be a kind of handbook for King Chandragupta Maurya,
the founder of Mauryan empire, containing directives as to how to reign over the
kingdom and encouraging direct action in addressing political concerns without
regard for ethical considerations.
Artha is not wealth alone; rather it encompasses all aspects of the material well-
being of individuals. Arthashastra is the science of ‘artha’ or material prosperity, or
“the means of subsistence of humanity,” which is, primarily, ‘wealth’ and, secondarily,
‘the land’. The major focus of the work is on the means of fruitfully maintaining and
using land. Kautilya emphasizes the importance of robust agricultural initiatives for
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an abundant harvest which will go toward filling the state's treasury. Taxes, which
were charged equal for private and state-owned businesses, must be fair to all and
should be easily understood by the king's subjects.
Being a multidisciplinary discourse on areas such as politics, economics, military
strategy, diplomacy, function of the state, and the social organization, Kautilya’s
writings relate to statecraft, political science, economic policy and military strategy.
True kingship is defined as a ruler's subordination of his own desires and ambitions to
the good of his people; i.e. a king's policies should reflect a concern for the greatest
good of the greatest number of his subjects.
The preservation and advancement of this good was comprised of seven vital
elements, namely the King, Ministers, Farmlands, Fortresses, Treasury, Military and
the Allies.
The advent of the Europeans and the British marked a shift in the economic history
of India.
The period of British rule can be divided into two sub periods:
1. The rule of East India Company from 1757 to 1858
2. British government in India from 1858 to 1947
The historical legacy of British colonialism is an important starting point to illustrate
the development path of India. With the onset of Industrial revolution in the latter
half of the 18th century, the manufacturing capabilities of Britain increased manifold,
and consequently there arose the need to augment raw material supply as well as
the need for finding markets for finished goods. This led to a virtual reversal of the
nature of India’s foreign trade from an exporter of manufactures to an exporter of
raw materials.
The Indian exports of finished goods were subjected to heavy tariffs and the imports
were charged lower tariffs under the policy of discriminatory tariffs followed by
the British. This made the exports of finished goods relatively costlier and the
imports cheaper. In this backdrop, the Indian goods lost their competitiveness.
Consequently, the external as well as the domestic demand for indigenous products
fell sharply culminating in the destruction of Indian handicrafts and manufactures.
The destruction of Indian manufactures, mainly due to the hostile imperial policies
to serve the British interests and the competition from machinemade goods, had far
reaching adverse consequences on the Indian manufacturing sector. The problem
was aggravated by the shift in patterns of demand by domestic consumers favouring
foreign goods as many Indians wanted to affiliate themselves with western culture
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and ways of life.

The damage done to the long established production structure had far reaching
economic and social consequences as it destroyed the internal balance of the
traditional village economy which was characterized by the harmonious blending of
agriculture and handicrafts.
These were manifest as:

1. Large scale unemployment and absence of alternate sources of employment
which forced many to depend on agriculture for livelihood
2. The increased pressure on land caused sub division and fragmentation of land
holdings, subsistence farming, reduced agricultural productivity and poverty.
3. The imports of cheap machine made goods from Britain and an overt shift of
tastes and fashion of Indians in favour of imported goods made the survival of
domestic industries all the more difficult.
4. The systems of land tenure, especially the zamindari system created a class of
people whose interests were focused on perpetuating the British rule.
5. Excessive pressure on land increased the demand for land under tenancy,
and the zamindars got the opportunity to extract excessive rents and other
payments
6. Absentee landlordism, high indebtedness of agriculturists, growth of a class
of exploitative money lenders and low attention to productivity enhancing
measures led to a virtual collapse of Indian agriculture.
We shall now have a look into the stagnated nature of industrialisation during
the colonial era. Factory-based production did not exist in India before 1850.The
‘Modern’ industrial enterprises in colonial India started to grow in the mid-19th
century. The cotton milling business grew steadily throughout the second half of
the 19th century, and achieved high international competitiveness. The cotton mill
industry in India had 9 million spindles in the 1930s, which placed India in the fifth
position globally in terms of number of spindles.
Jute mills also expanded rapidly in and around Calcutta in response to a mounting
global demand for ropes and other products, and Indian jute occupied a large share
of the international market by the late 19th century. At the end of the 19th century,
the Indian jute mill industry was the largest in the world in terms of the amount
of raw jute consumed in production. In addition, brewing, paper-milling, leather-
making, matches, and rice-milling industries also developed during the century.
Heavy industries such as the iron industry were also established as early as 1814
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by British capital. India’s iron industry was ranked eighth in the world in terms of
output in 1930. Due to progress in modern industrial enterprises, some industries
even reached global standards by the beginning of the 20th century. Just before the
Great Depression, India was ranked as the twelfth largest industrialised country
measured by the value of manufactured products.
The producer goods industries, however, did not show high levels of expansion.
Perhaps, the most important of the factors that led to this state of affairs was
the pressure exerted by the English producers in matters of policy formulation to
positively discourage the development of industries which were likely to compete
with those of the English producers.
India’s industrial growth was insufficient to bring in a general transformation in its
economic structure. The share in the net domestic product (NDP) of the manufacturing
sector (excluding small scale and cottage industries) had barely reached 7% even
in 1946.Considering its slow progress, the share of factory employment in India was
also small (i.e. 0.4% of the total population in 1900 and 1.4% in 1941).
2. INDIAN ECONOMY: POST-INDEPENDENCE (1947- 1991)

At the time of independence, India was overwhelmingly rural inhabited by mostly
illiterate people who were exceedingly poor. We had a deeply stratified society
characterized by extreme heterogeneity on many counts. With the literacy rate just
above 18 percent and barely 32 years of life expectancy in 1951, India’s poverty
was not just in terms of income alone, but also in terms of human capital, For
historical reasons, the Nehruvian model which supported social and economic
redistribution and industrialization directed by the state came to dominate the post-
Independence Indian economic policy. Centralized economic planning and direction
was at the core of India’s development strategy and the economic policies were
crafted to accomplish rapid economic growth accompanied by equity and distributive
justice. The Planning Commission of India was established to meticulously plan for
the economic development of the nation in line with the socialistic strategy. This
was carried through the five-year plans which were developed, implemented and
monitored by the Planning Commission.
It is pertinent here to have a look at the ideology of industrialization prevailed in the
early days of independence. India’s political leadership was keen on establishing an
economic system in which the central government would have authority to design
the economic strategy and to carry out the necessary investments in coordination
with the private sector. Rapid industrialization of the economy was the cornerstone
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of Nehru’s development strategy. The concept of ‘planned modernization’ meant a

systematic planning to support industrialization. The bureaucrats and the technocrats
envisioned a substantially significant role for the state in industrialisation.
The Industrial Policy Resolution (1948) envisaged an expanded role for the public
sector and licensing to the private sector. It granted state monopoly for strategic
areas such as atomic energy, arms and ammunition and railways. Also, the rights to
new investments in basic Industries were exclusively given to the state.
The policies in 1950’s were guided by two economic philosophies:
1. The then prime minister Nehru’s visualization to build a socialistic society with
emphasis on heavy industry, and
2. The Gandhian philosophy of small scale and cottage industry and village
republics.
The Industrial Policy Resolution of 1956 though provided a comprehensive framework
for industrial development, was lopsided as its guiding principle supported enormous
expansion of the scope of the public sector. A natural outcome of the undue priority
for public sector was the dampening of private initiative and enterprise. For obvious
reasons, private investments were discouraged and this had long-lasting negative
consequences for industrial growth.
India followed an open foreign investment policy and a relatively open trade policy
until the late 1950s.A balance of payments crisis emerged in 1958 causing concerns
regarding foreign exchange depletion. Consequently, there emerged a gradual
tightening of trade and reduction in investment-licensing of new investments
requiring imports of capital goods. The comprehensive import controls were
maintained until 1966.
In the first three decades after independence (1950–80), India’s average annual rate
of growth of GDP- often referred to as the ‘Hindu growth rate’- was a modest 3.5
percent. While agriculture was not neglected, the thrust of the first decade and a
half was on capital goods— capital-intensive projects such as dams, power plants,
and heavy industrialization—rather than consumer goods.
The first major shift in Indian economic strategy was in the mid-1960s. Agriculture
was not given adequate priority during the second plan and the outlays were reduced.
The strategy for agricultural development till then was reliance on institutional
model i.e. land reforms, farm cooperatives etc. and not much importance was
given to technocratic areas such as research and development, irrigation etc. These
institutional reforms were only modestly successful and the productivity increase in
agriculture was meagre.
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With continuous failures of monsoon, two severe and consecutive droughts struck
India in 1966 and 1967. The agricultural sector recorded substantial negative growth
and India faced a serious food problem. India had to depend on the United States for
food aid under PL 480. A quantum jump in the food grain production was the need
of the hour. Increasing productivity in agriculture was given the highest priority. This,
in fact, kick-started a strategic change in the government’s agricultural policies. The
new wave of change relied less on the earlier efforts at institutional change and
relied more on enhancing productivity of agriculture, especially of wheat. A thorough
restructuring of agricultural policy referred to as the ‘green revolution’ was initiated.
The green revolution was materialised by innovative farm technologies, including
high yielding seed varieties and intensive use of water, fertilizer and pesticides.
The green revolution was successful in increasing agricultural productivity through
technical progress and significantly increased food grain production enabling India
to tide over the food problem.
While India drastically changed its agricultural policies, the government introduced
extra stringent administrative controls on both trade and industrial licensing and
launched a wave of nationalization. The government nationalized 14 banks in 1969
and then followed it up with nationalizing another 6 in 1980. The wide sweep of
the interventionist policies that had come to exist in the 1960s had irreparable
consequences in the next decade.
The economic performance during the period of 1965-81 is the worst in independent
India’s history. The decline in growth during this period is attributed mainly to
decline in productivity. The license-raj, the autarchic policies that dominated the
1960s and 1970s, the external shocks such as three wars (in 1962, 1965, and
1971), major droughts (especially 1966 and 1967), and the oil shocks of 1973 and
1979contributed to the decelerated growth that lasted two decades. India being
practically a closed economy missed out on the opportunities created by a rapidly
growing world economy.
Many government policies aimed at equitable distribution of income and wealth
effectively killed the incentive for creating wealth. Equity driven policies were also
largely anti growth. The Monopolies and Restrictive Trade Practices (MRTP) Act, 1969
was aimed at regulation of large firms which had relatively large market power.
Several restrictions were placed on them in terms of licensing, capacity addition,
mergers and acquisitions. Thus, policies restricting the possibility of expansion of
big business houses kept their entry away from nearly all but a few highly capital
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intensive sectors.
In 1967, the policy of reservation of many products for exclusive manufacture by
the small scale sector was initiated with the objective of promotion of small scale
industries. It was argued that this policy will encourage labour-intensive economic
growth and allow redistribution of income by shifting incomes towards lower wage
earners. However, this policy excluded all big firms from labour intensive industries
and India was not able to compete in the world market for these products. Stringent
labour laws which were in place also discouraged starting of labour intensive
industries in the organized sector.
There was a growing realisation among policymakers and industrialists that the
prevailing strict regime is invariably counterproductive and that most of the controls
and regulations had not delivered in the absence of adequate incentives and openness
which are necessary conditions for sustained rapid growth.
3. THE ERA OF REFORMS

The seeds of early liberalisation and reforms were sown during the 1980s, especially
after 1985. In early 1980s considerable efforts were initiated in different directions
to restore reasonable price stability through a combination of tight monetary policy,
fiscal moderation and a few structural reforms. These initiatives, spanning 1981
to 1989, practically referred to as ‘early liberalization’ were specifically aimed at
changing the prevailing thrust on ‘inward - oriented’ trade and investment practices.
In fact, this liberalization is often referred to as ‘reforms by stealth’ to denote its ad
hoc and not widely publicized nature. Despite the fact that these efforts were not in
the form of a comprehensive package (as the one in 1991) to reverse the centralised
controls and the protectionist bias in policies, they started bearing fruits in the form
of higher growth rate during the 1980s as compared with the previous three decades.
The average annual growth rate of GDP during the sixth plan period (1980–1985)
and the seventh plan period (1985–1990) were 5.7 and 5.8 percent respectively.
The early reforms of 1980’s broadly covered three areas, namely industry, trade
and taxation. Simultaneously, the government also embarked on a policy of skilful
exchange rate management. The prominent industrial policy initiatives during
this period directed towards removing constraints on growth and creating a more
dynamic industrial environment were:
• In 1985 delicensing of 25 broad categories of industries was done. This was
later extended to many others
• The facility of ‘broad-banding’ was accorded for industry groups to allow
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flexibility and rapid changes in their product mix without going in for fresh
licensing. In other words, the firms in the engineering industry were allowed to
change their product mix within their existing capacity. For example, firms may
switch production between different production lines such as trucks and car
without a new licence
• To relax the hold of the licensing and capacity constraints on larger MRTP firms,
in 1985–86, the asset limit above which firms were subject to MRTP regulations
was raised from 20 crore to 100 crore.
• The multipoint excise duties were converted into a modified value-added
(MODVAT) tax which significantly reduced the taxation on inputs and the
associated distortions.
• Establishment of the Securities and Exchange Board of India (SEBI) as a non-
statutory body on April 12, 1988 through a resolution of the Government of
India
• The open general licence (OGL) list was steadily expanded. The number of
capital goods items included in the OGL list expanded steadily reaching1,329
in April 1990.
• Several export incentives were introduced and expanded
• The exchange rate was set at a realistic level which helped expand exports and
in turn reduced pressure on foreign exchange needed for imports
• Price and distribution controls on cement and aluminum were entirely abolished.
• Based on the real effective exchange rate (REER), the rupee was depreciated
by about 30.0 per cent from 1985–86 to 1989–90. This reflects a considerable
change in the official attitude towards exchange rate depreciation
• The budget for 1986 introduced policies of cutting taxes further, liberalising
imports and reducing tariffs.
However, the growth performance of the economy was thwarted due to structural
inadequacies and distortions. The private sector investments were inhibited due
to reasons such as convoluted licensing policies, public sector reservations and
excessive government controls. Due to reservation of goods to small scale sector
as well as excessive price and distribution controls, the private sector was virtually
discouraged from making investments.
The public sector which led the manufacturing and service sectors was plagued by
inefficiency, government controls and bureaucratic procedures. Despite the fact that
they were of massive in size and enjoyed monopoly in their respective areas, their
performance was far from satisfactory and yielded very low returns on investment.
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The MRTP act had many restrictive conditions creating barriers for entry, diversification
and expansion for large industrial houses. Import controls in the form of tariffs, quotas
and quantitative restrictions ensured that foreign manufactures and components did
not cross the borders and compete with the domestic industries. Foreign investments
and foreign competition were not allowed on grounds of affording protection to
domestic industries. Briefly put, the rules and regulations which were aimed at
promoting and regulating the economic activities became major hindrances to
growth and development.
Though the reforms in 1980’s were limited in scope and were without a clearly
observable road map as compared to the New Economic Policy in 1990, they were
instrumental in bringing confidence in the minds of politicians and policy makers
regarding the efficacy of policy changes to produce sustained economic growth. The
belief that well-regulated competitive markets can ensure economic growth and
also increase total welfare got fostered in the minds of policy makers. In other words,
the idea that government intervention in markets need not always be accepted as
‘the standard’ and that markets should be given priority over government in the
conduct of a good number of economic activities gained a broad acceptance. Thus,
the liberalization in the 1980s served as the necessary foundation for the more
universal and organized reforms of the 1990s.
4. THE ECONOMIC REFORMS OF 1991

India embarked on a bold set of economic reforms in 1991 under the Narsimha Rao
government.
The causes attributed to the immediate need for such a drastic change are:
1. The fiscal initiatives for enhanced economic growth in 1980s saw the government
revenue expenditure consistently exceeding revenue receipts. The fiscal deficit
was financed by huge amounts of domestic as well as external debt. The high
level current expenditure proved clearly unsustainable and got manifested on
extremely large fiscal deficits and adverse balance of payments.
2. Persistent huge deficits led to swelling public debt and a large proportion of
government revenues had to be earmarked for interest payments.
3. The surge in oil prices triggered by the gulf war in 1990 and the consequent
severe strain on a balance of payments.
4. The foreign exchange reserves touched the lowest point with a reserve of only
$1.2 billion which was barely sufficient for two weeks of imports. This was the
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major context that triggered economic reforms.

5. Tightening of import restrictions to muster forex for essential imports resulted
in reduction in industrial output.
6. India had to depend on external borrowing from the International Monetary
Fund which in turn put forth stringent conditions in terms of corrective policy
measures before additional drawings could be made.
7. The fragile political situation along with the crises in the economic front
ballooned into what may be called a ‘crisis of confidence’.
The year 1991 marked a paradigm shift in the Indian policy reforms. The nation
which had embraced the ‘socialist model’, with the state playing an overriding role
in the economy had the history of the government persistently intervening in the
markets. Collapse of the Soviet Union and the spectacular success of China, based
on outward oriented policies were lessons for the Indian policy makers. The reforms
instituted in 1991 aimed to move the economy toward greater market orientation
and external openness.
The reforms, popularly known as liberalization, privatization and globalisation,

spelt a major shift in economic philosophy and fundamental change in approach
and had two major objectives:
1. reorientation of the economy from a centrally directed and highly controlled
one to a ‘market friendly’ or market oriented economy.
2. macroeconomic stabilization by substantial reduction in fiscal deficit.
A detailed description of reform measures is beyond the scope of this unit. We shall
now have a brief account of the major measures taken in 1991.
As we know, the momentum for reforms originated in the critical economic, fiscal
and balance of payments crises. Therefore, the reform package was structured as
a core package of mutually supportive reforms to address the balance of payment
crisis and the structural rigidities. The policy paradigm focused on shifting from
central direction to market orientation.
The policies can be broadly classified as :

1. stabilisation measures which were short term measures to address the problems
of inflation and adverse balance of payment and
2. the structural reform measures which are long term and of continuing nature
aimed at bringing in productivity and competitiveness by removing the structural
385
rigidities in different sectors of the economy.

 The Fiscal Reforms
The escalating deficit levels rendered the stabilisation efforts rather complicated.
Bringing in fiscal discipline by reducing the fiscal deficit was vital because the
crisis was caused by excess domestic demand, surge in imports and the widening
of the current account deficit (CAD) which was to be financed by drawing down
on reserves. This was attempted by radical measures to augment revenues and
to curtail government expenditure. Measures to this effect included:
1. Introduction of a stable and transparent tax structure,
2. Ensuring better tax compliance,
3. Thrust on curbing government expenditure
4. Reduction in subsidies and abolition of unnecessary subsidies
5. Disinvestment of part of government’s equity holdings in select public
sector undertakings and
6. Encouraging private sector participation.
In order to bring in fiscal discipline, it was essential to do away with the
temptation to finance deficit thorough the easy path of money creation.
Therefore, the government entered into a historic agreement with the
Reserve Bank in September 1994 to bring down the fiscal deficit in a
phased manner to nil by 1997–98.
 Monetary and Financial Sector Reforms

Drastic monetary and financial sector reforms were introduced with the objective
of making the financial system more efficient and transparent. The focus was
mostly on reducing the burden of nonperforming assets on government banks,
introducing and sustaining competition, and deregulating interest rates. These
included many measures, important among them are:
1. Interest rate liberalization and reduction in controls on banks by the
Reserve Bank of India in respect of interest rates chargeable on loans and
payable on deposits.
2. Opening of new private sector banks and facilitating greater competition
among public sector, private sector and foreign banks and simultaneously
removal of administrative constraints that reduced efficiency
3. Reduction in reserve requirements namely, statutory liquidity ratio (SLR)
and cash reserve ratio (CRR) in line with the recommendations of the
Narasimham Committee Report, 1991.
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4. Liberalisation of bank branch licensing policy and granting of freedom to

banks in respect of opening, relocating or closure of branches
5. Prudential norms of accounting in respect of classification of assets,
disclosure of income and provisions for bad debt were introduced in tune
with the Narasimham Committee recommendations to ensure that the
books of commercial banks reflect the accurate and truthful picture of
their financial position.
 Reforms in Capital Markets

The Securities and Exchange Board of India (SEBI) which was set up in 1988 was
given statutory recognition in 1992. SEBI has been mandated as an independent
regulator of the capital market so as to create a transparent environment which
would facilitate mobilization of adequate resources and their efficient allocation.
 The ‘New Industrial Policy’

The ‘New Industrial Policy’ announced by the government on 24 July 1991 sought
to substantially deregulate industry so as to promote growth of a more efficient
and competitive industrial economy. In order to provide greater competitive
stimulus to the domestic industry, a series of reforms were introduced
1. The New Economic Policy put an end to the ‘License Raj’ by removing
licensing restrictions for all industries except for 18 that ‘related to security
and strategic concerns, social reasons, problems related to safety and
overriding environmental issues’. Consequently, 80 percent of the industry
was taken out of the licensing framework. This is subsequently reduced
to 5,namely, arms and ammunition, atomic substances, narcotic drugs
and hazardous chemicals, distillation and brewing of alcoholic drinks and
cigarettes and cigars as these have severe implications on health, safety,
and environment.
2. Public sector was limited to eight sectors based on security and strategic
grounds. Subsequently only two items remained – railway transport and
atomic energy
3. The Monopolies and Restrictive Trade Practices (MRTP) Act was restructured
and the provisions relating to merger, amalgamation, and takeover were
repealed. This has eliminated the need for pre-entry scrutiny of investment
decisions and prior approval for large companies for capacity expansion
or diversification.
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4. Many goods produced by small-scale industries have been de reserved

enabling entry of large scale industries.
5. The policy ended the public sector monopoly in many sectors The number
of areas reserved for public sector was narrowed down to ensure liberal
participation by the private sector. Only eight industries which are of
importance due to strategic and security concerns were reserved for the
public sector. The changes continued and we find that now the industries
reserved for the public sector are only a part of atomic energy generation
and some core activities in railway transport.
6. Foreign investment was also liberalised. The concept of automatic
approval was introduced for foreign direct investments up to 51 percent
which was later extended to nearly all industries except the reserved ones.
FDI is prohibited only in four sectors viz. retail trade, atomic energy, lottery
business and betting and gambling.
7. External trade was further liberalised by substituting ‘the positive list
approach’ of listing license-free items on the OGL list with the negative list
approach. The policy did away with import licensing on all but a handful
of intermediate and capital goods. The consumer goods which remained
under licensing was made free 10 years later. Today, except for a handful
of goods disallowed on health, environmental and safety grounds, and
few others such as edible oil, fertilizer and petroleum products all goods
can be imported
8. In 1990-91, the highest tariff rate was 355%, The top tariff rate was
brought down to 85% in 1993-94 and to 50% in 1995-96 and by 2007-
08, it has come down to 10% with some exceptions such as automobile at
100%
9. Rupee was devalued by 18% against the dollar. From 1994 onwards, all
current account transactions including business, education, medical and
foreign travel were permitted at market exchange rate and rupee became
officially convertible on current account
10. The disinvestment of government holdings of equity share capital of public
sector enterprises was a very bold step. The hitherto constrained public
sector units were provided with greater autonomy in decision making and
opportunity for professional management for ensuring reasonable returns.
The budgetary support to public sector was progressively reduced.
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 Trade Policy Reforms

The trade policy reforms aimed at:
• dismantling of quantitative restrictions on imports and exports
• focusing on a more outward oriented regime with phased reduction and
simplification of tariffs, and
• removal of licensing procedures for imports.
A number of export incentives were continued and new ones were
initiated for boosting exports. Export duties were removed to increase the
competitive position of Indian goods in the international markets. In 1991,
India still had a fixed exchange rate system, under which the rupee was
pegged to the value of a basket of currencies of major trading partners.
In July 1991 the Indian government devalued the rupee by between 18
and 19 percent. In March 1992 the government decided to establish a
dual exchange rate regime. The government allowed importers to pay
for some imports with foreign exchange valued at free-market rates and
other imports could be purchased with foreign exchange purchased at a
government- mandated rate In March 1993 the government unified the
exchange rate and allowed, for the first time, the rupee to float. From
1993 onwards, India has followed a managed floating exchange rate
system.
India has witnessed vast changes over the last 31 years of economic
reforms. Changes enumerated below are only broad observations and are
in no way comprehensive.
• India has increasingly integrated its economy with the global economy.
• India has progressively moved towards a market oriented economy, with
a sizeable reduction in government’s market intervention and controls
• There is an unprecedented growth of private sector investment and
initiatives
• A number of sectors such as auto components, telecommunications,
software, pharmaceuticals, biotechnology, and professional services have
achieved vey high levels of international competitiveness
• Easing of trade controls has enabled easier access to foreign technology,
inputs, knowhow and finance
• Stable foreign direct investment inflows and substantial foreign portfolio
investments
• India enjoys a solid cushion of foreign exchange reserves close to
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eight months of import cover. India has one of the largest holdings of
international reserves in the world.
• Robust demand for information technology and financial services has kept
the services trade surplus high at around 3.7 percent of GDP
• Pressure on the Indian rupee is lower compared to other emerging market
economies (EMEs)
• Increased incomes, large domestic market and high levels of aggregate
demand sustains the economy.
• India is better placed than most of the emerging market economies to
deal with global headwinds
• Poverty has reduced substantially
• Reforms led to increased competition in sectors like banking, insurance and
other financial services leading to greater customer choice and increased
efficiency. It has also led to increased investment and growth of private
players in these sectors.
• Infrastructure sectors have achieved phenomenal growth
• Value-added share of agriculture and allied activities has declined steadily
over the past four decades.
• India’s financial sector has also deepened considerably due to increased
financial sector liberalisation.
However, the country is constrained by high levels of fiscal deficit, inflation
and a high level of debt as a share of GDP at 86 percent of GDP in FY21/22.
Among the emerging market and developing economies (EMDEs), India’s
debt is higher than their average of 64.5% for 2022(IMF).
5. GDP GROWTH RATES POST 1991 REFORMS

As we are aware, GDP growth rate is regarded as the most reliable indicator of
economic growth. The following table and graphical presentation present data on
GDP growth rate post 1991 reforms.
Table 10.1
GDP Growth (Annual %) – India from 1991 to 2021
Year GDP Growth (Annual %) Year GDP Growth (Annual %)
1991 1.056831 2006 8.060733
1992 5.482396 2007 7.660815
1993 4.750776 2008 3.086698
1994 6.658924 2009 7.861889
1995 7.574492 2010 8.497585
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1996 7.549522 2011 5.241315

1997 4.049821 2012 5.456389
1998 6.184416 2013 6.386106
1999 8.845756 2014 7.410228
2000 3.840991 2015 7.996254
2001 4.823966 2016 8.256306
2002 3.803975 2017 6.795383
2003 7.860381 2018 6.453851
2004 7.922937 2019 3.737919
2005 7.923431 2020 -6.59608
2021 8.681229
6. NITI AAYOG: A BOLD STEP FOR TRANSFORMING INDIA

For nearly sixty four years, the Planning Commission of India - a powerful advocate
of public investment-led development - was one of the most important institutions
within India's central government. The new ideologies of the neoliberal era with their
centre of attention on market orientation and shrinking roles of the government and
the collapse of the planning system called for a change in the nature, composition
and scope of institutions of governance.
On 1st January 2015, the apex policy-making body namely Planning Commission,
was replaced by the National Institution for Transforming India (NITI) Aayog. The
major objective of such a move was to ‘spur innovative thinking by objective ‘experts’
and promote ‘co-operative federalism’ by enhancing the voice and influence of the
states’. NITI Aayog is expected to serve as a 'Think Tank' of the government. [and] a
‘directional and policy dynamo’.
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NITI Ayog will work towards the following objectives*:

1. To evolve a shared vision of national development priorities, sectors and
strategies with the active involvement of states.
2. To foster cooperative federalism through structured support initiatives and
mechanisms with the states on a continuous basis, recognizing that strong
states make a strong nation.
3. To develop mechanisms to formulate credible plans at the village level and
aggregate these progressively at higher levels of government.
4. To ensure, on areas that are specifically referred to it, that the interests of
national security are incorporated in economic strategy and policy.
5. To pay special attention to the sections of our society that may be at risk of not
benefiting adequately from economic progress.
6. To design strategic and long-term policy and programme frameworks and
initiatives, and monitor their progress and their efficacy
7. To provide advice and encourage partnerships between key stakeholders and
national and international like-minded think tanks, as well as educational and
policy research institutions.
8. To create a knowledge, innovation and entrepreneurial support system through
a collaborative community of national and international experts, practitioners
and other partners.
9. To offer a platform for the resolution of inter-sectoral and inter departmental
issues in order to accelerate the implementation of the development agenda.
10. To maintain a state-of-the-art resource centre, be a repository of research on
good governance and best practices in sustainable and equitable development
as well as help their dissemination to stake-holders.
11. To actively monitor and evaluate the implementation of programmes and
initiatives, including the identification of the needed resources so as to strengthen
the probability of success and scope of delivery.
12. To focus on technology up gradation and capacity building for implementation
of programmes and initiatives.
13. To undertake other activities as may be necessary in order to further the
execution of the national development agenda, and the objectives mentioned
above. *NITI Aaayog https://niti.gov.in/objectives-and-features
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The key initiatives of NITI Aayog are:

1. ‘Life’ which envisions replacing the prevalent 'use-and-dispose' economy
2. The National Data and Analytics Platform (NDAP) facilitates and improves
access to Indian government data
3. Shoonya campaign aims to improve air quality in India by accelerating the
deployment of electric vehicles
4. E-Amrit is a one-stop destination for all information on electric vehicles
5. India Policy Insights (IPI)
6. 'Methanol Economy' programme is aimed at reducing India's oil import
bill, greenhouse gas (GHG) emissions, and converting coal reserves and
municipal solid waste into methanol, and
7. 'Transforming India’s Gold Market' constituted by NITI Aayog to recommend
measures for tapping into the potential of the sector and provide a stimulus
to exports and economic growth
There are arguments put forth by experts about the weaknesses of the
system. They argue that NITI has a limited role; it does not produce
national plans, control expenditures, or review state plans. The major
shortcoming of NITI is its exclusion from the budgeting process. It also
lacks autonomy and balance of power within the policy making apparatus
of the central government. The termination of the Planning Commission
has strengthened the hand of the Ministry of Finance, with its ‘fixation
on near-term macroeconomic stability and the natural instinct to limit
expenditure’. But NITI lacks the independence and power to perform
as a ‘counterweight’ to act as a "voice of development" concerned with
inequities.
7. THE CURRENT STATE OF THE INDIAN ECONOMY: A BRIEF OVERVIEW

On account of the enormity of the economic phenomena and the dynamic nature
of economic variables, it is not possible to have an up-to-date and comprehensive
documentation on the current state of the economy. Given the constraints of the
unit, an attempt is made in the following sections to present the broad nature of the
present day Indian economy based on the three sectors namely, primary, secondary
and tertiary.
 The Primary Sector
Agriculture, with its allied sectors, is indisputably the largest source of livelihood
in India. Till the end of 1960’s, India was a food deficient nation and depended
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on imports. India has emerged as the world’s largest producer of milk, pulses,
jute and spices. India has the largest area planted under wheat, rice and cotton.
It is the second-largest producer of fruits, vegetables, tea, farmed fish, cotton,
sugarcane, wheat, rice, cotton, and sugar. Indian food and grocery market is
the world’s sixth largest, with retail contributing 70% of the sales. India has
the world’s largest cattle herd (buffaloes).The Indian livestock sector attained
a record growth of 6.6 per cent during the last decade (2010-19) emerging as a
major producer of milk, egg and meat in the world. India grows large varieties
of cash crops of which cotton, jute and sugarcane are prominent. Although the
share of agriculture has been declining in overall gross value added (GVA) of
India, it continues to grow in absolute terms.
According to the latest estimates, 47 per cent of India’s population is directly
dependent on agriculture for living. It also contributes a significant figure to
the Gross Domestic Product (GDP). Gross Value Added by the agriculture and
allied sector was 18.8% in 2021-22 (until 31 January, 2022).
The index numbers of agricultural production in 2021-22 (base: triennium ending
2007- 08=100) for categories namely, all crops, food-grains, cereals, wheat and
coarse cereals was above 140; and that of rice and pulses was 138.7 and 196.2
respectively. For non- food grains, it was 142.9. These figures show sustained
increase in agricultural output. Food grains production has reached 315.7 million
tonnes in 2021-22. Private investment in agriculture has increased to 9.3% in
2020-21. (Source: Handbook of Statistics on the Indian Economy, 2021-22)
As per the economic survey, 2022-23, agriculture remained robust, recording
a growth of 3.5 per cent in 2022-23, driven by buoyant rabi sowing and
allied activities. The performance of the agriculture and allied sectors has
been buoyant over the past several years, much of which is on account of the
measures taken by the government to:
• augment crop and livestock productivity,
• ensure certainty of returns to the farmers through price support (The
Minimum Support Price (MSP) of all 23 mandated crops is fixed at 1.5
times of all India weighted average cost of production)
• promote crop diversification,
• improve market infrastructure through the impetus provided for the
setting up of farmer-producer organisations and
• promotion of investment in infrastructure facilities through the Agriculture
Infrastructure Fund.
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India has achieved a remarkable shift from a food deficient and import
dependent nation during the early nineteen sixties to a food exporting
nation. India is among the top ten exporters of agricultural products
in the world. Export of agricultural and allied products has witnessed
significant increase during the last few years and touched an all-time
peak of Rs 374611 crore during the last one year. Exports of agricultural
and processed food products rose by 25 percent within six months of the
current financial year 2022-23 (April-September) in comparison to the
corresponding period in 2021-22. Agricultural and Processed Food Export
Development Authority (APEDA) is entrusted with the responsibility of
exportpromotion of agri-products.
A number of liberalization measures are adopted by the government. The
Government of India has allowed 100% FDI in marketing of food products
and in food product E-commerce under the automatic route. Considering the
diverse needs of the agricultural sector and the larger farming community,
a large number of interventions are undertaken by different governments.
A few such recent measures are:
• Income support to farmers through PM KISAN
• Fixing of Minimum Support Price (MSP) at one-and-a half times the cost
of production
• Institutional credit for agriculture sector at concessional rates
• Launch of the National Mission for Edible Oils
• Pradhan Mantri Fasal BimaYojana (PMFBY) – a novel insurance scheme
for financial support to farmers suffering crop loss/damage
• Mission for Integrated Development of Horticulture (MIDH) for the holistic
growth of the horticulture sector
• Provision of Soil Health Cards
• Paramparagat Krishi Vikas Yojana (PKVY) supporting and promoting
organic farming, and improvement of soil health.
• Agri Infrastructure Fund, a medium / long term debt financing facility for
investment in viable projects for post-harvest management Infrastructure
and community farming assets
• Promotion of Farmer Producer Organisations (FPOs) to ensure better
income for the producers through an organization of their own.
• Per Drop More Crop (PDMC) scheme to increase water use efficiency at the
farm level
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• Setting up of Micro Irrigation Fund

• Initiatives towards agricultural mechanization
• Setting up of E-NAM -a pan-India electronic trading portal which
networks the existing APMC mandis to create a unified national market
for agricultural commodities.
• Introduction of Kisan Rail for improvement in farm produce logistics, and
• Creation of a Start-up Eco system in agriculture and allied sectors
Despite phenomenal increase in output of both food crops and commercial
crops, Indian agriculture faces many issues such as:
• Indian agriculture is dominated by small and medium farmers. Small and
fragmented landholdings, low farm productivity and subsistence farming
result in very little marketable surplus and the consequent lower income
levels of the agriculturists. These also reduce their ability to participate
in the domestic as well as export market.
• Indian agriculture is resource intensive, cereal centric and regionally
biased. There is Increasing stress on water resources and soil fertility.
Unscientific and wasteful agricultural practices lead to desertification
and land degradation in many parts of the country.
• Inadequate agro-processing infrastructure and failure to build competitive
value chains from producers to urban centers and export markets
• Sluggish agricultural diversification to higher-value commodities
• Inadequate adoption of environmentally sustainable and climate resistant
new farm technology
• Poor adoption of new agricultural technologies
• Lopsided marketing practices and ineffective credit delivery
• Complexities associated with adaptation to climate change disturbances
• High food price volatility
• Heavy dependence on monsoons and loss of crops and livelihood due to
vagaries of nature
• Issues related to marketing and warehousing of agricultural products
• Inability to tap the full export potential of primary as well as value added
products
• Inability to effectively channelize huge surpluses in some commodities to
alternative profitable destinations
• Inadequate post-harvest infrastructure and management practices
• Incidence of poverty and malnutrition
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 The Secondary Sector

The Indian industry holds a significant position in the Indian economy contributing
about 30 percent of total gross value added in the country and employing
over 12.1 crores of people. The industrial sector in India broadly comprises of
manufacturing, heavy industries, fertilizers, pharmaceuticals, chemicals and
petrochemicals, oil and natural gas, food processing, mining, defence products,
textiles, retail, micro, small & medium enterprises, cottage industries and tourism.
The share of informal sector in the economy is more than 50% of GVA. Rapid
industrial growth of domestic industries and diversification of industrial structure
are essential elements for sustainable economic growth. The development of a
robust manufacturing sector is a key priority of the Indian Government.
A detailed discussion on industrial development is beyond the scope of this
unit. Starting with the industrial growth figures, we shall briefly touch upon the
general aspects related to industries. In India, industrial production measures
the output of businesses integrated in industrial sector of the economy.
Manufacturing is the most important sector and accounts for 78 percent of
total production. The manufacturing GVA at current prices was estimated
at US$ 77.47 billion in the third quarter of financial year 2021-22 and has
contributed around 16.3% to the nominal GVA during the past ten years. In
2022- 23 (until September 2022), the combined index of eight core industries*
stood at 142.8 driven by the production of coal, refinery products, fertilizers,
steel, electricity and cement industries. In Jan 31, 2023 the Manufacturing
Purchasing Managers’ Index (PMI) in India stood at 55.4 . India’s rank in the
Global Innovation Index (GII) improved to 40th in 2022 from 81st in 2015.
[*ICI measures combined and individual performance of production of eight
core industries viz. Coal, Crude Oil, Natural Gas, Refinery Products, Fertilizers,
Steel, Cement and Electricity. The Eight Core Industries comprise 40.27 percent
of the weight of items included in the Index of Industrial Production (IIP)].
The Department for Promotion of Industry and Internal Trade (DPIIT) has a role
in the formulation and implementation of industrial policy and strategies for
industrial development in conformity with the development needs and national
objectives. Ever since independence, many innovative schemes are undertaken
by different governments from time to time to boost industrial performance.
Some of the policies are presented below:
• Introduction of goods and services tax (GST) on 1 July 2017 as a single
domestic indirect tax law for the entire country replacing many indirect
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taxes in India such as the excise duty, VAT, services tax, etc.
• Reduction of corporate tax to domestic companies giving an option to pay
income-tax at the rate of 22% subject to condition that they will not avail
any exemption/incentive.
• ‘Make in India’ is a 'Vocal for Local' initiative launched in 2014 to facilitate
investment, foster innovation, build excellent infrastructure and make India
a hub for manufacturing, design and innovation. Make in India 2.0’ is now
focusing on 27 sectors, which include 15 manufacturing sectors and 12
service sectors.
• ‘Ease of Doing Business’ with key focus areas as simplification of procedures,
rationalization of legal provisions, digitization of government processes,
and decriminalization of minor, technical or procedural defaults. India
ranks 63rdin the World Bank’s annual Doing Business Report (DBR), 2020
as against 77thrank in 2019 registering a jump of 14 ranks.
• The National Single Window System is a one-stop-shop for investor related
approvals and services in the country and aims to provide continuous
facilitation and support to investors.
• PM Gati Shakti National Master Plan to facilitate data-based decisions
related to integrated planning of multimodal infrastructure, thereby
reducing logistics cost.
• National Logistics Policy (NLP) launched in September 2022, aims to lower
the cost of logistics and make it at par with other developed countries.
• Keeping in view India’s vision of becoming ‘Atmanirbhar’, the Production
Linked Incentive (PLI) Scheme was initiated in March 2020 for 14 key sectors
to enhance India’s manufacturing capabilities and export competitiveness.
PLI Scheme is now extended for white goods (air conditioners and led
lights).
• Industrial Corridor Development Programme: Greenfield Industrial regions/
areas/nodes with sustainable infrastructure and to make available ‘plug
and play’ infrastructure at the plot level.
• FAME-India Scheme (Faster Adoption and Manufacturing of Hybrid and
Electric Vehicles) to promote manufacturing of electric and hybrid vehicle
technology and to ensure sustainable growth of the same.
• ‘Udyami Bharat’ aims at the empowerment of Micro Small and Medium
Enterprises (MSMEs).
• PM Mega Integrated Textile Region and Apparel (PM MITRA): to ensure
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world-class industrial infrastructure which would attract cutting age

technology and boost FDI and local investment in the textiles sector.
• Opening up for global investments: To make India a more attractive
investment destination, the government has implemented several radical
and transformative FDI reforms across sectors such as defence, pension,
e-commerce activities etc.
• 100 per cent FDI under automatic route is permitted for the sale of coal,
and coal mining activities, including associated processing infrastructure
and for insurance intermediaries.
• Foreign Investment Promotion Board (FIPB) was abolished in May 2017,
and a new regime namely Foreign Investment Facilitation Portal (FIF) has
been put in place. Under the new regime, the process for granting FDI
approvals has been simplified. 853 FDI proposals were disposed off in the
last 5 years. FDI has increased jumped by 39% since FIF came into being.
• Remission of Duties and Taxes on Export Products (RoDTEP) 2021 formed
to replace the existing MEIS (Merchandise Exports from India Scheme) to
boost exports. It provides for rebate of all hidden central, state, and local
duties/taxes/levies on the goods exported which have not been refunded
under any other existing scheme.
• Initiatives towards fostering innovation include incubation, handholding,
funding, industry-academia partnership and mentorship and strengthening
of IPR regime.
• National Logistics Policy (NLP) is comprehensive policy framework for the
Logistics Sector.
• Start-up India Programme acts as the facilitator for ideas and innovation
in the country. India’s rank in the Global Innovation Index (GII) has improved
from 81st in 2015 to 40th in 2022.
• Public Procurement (Preference to Make in India) Order, 2017gives
preference to locally manufactured goods, works and services in public
procurement thereby giving boost to industrial growth.
• The Emergency Credit Line Guarantee Scheme (ECLGS)is a fully guaranteed
emergency credit line to monitor lending institutions.
India is gearing up for the fourth industrial revolution or Industry 4.0 in

which manufacturing transformation needs to integrate new technologies
such as cloud computing, IoT, machine learning, and artificial intelligence
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(AI). The National Manufacturing Policy which aims to increase the share of
manufacturing in GDP to 25 percent by 2025 is a step in this direction. India
is an attractive hub for foreign investments in the manufacturing sector. Over
the last few years, FDI equity inflows in the manufacturing sector have been
progressively rising. India continues to open up its sectors to global investors
by raising FDI limits and removing regulatory barriers in addition to developing
infrastructure and improving the business environment. According to the
Department for Promotion of Industry and Internal Trade (DPIIT), India received
a total foreign direct investment (FDI) inflow of US$ 58.77 billion in 2021-22.
There are many challenges to the industrial sector; a few of these are
enumerated below:
• Shortage of efficient infrastructure and manpower and consequent
reduced factor productivity.
• Reliance on imports, exchange rate volatility and associated time and
cost overruns
• The MSME sector is relatively less favorably placed in terms of credit
availability.
• Industrial locations established without reference to cost-effective points
tend to experience unsustainable cost structure.
• Heavy losses, inefficiencies, lower productivity and unsustainable returns
plaguing public sector industries.
• Strained labor-management relations and loss of man hours.
• Lower export competitiveness, slowing external demand and imposition
of non tariff barriers by other countries.
• Global supply chain disruptions and uncertainties.
• Inflation and associated macro economic developments leading to input
cost escalations and lower demand.
• Global slowdown and related negative sentiments affecting investment.
• Aggressive tightening of monetary policy and increases in cost of credit.
• High and increasing fuel prices, and
• Mounting presence of informal sector.
 The Tertiary Sector

A remarkable feature of the post reform Indian economy is the overarching
role of the services sector in generating growth of income and employment.
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Unlike the usual economic development process of nations where economic

growth has led to a shift from agriculture to industries, or from the primary
sector to the secondary sector, India has the unique experience of bypassing
the secondary sector in the growth trajectory by a shift from agriculture to the
services sector.
India’s services sector covers a wide variety of activities. (Refer Box 2 Below)
BOX 2. The broad classification of services as per the National Industrial
Classification, 2008
1. Wholesale and retail trade and repair of vehicles
2. Transportation and storage
3. Accommodation and food service activities
4. Information and communication
5. Financial and insurance activities
6. Real estate activities
7. Professional, scientific and technical activities
8. Administrative and support services
9. Public administration, defence and compulsory social security
10. Education
11. Human health and social work activities
12. Arts, entertainments and recreation
13. Other service activities
14. Activities of households as employers, undifferentiated goods and
services producing activities of households for own use
15. Activities of extra territorial organizations and bodies

Source: The Service Sector in India Arpita Mukherjee ADB Economics Working Paper
Series No. 352 / June 2013
The service sector refers to the industry producing intangible goods viz. services as
output. The services sector is the largest sector of India and accounts for 53.89% of
total India's GVA.
The Gross Value Added (GVA) at current prices for the services sector is estimated at
` 96.54 lakh crore in 2020-21.
The service sector is the fastest growing sector in India and has the highest labour
productivity. Both domestic and global factors influence the growth of the services
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sector. The exceptionally rapid expansion of knowledge-based services such as

professional and technical services has been responsible for the faster growth of the
services sector. The production and consumption of information-intensive service
activities such as computing, accounting, inventory management, quality control,
personnel administration, marketing, advertising and legal services has increased
manifold due to application of state- of the- art information technology. Services
sector growth can also complement growth in the manufacturing sector.
The start-ups which have grown remarkably over the last few years mostly belong
to the services sector.
India is among the top 10 World Trade Organization (WTO) members in service
exports and imports. India’s services exports at US$ 27.0 billion recorded robust
growth in November 2022 due to software, business, and travel services. While
exports from all other sectors were adversely affected, India’s services exports
have remained resilient during the Covid-19 pandemic. The reasons are the higher
demand for digital support and need for digital infrastructure modernization.
The Indian services sector is the largest recipient of FDI inflows. FDI equity inflows
into the services sector accounted for more than 60 per cent of the total FDI equity
inflows into India.
The World Investment Report 2022 of UNCTAD places India as the seventh largest
recipient of FDI in the top 20 host countries in 2021. In 2021-22, India received the
highest-ever FDI inflows of US$ 84.8 billion including US$ 7.1 billion FDI equity
inflows in the services sector.
To ensure the liberalisation of investment in various industries, the government has
permitted 100 per cent foreign participation in telecommunication services through
the Automatic Route including all services and infrastructure providers. The FDI
ceiling in insurance companies was also raised from 49 to 74 per cent. Measures
undertaken by the Government, such as the launch of the National Single-Window
system and enhancement in the FDI ceiling through the automatic route, have
played a significant role in facilitating investment.
8. CONCLUSION
The India Development Update (IDU) of the World Bank published in November 2022,
observes that India had to face an unusually challenging external environment
following the Russia-Ukraine war, increased crude oil and commodity prices,
persistent global supply disruptions, tighter financial conditions and high domestic
inflationary pressures. Despite all these, the real GDP of India grew by 6.3 percent in
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July-September of 2022-23 driven by strong private consumption and investment.

The report observes that India’s economy is relatively more insulated from global
spillovers than other emerging markets and is less exposed to international trade
flows on account of reliance on its large domestic market. As such, compared to
other emerging economies, India is much more resilient to withstand adversities in
the global arena.
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1. The Indian industry stagnated under the colonial rule because

(a) Indians were keen on building huge structures and monuments only
(b) Deterioration was caused by high prices of inputs due to draught
(c) The Indian manufactures could not compete with the imports of cheap machine
made goods
2. The first wave of liberalization starts in India

(a) In 1951 (b) In 1980’s
(c) In 1990 (d) In 1966
3. The sequence of growth and structural change in Indian economy is characterized by

(a) The historical pattern of prominence of sectors as agriculture, industry, services
(b) The historical pattern of prominence of sectors as industry, services, agriculture
(c) Unique experience of the sequence as agriculture, services, industry
4. Merchandise Exports from India Scheme was replaced by -

(a) Remission of Duties and Taxes on Export Products (RoDTEP) in 2021
(b) National Logistics Policy (NLP) in 2020
(c) Remission of Duties and Taxes on Export Products (RoDTEP) in 2019
5. The Foreign Investment Promotion Board (FIPB)

(a) a government entity through which inward investment proposals were routed
to obtain required government approvals
(b) no more exists as the same is replaced by a new regime namely Foreign
Investment Facilitation Portal
(c) no more exists as all inward investments are through automatic route and
need no approval
(d) is the body which connects different ministries in respect of foreign por tfolio
investments
404
6. FAME-India Scheme aims to

(a) Enhance faster industrialization through private participation
(b) to promote manufacturing of electric and hybrid vehicle technology
(c) to spread India’s fame among its trading partners
7. In terms of Ease of Doing Business in 2020 India ranks

(a) 63 (b) 77
(c) 45 (d) None of the above
8. E-NAM is -
(a) An electronic name card given to citizens of India
(b) National Agriculture Market with the objective of creating a unified national
market for agricultural commodities.
(c) a pan-India electronic trading portal which networks the existing APMC mandis
9. Which of the following is not a policy reform included in the new economic policy of
1991 -
(a) removing licensing requirements for all industries
(b) Foreign investment was liberalized
(c) Liberalisation of international trade
(d) The disinvestment of government holdings of equity share capital of public
sector enterprises
10. Imports of foreign goods and entry of foreign investments were restricted in India
because -
(a) The government wanted people to follow the policy of’ Be Indian; Buy Indian’
(b) Because foreign goods were costly and meant loss of precious foreign exchange
(c) Government policy was directed towards protection of domestic industries
from foreign competition
(d) Government wanted to preserve Indian culture and to avoid influence of foreign
culture
405
11. The ‘Hindu growth rate’ is a term used to refer to -

(a) the high rate of growth achieved after the new economic policy of 1991
(b) the low rate of economic growth of India from the 1950s to the 1980s, which
averaged around 3.5 per cent per year
(c) the low growth of the economy during British period marked by an average of
3.5 percent
(d) the growth rate of the country because India is referred to as ‘Hindustan’
12. In the context of the new economic policy of 1991, the term ‘disinvestment’ stands
for -
(a) A policy whereby government investments are reduced to correct fiscal deficit
(b) The policy of sale of portion of the government shareholding of a public sector
enterprise
(c) The policy of public partnership in private enterprise
(d) A policy of opening up government monopoly to the privates sector
13. The objective of introducing Monopolies and Restrictive Trade Practices Act 1969
was -
(a) to ensure that the operation of the economic system does not result in the
concentration of economic power in hands of a few
(b) to provide for the control of monopolies
(c) to prohibit monopolistic and restrictive trade practice
(d) all the above
14. Which one of the following is a feature of green revolution -

(a) use of soil friendly green manure to preserve fertility of soil
(b) grow more crops by redistributing land to landless people
(c) High yielding varieties of seeds and scientific cultivation
(d) Diversification to horticulture
15. The strategy of agricultural development in India before green revolution was -
(a) High yielding varieties of seeds and chemical fertilizers to boost productivity
(b) Institutional reforms such as land reforms
(c) Technological up gradation of agriculture
(d) All the above
406
16. The Industrial Policy Resolution (1948) aimed at -

(a) Market oriented economic reforms and opening up of economy
(b) A shift from state led industrialization to private sector led industrialisation
(c) an expanded role for the public sector and licensing to the private sector
(d) an expanded role of private sector a limited role of public sector
17. The new economic policy of 1991 manifest in -

(a) State led industrialization and import substitution
(b) Rethinking the role of markets versus the state
(c) Emphasized the role of good governance
(d) Bringing about reduction in poverty and redistributive justice
18. The post independence economic policy was rooted in -

(a) A capitalist mode of production with heavy industrialization
(b) social and economic redistribution and industrialization directed by the state
(c) social and economic redistribution through private sector initiatives
(d) Industrialization led by private entrepreneurs and redistribution by state
ANSWERS:
1 (c) 2 (b) 3 (c) 4 (a) 5 (b)

6 (b) 7 (a) 8 (d) 9 (a) 10 (c)
11 (b) 12 (b) 13 (d) 14 (d) 15 (b)
16 (c) 17 (b) 18 (b)
407
SUMMARY
 India is believed to have had the largest economy of the ancient and the medieval
world and controlled between one third and one fourth of the world's wealth. It was
prosperous and self-reliant and had flourishing cities and self sufficient villages.
 The advent of the Europeans and the rule of British from 1757 to 1947 brought
about a marked shift in the economic history of India.
 Higher production on account of industrial revolution in Britain necessitated raw
materials and markets for finished goods for which India was made the target. This,
along with adverse imperial policies towards Indian manufacturing and the ease
of importing cheap machine made goods decreased the competitiveness of Indian
manufactures and reduced their domestic demand leading to a virtual destruction
of the Indian manufacturing sector.
 The consequence of collapse of manufacturing sector was felt heavily on agricultural
sector in the form of overcrowding on farms, subdivision and fragmentation,
subsistence farming, low productivity, lower incomes and aggravated poverty.
 Institutional inadequacies in land tenure and growth of a class of exploitative money
lenders and zamindars resulted in vices such as absentee landlordism, high rents,
high indebtedness, deterioration of fertility of land and low productivity.
 During the British period, modern industrial sector saw lopsided growth with
preponderance of cotton and jute industry. Producer goods industries lagged behind
due to the discriminatory attitudes of self interested British rulers. The share of
manufacturing and of employment in this sector was pathetically low.
 At the time of independence, India was overwhelmingly rural, inhabited by mostly
illiterate and poor people with low life expectancy. The social structure was deeply
stratified and exceedingly heterogeneous on many counts. The country was deficient
in physical, financial and human capital.
 The economic development strategy adopted was the Nehruvian model which
supported social and economic redistribution and industrialization directed by the
state. Accordingly the Planning Commission of India was established to meticulously
lan for economic development on socialistic lines with equity and distributive justice.
The five-year plans were developed, implemented, and monitored by the Planning
Commission with this objective.
408
 Rapid industrialization of the economy was the cornerstone of Nehru’s development

strategy. The concept of ‘planned modernization’ meant a systematic planning to
support industrialization.
 The Industrial Policy Resolution (1948) envisaged an expanded role for the public
sector and licensing to the private sector.
 The policies in 1950’s were guided by both Nehruvian and Gandhian philosophies
with the former visualizing a socialistic society with emphasis on heavy industries
and the latter stressing on small scale and cottage industry and village republics.
 The Industrial Policy Resolution of 1956 supported undue priority and enormous
expansion of the scope of the public sector which resulted in dampening of private
initiative and enterprise.
 In the first three decades after independence (1950–80), India’s average annual rate
of growth of GDP, often referred to as the ‘Hindu growth rate’, was a modest 3.5
percent.
 The first major shift in Indian economic strategy was in the mid-1960s. Due to
continuous failures of monsoon, droughts struck India in 1966 and 1967 and food
crisis set in. The need for increased productivity in agriculture kick-started a strategic
change in agriculture policies.
 The strategy for agricultural development which had so far relied on institutional
model such as land reforms gave way to technological and farm management
reforms giving rise to a revolutionary transformation in agricultural production and
productivity.
 This radical change materialised by innovative farm technologies, including high
yielding seed varieties and intensive use of water, fertilizer and pesticides is referred
to as ‘Green Revolution’.
 Many government policies aimed at prevention of growth of monopolies and
equitable distribution of income and wealth such as reservation of many products
for exclusive manufacture by the small scale sector and the Monopolies and
Restrictive Trade Practices Act, 1969 (MRTP) (which placed several restrictions on
large enterprises in terms of licensing, capacity addition, mergers and acquisitions)
effectively killed the incentive for creating wealth.
 The economic performance during the period of 1965-81 is the worst in independent
India’s history. The license-raj, the autarchic policies that dominated the 1960s
and 1970s, and the external shocks such as three wars, major droughts, and the
oil shocks of 1973 and 1979 contributed to the decelerated growth lasting two
decades.
409
 The seeds of early liberalisation and reforms were sown during the 1980s, especiall
after 1985. In early 1980s considerable efforts were made to restore reasonable
price stability through a combination of tight monetary policy, fiscal moderation
and a few structural reforms.
 The reform initiatives- covering three areas, namely industry, trade and
taxationspanning 1981 to 1989, is referred to as ‘early liberalization’ or ‘r eforms by
stealth’ to denote its ad hoc and not widely publicized nature. They were aimed at
changing the prevailing thrust on ‘inward-oriented’ trade and investment practices.
 The major reforms in 1980’s included de licensing of 25 broad categories of industries,
granting of the facility of ‘broad-banding’ to allow flexibility and rapid changes
in the product mix of industries without going in for fresh licensing, increase in
the asset limit of MRTP firms from 20 crore to 100 crore, introduction of modified
value-added (MODVAT), establishment of the Securities and Exchange Board of
India (SEBI) as a non-statutory body ,extension of the Open General Licence (OGL),
export incentives, liberalisation of imports , reduction in tariffs and removal of price
and distribution controls on cement and aluminium.
 The private sector investments were inhibited due to reasons such as convoluted
licensing policies, public sector reservations and excessive government controls,
reservation of goods to small scale sector as well as excessive price and distribution
controls.
 The public sector which led the manufacturing and service sectors was plagued by
inefficiency, government controls and bureaucratic procedures and yielded very low
returns on investment.
 Import controls in the form of tariffs, quotas and quantitative restrictions, and
restrictions on foreign trade and investments virtually insulated the economy from
foreign competition.
 The reforms in 1980’swere instrumental in bringing confidence in the minds of
politicians and policy makers that a well-regulated competitive market can ensure
economic growth and increase in overall welfare.
 Extremely large fiscal deficits, severe strain on balance of payments, heavy internal
as well as external debt, unprecedented levels of interest payments, all-time low
foreign exchange reserves, lessons from collapse of Soviet Union, spectacular success
of China through adoption of outward oriented policies and above all, the stringent
conditions put forth by the International Monetary Fund for availing further loans
were the reasons for launching the drastic economic reforms of 1991.
410
 The twin objectives of reforms were reorientation of the economy from a centrally
directed and highly controlled one to a ‘market friendly’ or ‘market oriented’ economy
and macroeconomic stabilization by substantial reduction in fiscal deficit.
 The reform policies can be broadly classified as a) stabilisation measures which were
short term measures to address the problems of inflation and adverse balance of
payment and b) structural reform measures which are long term and of continuing
nature aimed at bringing in productivity and competitiveness by removing the
structural rigidities in different sectors of the economy.
 The fiscal reforms included introduction of a stable and transparent tax structure,
better tax compliance, control of government expenditure, reduction /abolition of
subsidies, disinvestment of part of government’s equity holdings and encouraging
private sector participation.
 The monetary and financial sector reforms were in the form of interest rate
liberalization, reduction in controls on banks by the Reserve Bank of India in
respect of interest rates and facilitating greater competition in the banking sector
by privateparticipation and foreign competition, reduction in reserve requirements,
liberalisation of bank branch licensing policy and establishing prudential norms of
accounting in respect of classification of assets, disclosure of income and provisions
for bad debt.
 Reforms in Capital Markets included granting of statutory recognition to the
Securities and Exchange Board of India (SEBI) to facilitate mobilization of adequate
resources and their efficient allocation.
 The ‘New Industrial Policy’ announced by the government on 24 July 1991 sought to
substantially deregulate industry so as to promote growth of a more efficient and
competitive industrial economy.
 The policy put an end to the ‘License Raj’ by removing licensing restrictions for all
industries except for 18 on strategic considerations.
 Other initiatives included reduction in the number of industries reserved for the
public sector and the small scale sector, restructuring of the polices related to
merger, amalgamation, and takeover under the MRTP act, devaluation of rupee,
liberalization of foreign investments and disinvestment of government holdings of
equity share capital of public sector enterprises.
 The trade policy reforms included liberalisation of external trade, removal of
licensing for imports, dismantling of quantitative restrictions on imports and exports
and phased reduction and simplification of tariffs.
 Reforms resulted in major changes such as increasing integration with the global
411
economy, progressive shift towards a market oriented economy, sizeable reduction

in government’s market intervention and controls, unprecedented growth of private
sector investments and initiatives, increased levels of international competitiveness,
easier access to foreign technology, inputs ,know-how and finance, steady inflow of
foreign direct and portfolio investments , solid cushion of foreign exchange reserves,
increased incomes, large domestic market, sustainable levels of aggregate demand,
substantial reduction in poverty, greater customer choice, increased efficiency,
phenomenal growth of infrastructure sector and the deepening of the financial
sector.
 The GDP growth rate, on an average, has been commendable throughout the
post reform period except for the pandemic ridden year 2020 when the economy
registered a negative growth rate.
 Despite the above achievements, the country is constrained by high levels of fiscal
deficit, growing inequalities, inflation and high levels of debt as a share of GDP.
 The Planning Commission of India was one of the most important institutions
within India's central government for nearly sixty four years. The new ideologies
of the neoliberal era called for a change in the nature, composition and scope of
institutions of governance.
 On 1st January 2015, the apex policy-making body namely Planning Commission,
was replaced by the National Institution for Transforming India (NITI) Aayog with
the objective to ‘spur innovative thinking by objective ‘experts’ and promote ‘co-
operative federalism’ by enhancing the voice and influence of the states’ .
 NITI Aayog is expected to serve as a 'Think Tank' of the government. [and] as ‘directional
and policy dynamo’. The key initiatives of NITI Aayog are: ‘Life’, The National Data
and Analytics Platform (NDAP), Shoonya, E-Amrit, India Policy Insights (IPI), and
'Transforming India’s Gold Market'.
 The weaknesses of the system are that NITI has a limited role; it is excluded from the
budgeting process, lacks autonomy and balance of power within the policy making
apparatus of the central government and that it lacks the independence and power
to perform as a ‘counterweight’ to act as a "voice of development" concerned with
inequities.
 The Primary sector i.e agriculture with its allied sectors is the largest source of
livelihood for people. India has emerged as the world’s largest producer of milk,
pulses, jute and spices and has the largest area planted under wheat, rice and
cotton. It is the second largest producer of fruits, vegetables tea, farmed fish, cotton,
sugarcane, wheat, rice, cotton, and sugar. Forty seven per cent of India’s population
412
is d irectly dependent on agriculture for living which contributes a significant figure

to the Gross Domestic Product18.8% in 2021-22 (until 31 January, 2022). Food
grains production has reached 315.7 million tonnes in 2021-22.
 India is among the top ten exporters of agricultural products in the world. Agricultural
and Processed Food Export Development Authority (APEDA) is entrusted with the
responsibility of export promotion of agri-products.
 Various measures are adopted by the government such as 100% FDI in marketing of
food products and in food product E-commerce, income support to farmers through
PM KISAN, fixing of Minimum Support Price (MSP) at one-and-a half times the
cost of production, institutional credit for agriculture sector at concessional rates ,
National Mission for Edible Oils, Pradhan Mantri Fasal BimaYojana (PMFBY) a novel
insurance scheme, Mission for Integrated Development of Horticulture (MIDH, Soil
Health Cards, Paramparagat Krishi Vikas Yojana (PKVY), Agri Infrastructure Fund,
Promotion of Farmer Producer Organisations (FPOs), Per Drop More Crop (PDMC),
setting up of Micro Irrigation Fund, creation of E-NAM -a pan-India electronic
trading portal, introduction of Kisan Rail and creation of a Start-up Eco system in
agriculture and allied sectors.
 Indian agriculture faces many issues, such as small and fragmented landholdings, low
farm productivity and subsistence farming, low marketable surplus and the consequent
lower income levels, inability to participate in the domestic as well as export market,
inadequate agro-processing infrastructure, failure to build competitive value chains,
sluggish agricultural diversification to higher-value commodities, inadequate adoption
of environmentally sustainable and climate resistant new farm technology, lopsided
marketing practices, ineffective credit delivery, high food price volatility, heavy
dependence on monsoons, poor warehousing, inadequate post-harvest infrastructure
management practices and incidence of poverty and malnutrition.
 The industrial sector contributes about 30 percent of total gross value added and
employs over 12.1 crores of people. Manufacturing is the most important sector
and accounts for 78 percent of total production.
 In 2022- 23 (until September 2022), the combined index of eight core industries
stood at 142.8 In Jan 31, 2023 the Manufacturing Purchasing Managers’ Index (PMI)
in India stood at 55.4. India’s rank in the Global Innovation Index (GII) improved to
40th in 2022 from 81st in 2015.
 The Department for Promotion of Industry and Internal Trade (DPIIT) has a role in
the formulation and implementation of industrial policy and strategies for industrial
development.
413
 Some of the policies for industrial development include introduction of goods and
services tax (GST) 2017 as a single domestic indirect tax law for the entire country,
reduction in corporate tax of domestic companies, ‘Make In India’ a 'Vocal for Local'
initiative, Ease of Doing Business , the National Single Window System, PM Gati
Shakti National Master Plan, National Logistics Policy (NLP), Production Linked
Incentive (PLI) Scheme, Industrial Corridor Development Programme, FAME-India
Scheme, Udyami Bharat’, PM Mega Integrated Textile Region and Apparel, Remission
of Duties and Taxes on Export Products (RoDTEP) ,National Logistics Policy (NLP),
Start-up India, Programme of Public Procurement (Preference to Make in India) and
the Emergency Credit Line Guarantee Scheme.
 The major challenges to the industrial sector are shortage of efficient infrastructure
and manpower, reduced factor productivity, heavy reliance on imports, exchange
rate volatility, industrial locations established without reference to cost-effective
points, heavy losses, inefficiencies, lower productivity and unsustainable returns
plaguing the public sector industries, strained labour-management relations, lower
export competitiveness, slowing external demand, imposition of non tariff barriers
by other countries, global supply chain disruptions and uncertainties, inflation,
leading to input cost escalations and lower demand, global slowdown and related
negative sentiments affecting investments, aggressive tightening of monetary policy
and increases in cost of credit ,high and increasing fuel prices and the mounting
presence of informal sector.
 A remarkable feature of the post reform Indian economy is the unconventional
experience of bypassing the secondary sector in the growth trajectory by a shift
from agriculture to the services sector.
 The services sector is the largest sector of India and accounts for 53.89% of total
India's GVA. It has the highest labour productivity and is the fastest growing sector.
The exceptionally rapid expansion of knowledge-based services such as professional
and technical services has contributed substantially to the growth of tertiary sector.
 India is among the top 10 World Trade Organization (WTO) members in service
exports and imports. India’s services exports at US$ 27.0 billion recorded robust
growth in November 2022 due to software, business, and travel services.
 To ensure the liberalisation of investment in various industries, the government has
permitted 100 per cent foreign participation in telecommunication services through
the Automatic Route including all services and infrastructure providers.
 The India Development Update (IDU) of the World Bank published in November 2022
holds the optimistic view that compared to other emerging economies, India is much
414
more resilient to withstand adversities in the global arena, while acknowledging the
fact that India had to face an unusually challenging external environment following
the Russia-Ukraine war, increased crude oil and commodity prices, persistent global
supply disruptions, tighter financial conditions and high domestic inflationary
pressures.
415
Speak Your Mind
416
417

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CA FOUNDATION - ECONOMICS

2 THEORY OF DEMAND AND SUPPLY 5-12

3 THEORY OF PRODUCTION AND COST 13-18

5 BUSINESS CYCLES 25-26

7 PUBLIC FINANCE 122-222

8 MONEY MARKET 223-273

9 INTERNATIONAL TRADE 274-375

10 INDIAN ECONOMY 376-417

2. Economics has been defined in four different ways:

3. Economics as a Science: Economics is a science where various facts are systematically

4. Economics as an Art: Economics is an art as it has several branches which give

6. Microeconomics deals with behavior of individual decision making units such as

9. While Business Economics is basically concerned with Micro Economics, Macro

10. Business Economics is a normative science which is interdisciplinary and pragmatic in

13. Business Economics also considers Macroeconomics related to economic systems,

The central problems are:-

16. There are three forms of economic organization:

1. Meaning of Demand: Demand for a commodity refers to the quantity of a commodity

9. Price Elasticity of Demand (Ep) measures percentage change in quantity demanded of

10. The major determinants of price elasticity of demand are:

11. There are five degrees of ep. Check List

parallel to y-axis.  Substitute not  Substitute avail-

(v) Perfectly elastic demand (Ep = ∞)s.  Tied demand  Independent

12. Measurement of Price Elasticity of Demand:-

(ii) In the geometric method, ep at a point on a linear (straight) demand curve

13. Income Elasticity of Demand measures % ag changes in demand due to % ag change

(a) If value of ey is between 0 to1 then good is normal or essential.

14. Cross-Elasticity of Demand(ec): It measures% ag changes in the quantity demanded of

15. Advertisement elasticity of sales or promotional elasticity of demand measures the

16. Demand Distinctions

18. Methods of Demand Forecasting

Theory of Consumer’s Behaviour

2. Marginal Utility Theory:

 Assumption of the theory

 Marshall's consumer surplus :-

3. Indifference Curve Theory

A set of indifference curves is called an indifference map.

Features of indifference curve are:

MRSxy = Px ......... (1)

And Diminishing MRS

3. The major factors affecting supply of a good are:

9. Movement on supply curve can be expansion or contraction in supply whereas shift of

11. There are five degree of ES :

12. Methods of measurement of elasticity of supply –

13. Diagrammatic Method -

6. Capital formation or investment is defined as the surplus of production over

10. Law of variable proportions

11. Law of Returns to Scale

12. Production Optimization

(b) Short-run Average Costs -

The reason behind its shape is the law of variable proportions.

(c) Marginal Cost -

MC is the slope of the TC curve at each and every point. MC curve

MC is independent from TFC. It is function of variable cost and can also be

(d) Relationship between AC and MC

Meaning and Types of Markets

On the basis of time

On the basis of Nature of Transactions

On the basis of Regulation

On the basis of volume of business

On this basis of competition

MR = ∆TR . or MRn = TRn – TRn-1.