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IILM Institute for Higher Education

Course Manual
ECONOMIC ENVIRONMENT AND POLICY
ES-303

PGP 2010-12

ECONOMIC ENVIRONMENT AND POLICY


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PGP Batch [2010-12]

I. Course Facilitators

Facilitator Email-id

Prof. N. Chandra n.chandra@iilm.edu


Mr. Abhijit Mukhopadhyay abhijit.mukhopadhyay@iilm.edu
Ms. Rakhi Singh rakhi.singh@iilm.edu
Ms. Deepa Bhaskaran deepa.bhaskaran@iilm.edu
Ms. Rachna Madaan rachna.madaan@iilm.edu
Ms. Bhumika Kapoor bhumika.kapoor@iilm.edu
Mr. Rajneesh Kler rajneesh.kler@iilm.edu

II. Course Overview

The overall macroeconomic situation in the economy affects the performance of a company
and subsequently the decision making of even a manager. This was amply demonstrated in
real life events after the recession, all around the world. The objective of this course is to
facilitate the learning of macro business environment for informed decision making. The
focus of the course is on holistic understanding of the functioning of the economy and
putting business in broader macroeconomic framework.

III. Course Topics


• Macroeconomic Environment of Business: An Overview
• National Income Accounting
• Simple Keynesian Model of Output Determination
• Hicksian-Hansen Extension of Keynesian Model (IS-LM Model)
• Short Run Economic Fluctuations
• Monetary and Fiscal Policy
• Inflation and Unemployment
• Indian Economy: An Overview
• External Sector

IV. Learning Outcomes

1. Students will be able to develop an understanding of the macroeconomic framework,


national income and its components, key macro-economic variables, concepts, and
tools for business decision making.

2. Students will be able to develop a comprehensive understanding of the Indian and


global economic environment, institutions and policies which affect corporate
planning, good governance and business prospects.

V. Pre-requisites

The course on Managerial Economics helps in understanding macroeconomic concepts.


Completion of Managerial Economics course is a definite pre-requisite for this course. The
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students should also know fundamental concepts of algebra and two-dimensional geometry
to understand the concepts in this course.

VI. Books and References

Main Textbook

Soumyen Sikdar: Principles of Macroeconomics, Oxford University Press

Additional Readings
• N. Gregory Mankiw, Principles of Macroeconomics, Thomson Press.
• Economic Survey, Government of India, Latest year
• Macroeconomic and Monetary Developments, Reserve Bank of India, Latest
Issue
• R. Dornbusch, S. Fischer and R. Startz, Macroeconomics, Tata McGraw Hill
• Rakesh Mohan: Managing Monetary Policy – An Inside View
• Bimal Jalan- India’s Economic Policy: Preparing for the Twenty First Century,
Viking/ Penguin, 1997.
• T.N. Srinivasan- Eight Lectures on India’s Economic Reforms, Oxford University
Press.
• Ernst and Young- Doing Business in India, Ernst & Young Private Ltd.
• Reserve Bank of India- Latest Annual Report, RBI, Mumbai.
• Uma Kapila:Understanding the Problems of Indian Economy, Academic
Foundation.
• Justin Paul : Business Environment – Text and Cases, Tata McGraw Hill
• Richar T. Froyen : Macroeconomics, Pearson Education.
• Mankiw, Gregory : Macroeconomics, Worth Publishers Inc.

Journals / Magazines / Newspapers

• Economic and Political Weekly


• The Economist
• Business Today
• The Economic Times

Important Websites:

• www.indiabudget.nic.in
• www.rbi.org.in
• www.ciionline.org
• www.finmin.nic.in
• www.ficci.com
• www.planningcommission.nic.in

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VII. Assessment (Total 100 Marks)

Sl. No. Components Weight (%)


1 Test (MCQ) 20
Individual assignment / Project
2 20
3 End-Term Test 60
Total 100

VIII Session Plan


Sess
Topic Pre-Readings/Case Chapter / References
ion

Module 1: The macroeconomic environment of business: An overview

1 • Circular Flow of Income Study Material 1 Dernberg and Mcdougall,


ch 1

Module 2 :National Income

2 • Variants of National Study Material 2 Sikdar, ch 2


Income

3 • Measurement Study Material 2 Sikdar, ch 2


Income Method
Expenditure method
Value Added

Module 3: Simple Keynesian Model

4 • Aggregate Demand, Study Material 3 Sikdar, ch 3


aggregate supply, and
Equilibrium Output

5 • The Consumption Function Study Material 3 Sikdar, ch 3


and Aggregate Demand

6 • Multiplier Study Material 3 Sikdar, ch 3


• The Government Sector

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Module 4: Hicksian-Hansen extension of Keynesian Model (IS-LM)

7 • Goods Market Equilibrium Study Material 4 Sikdar, ch 4


(IS)

8 • Money Market Equilibrium Study Material 4 Sikdar, ch 4


(LM)

9 • Equilibrium in the Goods Study Material 4 Sikdar, ch 4


and Money Markets

Module 5: Short run economic fluctuations

10 • Key facts about economic newspaper articles Mankiw, ch 20


fluctuations

11 • Explaining short run newspaper articles Mankiw, ch 20


economic fluctuations

12 • Causes of economic newspaper articles Mankiw, ch 20,


fluctuations and recent
economic recession in the
world

13 Mid Term Examination

Module 6: Monetary and Fiscal Policy

14 • Monetary Policy Study Material 5 & 6 Sikdar, ch 5


Economic Survey

15 • Fiscal Policy and Crowding Study Material 5 & 6 Sikdar, ch 5


Out Economic Survey

16 • Monetary Policy in India Study Material 5 & 6 Sikdar, ch 6


• Role of RBI Economic Survey
• The Union Budget

17 Guest Lecture on the role of economic policies in Indian Economy

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Module 7: Inflation and Unemployment

18 • Inflation: Meaning and Mankiw, ch 17 & 22 Sikdar, ch 8 & 9


Types
• The Anatomy of
Unemployment

19 • Inflation in India Sikdar, ch 8 & 9 Economic Survey

20 Guest Lecture on inflation in India

Module 8: Indian Economy: An Overview

21 • Economic Reforms Study Material 8 & 9 Economic Survey


Case Study : Ministry of Industries
Economic Reforms documents/website
and Inclusive
Growth in India

• Industry Study Material 8 & 9 Economic Survey


22 Ministry of Industries
documents/website

• Agriculture Study Material 8 & 9 Economic Survey


23 Ministry of Industries
documents/website

24 • Service Sector Study Material 8 & 9 Economic Survey


Ministry of Industries
documents/website

25 Guest Lecture on latest happenings in Indian Economy

Module 9: External Sector

26 • Balance of payments – Dornbusch, Fischer Economic Survey


current account, capital & Startz, ch 12 Study Material 7
account Sikdar, ch 7
• Exchange Rate Mankiw, ch 18 & 19

27 • FDI in India Dornbusch, Fischer RBI documents


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& Startz, ch 12 Economic Survey
Study Material 7

Session Details
Session 1:
The students will be introduced to macroeconomics as a subject and subsequently relate it to
business environment. Subsequently then the basic flow of money/income in an economy
should be understood.
a) Pre-reading: Study Material 1
b) Question for discussion in class: How does macroeconomic knowledge help in business decision
making?
(c) Learning outcomes: Students should understand the distinction between macroeconomics and
microeconomics very clear. The basic flow of money in an economy should also be understandable to
them.
(d) Chapter: Dernberg & McDougall, Macroeconomics, ch 1
Session 2:
Like any individual or household, any nation also had its income and expenditure. There are
concepts and ideas which are well accepted worldwide to quantify or measure them. The
students would be introduced to all such relevant concepts of the economy.
a) Pre-reading: Study Material 2
b) Question for discussion in class: What are the ways by which any economy's health can be
judged?
c) Learning outcomes: Students should learn different definitions of national income
measuring concepts.
d) Chapter: Sikdar, Principles of Macroeconomics, ch 2
Session 3:
In this session, continuing with the concepts and measures of national income accounting, the
students would be introduced to concepts like GDP, NI and the basic methodologies to
measure them.
a) Pre-reading: Study Material 2
b) Question for discussion in class: Why GDP is important as an indicator? Does it capture
all aspects of economic well-being?
c) Learning outcomes: Students should get a feeling of real time GDP data on Indian
economy.
d) Chapter: Sikdar, Principles of Macroeconomics, ch 2
Session 4:
The concepts of aggregate demand and aggregate supply will be introduced to the students.
After that, concept of equilibrium of an economy will be explained. In this session,
preliminary concepts of Keynesian aggregate demand analysis will also be introduced.
a) Pre-reading: Study Material 3
b) Question for discussion in class: What are the factors that change the pattern of aggregate
demand and supply; and what are the effects on
economy?
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c) Learning outcomes: Students should be able to distinguish between the concept of demand
in microeconomics and aggregate demand in macroeconomics.
d) Chapter: Sikdar, Principles of Macroeconomics, ch 8 & 3
Session 5:
Determination of output under Keynesian demand analysis in simple closed economy and
open economy will also be done using this framework. The concept of multiplier will also be
introduced in this session.
a) Pre-reading: Study Material 3
b) Question for discussion in class: What is a multiplier and how does it work?
c) Learning outcomes: Students have to understand the mechanism of a multiplier. Whenever
investment or government expenditure rises, the mechanism of multiplier in the economy has
to be clear in their mind.
d) Chapter: Sikdar, Principles of Macroeconomics, ch 3
Session 6:
This session would be utilized to facilitate an overall understanding of Keynesian aggregate
demand analysis in the simplest framework. If different components of aggregate demand
changes then the resultant changes in output need to be shown also in this session.
a) Pre-reading: Study Material 3
b) Question for discussion in class: Why it was necessary to formulate an aggregate demand
analysis instead of regular demand-supply interaction?
c) Learning outcomes: Students should be able to identify the nuances and contrasts of
demand-side and supply-side oriented analysis.
d) Chapter: Sikdar, Principles of Macroeconomics, ch 8
Session 7:
This session will be utilized to show the relationship between investment and rate of interest.
After introducing investment function, the change in aggregate demand equation and
subsequently the derivation of IS curve will be done.
a) Pre-reading: Study Material 4
b) Question for discussion in class: What is the relationship between investment and rate of
interest?
c) Learning outcomes: Students should be able to understand the linkage between interest
rate and investment. Subsequently, they have to appreciate the effect of a change in
investment on aggregate demand.
d) Chapter: Sikdar, Principles of Macroeconomics, ch 4
Session 8:
This session would be devoted to introduce money market to the students. The concepts of
money demand and money supply will be incorporated in this session. Different components
of money demand will be explained in detail.
a) Pre-reading: Study Material 4
b) Question for discussion in class: What are different components of money demand and
how money demand is linked to rate of interest?
c) Learning outcomes: Students should be able to understand transaction and speculative
demand for money. Central Bank's role in the exogeneity of money supply has to be
explained along with the sense of opposing view of endogeneity.

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d) Chapter: Sikdar, Principles of Macroeconomics, ch 4
Session 9:
After the introduction of money market into the framework, the derivation of LM curve will
be done in this session. Then the equilibrium in IS-LM framework has to be derived and then
it is to be showed how changes in some of the key variables will affect equilibrium output
and interest. This will also facilitate the understanding of implications of monetary and fiscal
policies.
a) Pre-reading: Study Material 4
b) Question for discussion in class: How one can derive an equilibrium in both product and
money markets?
c) Learning outcomes: The objective is to make the students understand basic mechanisms of
product and money market; and subsequently the simultaneous equilibrium in both the
markets.
d) Chapter: Sikdar, Principles of Macroeconomics, ch 4
Session 10:
In this session, phenomenon of economic fluctuations with examples of different crises,
including the current economic crisis which originated from the USA, would be introduced.
a) Pre-reading: Newspaper articles
b) Question for discussion in class: How does one explain irregular, unpredictable
fluctuations in macroeconomic variables?
c) Learning outcomes: Current economic crisis originated in the USA financial market has to
be described as the background to the topic. The students should be aware of the basic facts.
d) Chapter: Mankiw, Principles of Macroeconomics, ch 20
Session 11:
This session will be utilized to probe and analyse various reasons and causes of a crisis to
occur.
a) Pre-reading: Newspaper articles
b) Question for discussion in class: Are economic fluctuations necessarily part of business
cycle or are they inherent to the system?
c) Learning outcomes: The different explanations behind short and long run economic
fluctuations have to be put forward.
d) Chapter: Mankiw, Principles of Macroeconomics, ch 20
Session 12:
To wrap up the topic of economic fluctuations, different aspects of short run and long run
economic fluctuations will be explained and analysed.
a) Pre-reading: Newspaper articles
b) Question for discussion in class: Describe and discuss economic crisis in different
countries in recent past.
c) Learning outcomes: Along with different streams of theories to explain economic crisis
and fluctuations, the students should also be aware of the financial and business fall-outs of
a crisis. Subsequently they also need to know the way out of such a crisis.
d) Chapter: Mankiw, Principles of Macroeconomics, ch 20
Session 13:
Mid term examination will be held in this session.
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Session 14:
This session will be devoted to explain and analyse different tools and instruments of
monetary policy. A special attention will be given to introduce the students to monetary
instruments used in Indian economy.
a) Pre-reading: Study Material 5 & 6
b) Question for discussion in class: What do you understand by monetary policy and what
are the standard monetary instruments?
c) Learning outcomes: Basic instruments and mechanisms of monetary policy have to be
known. The working logic of such instruments have to be very clear also.
d) Chapter: Economic Survey
Session 15:
This session will be devoted to explain and analyse different tools and instruments of fiscal
policy. A special attention will be given to introduce the students to fiscal tools used in
Indian economy.
a) Pre-reading: Study Material 5 & 6
b) Question for discussion in class: What do you understand by fiscal policy and what are
the standard fiscal instruments?
c) Learning outcomes: Basic instruments and mechanisms of fiscal policy have to be known.
The working logic of such instruments have to be very clear also.
d) Chapter: Economic Survey
Session 16:
This session will be a wrapping-up session to inculcate basic information on monetary and
fiscal policies in India and their short term and long term implications.
a) Pre-reading: Study Material 5 & 6
b) Question for discussion in class: What are the latest monetary and fiscal measures
undertaken by Indian government?
c) Learning outcomes: The highlights of fiscal policies, as described in Union Budget and
monetary policy measures, as described in monetary and credit policy by the RBI, should be
known to the students.
d) Chapter: Economic Survey
Session 17:
This session will be utilized for guest lecture on the relevance of economic policies with a
special focus on Indian economy and business.
Session 18:
In this session the teacher will explain the implications and importance of learning the
phenomenon of inflation and unemployment.
a) Pre-reading: Mankiw, ch 17 & 22
b) Question for discussion in class: Why high inflation and high unemployment are
detrimental to economic development?
c) Learning outcomes: The students should understand and know the ills of high inflation and
high unemployment scenario vis-a-vis economic development.
d) Chapter: Sikdar, Principles of Macroeconomics, ch 8 & 9
Session 19:

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The teacher will delve into different causes and reasons for inflation to occur in an economy.
Within mainstream theory, an emphasis has to be put on the relationship between inflation,
money supply and subsequently unemployment.
a) Pre-reading: Mankiw, ch 17 & 22
b) Question for discussion in class: How do you describe latest price and employment
situation in India?
c) Learning outcomes: The students should be aware of latest price level and unemployment
level prevailing in India.
d) Chapter: Sikdar, Principles of Macroeconomics, ch 8 & 9
Session 20:
This session will be utilized for guest lecture on inflation and its implication on Indian
economy and business.
Session 21:
This will be the first session in the series to introduce Indian economy with facts and figures
to the students. The basic fundamentals of India like GDP, growth, taxation etc. will be
introduced to the students with data and figures.
a) Pre-reading: Study Material 8 & 9
b) Question for discussion in class: Do you know some of the latest economic fundamentals
of India?
c) Learning outcomes: The students should come across the latest economic and standard of
living indicators in India. They should be able to remember at least some of the basic
indicators like GDP in real figures.
d) Chapter: Economic Survey
Session 22:
In this session, the teacher will make students aware of the sectoral composition of Indian
economy. A discussion will be ensued subsequently on the process of economic reforms
which started in the beginning of the 1990s.
a) Pre-reading: Study Material 8 & 9
b) Question for discussion in class: How do you judge Indian economic reform?
c) Learning outcomes: The circumstances under which economic reform was initiated, the
actual reform process, a review of the reform process – students should have some ideas
about all these.
d) Chapter: Economic Survey
Session 23:
The teacher will initiate, facilitate and encourage a detailed discussion on main segments of
Indian economy – agriculture, industry and services sector.
a) Pre-reading: Study Material 8 & 9
b) Question for discussion in class: How are Indian agriculture, industry and services
performing in the recent past?
c) Learning outcomes: Students should know the sectoral composition of Indian GDP. They
should also be clear about the importance of all major sectors in the economy.
d) Chapter: Economic Survey
Session 24:

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Analysis and evaluation of Indian economy in the last 15 years will be done to wrap up the
series of lectures based on Indian economy. Implications of Union Budget and Credit Policy
have to described in this session.
a) Pre-reading: Study Material 8 & 9
b) Question for discussion in class: What are the policies taken by Central government and
the RBI in Union Budget and Credit policy? What will
be their implications?
c) Learning outcomes: Students should be able to judge recent economic measures taken,
comparing them with past policy measures.
d) Chapter: Economic Survey
Session 25:
This session will be utilized for guest lecture on an overview of Indian economy.
Session 26:
In this session the teacher will introduce the basic concepts related to external sector like
BoP, foreign exchange depreciation and appreciation etc. to the students. The focus will be to
emphasise the need to understand external sector in view of increasing global integration.
a) Pre-reading: Study Material 7
b) Question for discussion in class: What are the major benefits of trade? How is India
placed in terms of export and import?
c) Learning outcomes: Latest highlights of Indian export and import have to be understood
fully with their implications.
d) Chapter: Economic Survey
Session 27:
This session will be utilized to conclude the discussion on external sector of India and global
context of business. Importance of FDI in India would be discussed in detail.
a) Pre-reading: Study Material 7
b) Question for discussion in class: Has India benefited from foreign direct investment?
c) Learning outcomes: Students should know the economic mechanisms by which foreign
direct investment helps Indian economy to grow. They should also be aware of certain perils
of foreign investments.
d) Chapter: Economic Survey

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Study Material 1

The Circular Flow of Income


The five-sector circular flow model describes the operation of the economy and the linkages
between the main sectors in the economy. The five-sector model is based on dividing the economy
into five sectors. A sector may be defined as a part of the economy where the participants are
engaged in a similar type of economic activity.
1. Individuals
2. Businesses
3. Financial institutions
4. Government
5. International Trade

Individuals
• This sector consists of all individuals in the economy.
• These individuals are the owners of productive resources, and the consumers in our economy.
• Individuals supply factors of production (inputs) such as labour and enterprise to businesses,
which they use to produce goods and services. As a reward for supply resources such as
labour and enterprise to firms, individuals receive incomes – rent, wages, interest and profit.
Businesses
• This sector consists of all the business firms engaged in the production and distribution of
goods and services (apart from financial services).
• It concerns all their activities involved with buying factors of production and using them to
produce and sell goods and services.
• Individuals and businesses are interdependent.
Financial Institutions
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• This sector consists of all those institutions that are engaged in the borrowing and lending of
money, acting as the intermediaries between those who save, and borrowers of money.
• Financial institutions are needed for individuals and firms to be able to undertake saving and
investment. They perform the function of mobilising savings for investment.
• Savings: leakage; Investment: injection
Government
• In India, this sector consists of the Central, State and local governments.
• It is involved in the satisfaction of collection (community) wants.
• It obtains the resources to do this through imposing taxes on the other sectors of the
economy.
• It uses this tax revenue to undertake various government expenditures.

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Study Material 2

National Income: Concepts and Measurement

National Income: It is defined as the monetary value of all the final goods and services
produced in an economy in a financial year.

Final goods and Services:


Those goods and services which are not further processed and converted into other goods
during the period in which they are produced. These are used only for the final consumption
purposes.

It can be measured using three different methods corresponding to the three different phases
in the cycle of economic activity.

Production Value Added Method (Product Method)


Distribution Income Method
Disposition Expenditure Method

Cycle of Economic Activity in any economy has three distinct phases: Production,
Distribution, and Disposition. The Cycle of Economic Activity starts with the production
process in which goods are manufactured and/or services rendered. The factors of production
which contribute in the production process get factor payment for its services. This captured
by distribution phase. Once the factors of production gets the factor income, they spend in
the market to by the goods and services (i.e. they dispose off money in the market). This
phase is termed as disposition.

Value Added Method (Product Method)


All the production units are considered separately in this method. For all the units, value
added is calculated and then they are aggregated to get the value of national income.

Value added = Gross Output – Intermediate consumption

Gross output: Total Value of output produced by the production unit.


Intermediate consumption: The inputs used by the production unit in manufacturing the
goods.

Let us consider the production of biscuits.


Ghazala is running a bakery. She needs flour, labours, sugar, electricity and machines to bake
the biscuits. Ghazala buys flour for Rs. 200 from Robert. She buys electricity for Rs.300
from Haryana SEB. Raghu supplies her sugar and machine. She pays Rs. 100 in return. She
also hires Sampat, Sabu, Akram and Ann as the laours and pays them Rs. 600. She, finally,
bakes biscuits worth Rs. 10000.

Calculation of Value Added


Gross Output = Rs. 3000
Intermediate Consumption
= 200 + 300 + 100 + 600 = 1200

Value Added = 3000 – 1200 = Rs. 1800


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Similarly after calculating the value added for all the economic units we can sum them up to
get the value of national income.

Consumption Gross
expenditure Output
By the Produc Intermed
household tion iate
By the consump
government tion
Capital
Formation by Dispos Distrib
firms ition ution
Export
Income Method Import Wages and
If we add all the factor incomes we get national income. Precisely, national income is equal
Salaries
to Net Domestic Product at Factor cost (NDPFC) Rent
NDPFC = Wages and Salaries Interest
+ Rent Fig. 1 Cycle of
Economic Activity Profit
+ Interest
+ Profit
+ Mixed Income of the Self-Employed

All the factors incomes are considered for all the production units.

Expenditure Method
In this method, expenditures made by different economic agents are considered. This can be
taken from Keynesian Model.

We wrote aggregate demand as follows

AD = C + I + G + X - M

C Private Final Consumption Expenditure (By the Household)


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I Gross Capital Formation (By the Firms)
G Government Final Consumption Expenditure (By the Government)
X Export (Expenditure made by foreigners on Indian products)
M Import (Expenditure made by Indian on foreign products)

Adding them up we get


Gross Domestic Product at Market Price (GDPMP)
Private Final Consumption Expenditure (By the Household)
+ Gross Capital Formation (By the Firms)
+ Government Final Consumption Expenditure (By the Government)
+ Export (Expenditure made by foreigners on Indian products)
- Import (Expenditure made by Indian on foreign products)

Therefore we get two different variants of national income. Expenditure method gives us
GDPMP , whereas income method gives us NDPFC .

There are eight variants of national income in all. The method to calculate different variant
is given by the exhibit in the next page (Ref. Fig. 2).

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GNPMP

- Dep - NIT
- NFYROW

NNPMP GDPMP GNPFC

- NIT
- Dep - NIT - Dep
- NFYROW - NFYROW

NDPMP NNPFC GDPFC

- NFYROW
- NIT - Dep

NDPFC

Legend
NFYROW Net Factor Income from
Abroad
NIT Net Indirect Taxes
Dep Depreciation

Fig. 2 Variants of National Income

Definition of the Key terms

Net Factor Income from Abroad


= (Factor income Received by Indians while working abroad)
- (Factor income Received by Foreigners while working in India)

Net Indirect Taxes


= Indirect Taxes
- Subsidies
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Depreciation
Wear and tear of machinery

Other Concepts Related to National Income

Base year
As price keeps changing all the time, the value of national income may also change only due
to change in price with no substantial change in total output. For example:

Assuming that only three goods are produced in the economy concerned, compare the
national income of a hypothetical economy no. 1 in 1993-94 and 2003-04
Table 1
1993-94 2003-04
Goods Total Price Total Total Price Total
Output Value Output Value
Rice 500 kg 30 1500 500 kg 60 3000
Cloth 200mts 40 8000 200mts 80 16000
House 40 1000 40000 40 2000 80000
National 49500 99000
Income

Above table (Ref. Table 1) clearly brings out that the national income has doubled
exclusively because of doubling up of price. Please note that the total output has remained
unchanged.

Therefore we need to introduce the concept of base year. Whenever we calculate the national
income of any economy we calculate it at two prices, one at the price of current year and
second at the price of some year in the past which can be chosen as the base. At present
1993-94 is considered as the base year in Indian economy.
Let us recalculate the national income given in the previous table. (Ref. Table 2)
Table 2
1993-94 (at current year price) 2003-04 (at base year price)
Goods Total Price Total Total Price Total
Output Value Output Value
Rice 500 kg 30 1500 500 kg 30 1500
Cloth 200mts 40 8000 200mts 40 8000
House 40 1000 40000 40 1000 40000
National 49500 49500
Income

Table 2 clearly reflects that the hypothetical economy no.1 has remained stagnant. Therefore
the significance of calculation at base year prices lies in giving the true picture of growth of
the economy. Let us look at the data of hypothetical economy no. 2 (Ref. Table 3)

Table 3

1993-94 (at current year price) 2003-04 (at base year price)
Goods Total Price Total Total Price Total
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Output Value Output Value
Rice 500 kg 30 1500 1000 kg 30 30000
Cloth 200mts 40 8000 250mts 40 10000
House 40 1000 40000 45 1000 45000
National 49500 85000
Income

Table 3 shows that economy no. 2 has grown substantially. Its national income has grown
from Rs. 49500 to 85000.

Nominal Income, Real Income and Deflators


The national Income at current prices can be termed as Nominal GDP, whereas national
income at base year prices (Constant prices) Real GDP. Given these two we can define GDP
deflator

Q11 , Q21 , Q31 ..................Qn1 Quantities of final output in the current year of goods from 1
to n
P11 , P21 , P31...........Pn1 Prices of final output in the current year of goods from 1 to n
P10 , P20 , P30 ..................Pn0 Prices of final output in the base year of goods from 1 to n

Then the GDP deflator can be defined as


∑Pi1Qi1
∑Pi o Qi1

eg Wholesale price index (WPI) and Consumer price index (CPI)


CPI includes the goods which form the consumption basket of the typical family and it uses
the retail prices, whereas the WPI includes the industrial raw materials, fuels and machinery
etc and it uses wholesale prices.

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Study Material 3

Simple Keynesian Model of Income Determination

Macroeconomics
Macroeconomics studies the economy as a whole. More specifically, it deals with the
determination of the economy’s total output of goods and services, the price level and total
employment of resources.

Simple Keynesian Model


In the General Theory, Keynes proposed that an economy’s total income was in the short run
determined largely by the desire to spend by the household, firms and the government. The
more people want to spend the more goods and services firms can sell. The more firms can
sell the more output they will choose to produce and the more workers they will choose to
hire.

Aggregate Demand
Let us try to derive aggregate demand in any economy. Sources of aggregate demand can be

Household Private Final Consumption Expenditure ( C )
Firm Investment ( I )
Government Government Expenditure (G)
Rest of the world Export (X) and Import (M)

Therefore aggregate demand can be written as

AD = C + I + G + X - M

Please note that import has been subtracted from the aggregate demand as aggregate demand
gets reduced by the amount of import (as the economic agents demand shifts to the product
from abroad)

In the formulation for AD, G is included as a separate component. It is so because factors


influencing other demand and the demand from government are quite different in nature.
While government can go beyond its means the private sector can not do so.

Consumption Function
C of AD represents consumption which is the function of income. This can be written as

C = C + cY
where C minimum level of consumption even when income is zero.

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Consumption

Income
Fig. 2 Consumption Function

Differentiating the consumption function


∆C
=c
∆Y
c is termed as marginal propensity to consume. It may be defined as the incremental change
in consumption level as a response to incremental change in income.

Savings Function
Saving is the difference between income and consumption. (Ref. Fig. 3)
S =Y −C
S =Y −(C +cY )
= −C +(1 −c )Y
= S + sY
where,
S = −C
s = (1 −c )

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Graphically,

Savings

Income

Fig. 3 Savings Function

Using consumption function, Aggregate Demand can be rewritten as

AD C cY I G++++= X-M
where C , I , G , X , M are exogenous variables
Exogenous variables can be rewritten as

A= C + I+ G + X-M
Then
AD = A +cY

Some key terminologies


Endogenous Variables: The variable, the value for which is derived from the system.
Exogenous Variables: The variable for which the values are given.

For any economy to be in equilibrium,


AD = Y

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3
Therefore, in equlibrium
Y = A + cY
⇒ Y − cY = A
⇒ ( 1 − c) Y = A
1
⇒ Y* = A
( 1 − c)
1
where, is multiplier
( 1 − c)
Re wrting

Y* =
1
( 1 − c)
(
C + I+ G+ X-M )
In differential

∆ Y = * ∆ ( C + I + G + X - M)
1
( 1 − c)
Therefore, the same formulation can also be looked differently.
We can say that if any of the endogenous variables changes, income in any economy can also
change via multiplier effect.

Therefore 1/(1 – c) is also called government expenditure multiplier and investment


multiplier.

Let us now look at the same thing graphically.

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4
AD AD = Y

Income
Y*

Y* Figure 4
Income Determination in Keynesian System

Alternative Formulation for equilibrium


Planned Investment = Planned Saving

Stability Analysis

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5
For any output above Y* there will be involuntary accumulation of inventories in the
economy, whereas for any output below Y* there will be run down on the stocks.
As a result of disequilibrium, the economy, will equilibriate through multiplier effect.

AD AD = Y

Income
Y1 Y* Y2
Figure 5
Accumulation and Run down

Concept of Multiplier
If the objective of the government is to raise the income of the economy it can be done by
increasing autonomous investment. Increase in investment would mean that there is increase
in income through multiplier effect. The graphical representation is as following.

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6
AD = Y
AD

Income
Y*

Y*
Figure 6
Change in autonomous investment

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Study material 4

Hicksian-Hansen Extension of Keynesian Model (IS-LM Model)

For a given price level, national income fluctuates because of shifts in the AD curve. The IS-LM
model takes the price level as given and shows what causes income to change.

Keyensian model focuses only on IS-LM model, whereas IS-LM model takes into consideration
money market as well.

Income

Assets Market Goods


Market
Money Bond
Market Market Aggregate
Output
DD DD
SS SS

Monetary Fiscal
Interest policy
policy
Rate

We wrote aggregate demand in Keynesian model as follows

AD = C + I + G + X - M

where C was written as


C = C + cY , where as other components of AD were kept as exogenous

variable. Investment was taken as autonomous variable, whereas in real life, investment is
found to be affected by the interest rate. Therefore it can be made the function of interest
rate. Symbolically
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I = I − hi
here h measures responsiveness investment spending to the interest rate and I is
autonomous investment spending that is independent of both income and interest rate.
dI
=h
di

Rate of
interest

Investment

Fig. 1 Investment Function

As the interest rate increases the firms’ incentive to invest decreases therefore there is less
investment. This gives rise to inverse relationship between interest rate and investment.

Aggregate Demand can, then, be rewritten as

In equilibrium we can rewrite it as


AD C cY I-hi G++++= X-M
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AD = A + cY - hi
AD = Y
Therefore, in equlibrium
Y = A + cY - hi
⇒ Y − cY = A - hi
⇒ ( 1 − c) Y + hi = A
This is called goods market equilibrium

Now we have one equation in two variables. We need to look for another equation to solve
this equation system. This brings us to Money market equilibrium.

Before we go on to goods market equilibrium we should look at the graph of goods market.
This graph will give us a locus where goods market is in equilibrium at various levels of
interest and income (IS). (Ref. Fig. 2)

Rate of
interest Goods Market Equilibrium

T
I*

I=S

Income
Y*
Figure 2
Goods Market equilibrium

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IS curve depicting goods market equilibrium is downwardly sloped. It means that when there
is rise in rate of interest there is less incentive for the firms to invest therefore there is a fall in
investment which further leads to fall in output and finally income. This gives inverse
relationship between income and interest rate.

i ↑⇒ I ↓⇒ O ↓⇒ Y ↓
Money market equilibrium

Money market will be in equilibrium when there is equality of money demand and money
supply.
At any point of time, Money supply is given by the central bank of any country (In India,
RBI). It may be written as
M
P
where M is nominal money supply and P is aggregate price. Therefore, M/P is real money
supply.

Money Demand
Money demand in any economy can be for three distinct purposes.
Transaction Demand for money (Mtd)
Money demanded to carry out day today transactions. How much will be demanded for this
purpose will depend on the level of income of the household. Therefore,
M td = f ( Y )

M TD = kY ..........................1
Ref. Fig. 3
Y
Fig. 3
Transaction Demand for Money

MTD

Precautionary Demand for money (Mpd)


How much money do you keep aside for contingency purposes will also depend on income.
Therefore
M pd = f ( Y )

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1
Speculative Demand for money (Msp)
Households need money for investment purposes as well. This is the function of interest rate.
If the interest is very high there will be less Msp and vice versa.
Symbolically,
M sp = f ( i )

i Fig. 4
Speculative Demand
for Money

M SP = −bi...........................2 Ms
Speculative demand for money depends on the cost of holding money. pThe cost of holding
money is the interest rate that is foregone by holding money rather other assets. The higher
the interest rate the more costly it is to hold money rather than other asset and accordingly
the less cash will be held at each level of income.

As Precautionary demand for money and Transaction demand for money are the functions of
income, therefore 1 and 2 can be clubbed together as follows.

M td = f ( Y )

Total demand for money can be written as (Ref. Fig. 5)


M d = M td + M sp = g ( i, y ) = kY − bi

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2
i
Fig. 5 Demand for Money

MD
The demand function for real balances implies that for a given level of income, the quantity
MSp
demanded is a decreasing function of the real rate of interest. In equilibriumMsp and
Md = Ms MD
M
g ( i, y ) =
P
Also,
M
kY − bi =
P
Graphically it be shown as follows, (Ref. Fig 6)
Rate of
interest Money Market Equilibrium

G
I*

L=M

Income
Y*
Figure 6 Money Market equilibrium

For economy to be in equilibrium, money market and goods market should simultaneously be in
equilibrium. Collecting the two equilibrium conditions we get,

Goods market Equilibrium


(1 −c )Y - hi = A
Money market Equilibrium
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M
g ( i, y ) =
P

These two are simultaneous equation in two variables. Solving this will give us the values of y
and i. Graphically, it can be seen as follows (Ref. Fig 7).

The point where the two curves, IS and LM intersect each other is the point (G) where the
economy will be in equilibrium.

Rate of
interest L=M

G
I*

I=S

Income
Y*

Figure 7
Goods and Money Market equilibrium

Fiscal Policy and Monetary Policy


Fiscal Policy is defined as tax and expenditure policy of the government, whereas monetary
policy is defined as polices regarding money supply and interest rate.

With the expansionary fiscal policy government expenditure will go up leading to the upward
shift in IS curve, this will further lead to rise in income level and interest rate, whereas
contractionary fiscal policy will have the opposite effect. (Ref. Appendix ‘Current Fiscal Trends
2002-03’)

With the expansionary fiscal policy IS will shift to IS’ and equilibrium will shift form G to H,
thereby leading to rise in income from Y* to Y’. (Ref. Fig. 8)

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Rate of
interest L=M

G
I*

I S’

IS

Income
Y* Y’
Figure 8 : Expansionary Fiscal Policy

With the increase in money supply LM curve will shift downward leading to fall in interest rate
and increase in income. (Ref. Fig. 9)

Rate of
interest LM

LM’

G
I*

IS

Income
Y* Y’

Figure 9 : Expansionary Monetary Policy

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Study Material 5

Monetary Policy

The Monetary policy is principally determined by the Reserve Bank of India (RBI), and
usually it is announced through the Monetary and Credit Policy as the policy statement,
traditionally announced twice a year, through which the RBI seeks to ensure price stability
for the economy as one of the main objectives.

The RBI also announces norms for the banking and financial sector and the institutions
which are governed by it. They are the banks, financial institutions, non-banking financial
institutions, primary dealers (money markets) and dealers in the foreign exchange (forex)
market.

Objectives of the Monetary Policy

The objectives are to maintain price stability and ensure adequate flow of credit to the
productive sectors of the economy.

Stability for the national currency (after looking at prevailing economic conditions), growth
in employment and income are also allied objectives of monetary policy. The monetary
policy affects the real sector through long and variable periods while the financial markets
are influenced through short-term implications.

There are four main 'channels' which the RBI looks at:

• Quantum channel: money supply and credit (affects real output and price level
through changes in reserves money, money supply and credit aggregates).
• Interest rate channel.
• Exchange rate channel (linked to the currency).
• Asset price.

Instruments of Monetary Policy

The instruments can be broadly classified into direct and indirect ones.

Typically, direct instruments include cash reserve (CRR) and/or statutory liquidity ratios
(SLR), directed credit and administered interest rates. The indirect instruments generally
operate through repurchase (repos) and outright transactions in government securities (open
market operations).

The reforms in the financial sectors have enabled RBI to expand the array of instruments at
its command. While the prime target of Monetary Policy continues to be banks' reserves, the
use of the same is sought to be de-emphasised and the liquidity management in the system is
being increasingly undertaken through open market operations (OMO), both outright and
repos.
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The CRR and SLR rates that peaked in the early 90's have now been considerably relaxed
with the RBI adopting other measures for controlling money supply. This has translated into
better liquidity for the banking sector.

The following is a brief explanation of each of the aforementioned instruments.

CRR/SLR: Cash reserve ratio (CRR) determines the level of cash banks need to hold against
their net demand and time liabilities. Similarly, statutory liquidity ratio (SLR) requires banks
to maintain a part of their liabilities in the form of liquid assets (e.g. government securities).

Bank rate: Bank rate is the rate at which RBI lends to the banking entities to meet their
liquidity requirements.

Interest rates: Credit and interest rate directives take the form of prescribed targets for
allocation of credit to preferred sectors or industries and prescription of deposit and lending
rates.

OMO and LAF: Liquidity management in the system is carried out through open market
operations (OMO) in the form of outright purchases or sales of government securities and
daily repo and reverse repo operations under Liquidity Adjustment Facility (LAF).

To illustrate the main features of monetary policy, let us take (for example) the First
Quarterly Review of Monetary Policy for the year 2006-07. The major highlights are as
following.

Highlights

• Reverse Repo Rate increased to 6.0 per cent and Repo Rate to 7.0 per cent.
• Bank Rate and Cash Reserve Ratio kept unchanged.
• GDP growth projection for 2006-07 retained at 7.5-8.0 per cent.
• Containing inflation within 5.0-5.5 per cent for 2006-07 warrants appropriate priority
in policy responses.
• Money supply, deposit and credit growth above the indicative projections, warranting
caution.
• Appropriate liquidity to be maintained to meet legitimate credit requirements,
consistent with price and financial stability.
• Barring the emergence of any adverse and unexpected developments in various
sectors of the economy and keeping in view the current assessment of the economy
including the outlook for inflation, the overall stance of monetary policy in the period
ahead will be:

• To ensure a monetary and interest rate environment that enables continuation of the
growth momentum while emphasising price stability with a view to anchoring
inflation expectations.
• To reinforce the focus on credit quality and financial market conditions to support
export and investment demand in the economy for maintaining macroeconomic and,
in particular, financial stability.

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• To consider measures as appropriate to the evolving global and domestic
circumstances impinging on inflation expectations and the growth momentum.

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Study Material 6

Fiscal Policy

Fiscal policy is an important instrument of the general economic policy of a government. It is


concerned with the use of a government’s taxation and expenditure powers to influence
economic activities in an economy at the aggregate level. It also deals with financial relations
between different tiers of government in a federal polity. Through the medium of budget,
fiscal policy determines the level of taxation, public expenditure, and borrowings by a
government and the issue of other additional expenditure by bodies like Planning
Commission.

Objectives of fiscal policy

The role of fiscal policy in developed economies is to maintain full employment and
stabilize growth. In contrast, in developing countries, fiscal policy is used to create an
environment for rapid economic growth. The various aspects of this are–

1. Mobilisation of resources: Developing economies are characterized by low levels of


income and investment, which are linked in a vicious circle. This can be successfully broken
by mobilizing resources for investment.

2. Acceleration of economic growth: The government has not only to mobilize more
resources for investment, but also to direct the resources to those channels where the yield is
higher and the goods produced are socially acceptable. Sectors to be focused have to be
prioritized by the government.

3. Minimization of the inequalities of income and wealth: Fiscal tools can be used to bring
about the redistribution of income in favor of the poor by spending revenue so raised on
social welfare activities. Some argue that taxing the rich is also an integral part of
redistribution of wealth.

4. Increasing employment opportunities: Fiscal incentives, in the form of tax-rebates and


concessions, can be used to promote the growth of those industries that have high
employment-generation potential. Here also priority sectors come into importance as the
government has to identify the sectors where there are more potential to generate
employment.

5. Price stability: Fiscal tools like taxation and price control can be employed to contain
inflationary and deflationary tendencies in the economy.

The limitations of Fiscal Policy

Most of the developed countries benefited from active fiscal policy regime till 1960s and 70s
which has been a great success. Later fiscal policy became out of fashion and under neo-
liberal economic policy less government intervention is prescribed. As a result in developing
countries also the role of fiscal policy became limited.
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The tax structure in the developing countries is often rigid and unnecessarily complex. Thus,
conditions conducive to the growth of well-knit and integrated tax policies are absent and
sorely missed. Following are some of the reasons that are hindrances for its implementation
in developing countries.

1. A sizeable portion of most developing economies is non-monetized, rendering fiscal


measures of the government ineffective and self-defeating.

2. Lack of statistical information as regards the income, expenditure, savings, investment,


employment etc. makes it difficult for the public authorities to formulate a rational and
effective fiscal policy.

3. Fiscal policy cannot succeed unless people understand its implications and cooperate with
the government in its implication. This is due to the fact that, in developing countries, a
majority of the people is illiterate.

4. Large-scale tax evasion, by people who are not conscious of their roles in development,
has an impact on fiscal policy.

5. Fiscal policy requires efficient administrative machinery to be successful. Most developing


economies have corrupt and inefficient administrations that fail to implement the requisite
measures vis-à-vis the implementation of fiscal policy.

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Study Material 7

Balance of Payments

The Balance of Payments (BOP) is the financial statement of account for the whole country.
It records economic transactions (i.e. financial relations) between the economy as a whole
and the rest of the world.

The BOP is the sum of two accounts:

1. The Current Account and


2. The Capital Account

The Current Account involves the import and export of goods and services as well as
transfer payments. It is the sum of:

1. Net of Trade
2. Net of Remittances
3. Net of Tourism
4. Net of Services Payment
5. Net of Interest
6. Net of Profits

The Trade Account includes item 1. The Invisibles Account is named so because these
accounts do not involve the physical movement of goods into and out of the country, and it
includes items 2 to 6. The Current Account is said to be in deficit when it is negative and in
surplus when it is positive.

The Capital Account deals with the movement of funds for investments and loans into and
out of a country. It is the sum of:

1. Borrowings or Debt and


2. Investment or Capital

Borrowings include:

1. Official Aid
2. External Commercial Borrowing
3. Government Borrowing
4. Foreign Currency Non-Resident accounts
5. FII money in debt

Investments include:

1. FDI
2. FII money in equity

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3. ADRs / GDRs
4. Acquisition of shares in M & A
5. Private Equity
6. Venture Capital

The latest figures for each of the above items can be found on the Reserve Bank of India’s
website.

Depreciation and appreciation of currency

Currency depreciation is the loss of value of a country's currency with respect to one or
more foreign reference currencies, typically in a floating exchange rate system. It is most
often used for the unofficial increase of the exchange rate due to market forces, though
sometimes it appears interchangeably with devaluation. Its opposite is called appreciation.

The depreciation of a country's currency refers to a decrease in the value of that country's
currency. For instance, if the Indian rupee depreciates relative to the euro, the exchange rate
(the Indian rupee price of euros) rises - it takes more Indian rupees to purchase 1 euro.

The appreciation of a country's currency refers to an increase in the value of that country's
currency. Continuing with the Indian rupee/euro example, if the Indian rupee appreciates
relative to the euro, the exchange rate falls - it takes fewer Indian rupees to purchase 1 euro.

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Study Material 8

India’s Economic Reforms

• Since 1991 there have been major changes in India's economic policies marking a
new phase in India's development strategy.
• The reforms were introduced in June 1991 in the wake a balance of payments crisis.
The crisis erupted suddenly at the end of a period of apparently healthy growth in the
1980s, when the Indian economy grew at about 5.5% per year on average

Aims of Reforms

• Reduction of Government Control over various aspects of domestic economy


• Increasing the role of private sector
• Redirecting scarce public sector resources to areas where the private is unlikely to
enter
• Opening up the economy to trade and foreign investment

Pace of Reforms

• Gradualism and evolutionary transition rather than rapid restructuring or "shock


therapy"
• The reason behind gradualism is that the reforms were not introduced in the
background of a prolonged economic crisis or system collapse of the type which
would have created a widespread desire for and willingness to accept, radical
restructuring. The crisis in 1991was not a prolonged crisis with a long period of non-
performance

Reforms in the 80s

• By the beginning of 80s - System of controls, with heavy dependence on the public
sector and highly protected inward oriented type of industrialization could not deliver
rapid growth
• Example of East Asian countries in 80s
• Second Half of 80s – Reduction of control, lowering tax rate, expand the role of
private sector, and liberalize controls on both trade and foreign investment
• Acceleration in growth in 80s and it created climate for continuing in the direction of
reform

Reforms in June 1991

• Fiscal Stabilisation
• Industrial Policy and Foreign Investment
• Trade and Exchange Rate Policy
• Tax Reforms
• Pubic Sector Policy
• Financial Sector Reforms
• Agricultural Sector Reforms
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• Labour Market Reforms

Fiscal Stabilisation

Why Fiscal Stabilisation?


• Essential precondition of successful reforms. High fiscal deficit leads to inflation.
• Central Government fiscal deficit reached at 8.4% of GDP in 1990-91. Allowing for
deficits of the State Governments overall Government fiscal deficit reached 10%.
This is high by any standard.

Reduction of Fiscal Deficit

• Abolition of export subsidies in 1991-92


• Partial restructuring of the fertilizer subsidy in 1992-93 (Rs. 6000 crores in 1991-92 )
• Phasing out of budgetary support to loss-making public-sector enterprises
• Sharp reductions in capital expenditures and the transfers to the state governments
• State governments were unable to cut their recurrent expenditures and responded by
decreasing their own capital expenditures
• Expenditure pattern of both central and state governments was biased in favour of
non-capital (or revenue) expenditures

Retrospective of Fiscal Deficit (FD)

• Central Government FD reduced from 8.4% of the GDP in 1990-91 to 5.9% in 1991-
92.
• FD in 1993-94 reached 7.3% of GDP due to reduction of tax.
• Customs revenue fall substantially due to fall in tariff
• Excise duty less collected because industrial production did not recover rapidly
• Higher government expenditure due to higher food subsidy in PDS and higher
developmental expenditure
• Willingness to accept expansionary fiscal policy due to existence of excess capacity
and reduction of inflation

FD after 1993-94

• Target for FD in 1994-95 has been set at 6% of GDP


• In the 1994-95 Budget it was announced that there will be a pre-determined cap on
the extent of monetisation of the Government deficit.
Industrial Policy and Foreign Investment

Industrial Policy Change


• Removing several barriers to entry in the earlier environment
• Abolition of erstwhile industrial licensing which required Government permission for
new investments as well as substantial expansion of existing capacity
• Licensing policy only for small list of industries, most of which are subject to
licensing primarily because of environmental and pollution consideration. Example:
Coal and Lignite; petroleum; plywood and wood base products; industrial explosive;
Drugs and Pharmaceuticals
• Investment and expansion by large industrial houses through the Monopolies and
Restrictive Trade Practices (MRTP) Act have also been eliminated
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• Comprehensive restructuring of the Companies Act which aims at simplifying and
modernising the legal framework governing the corporate sector
• Reservation of small scale industries continued due to social reasons but in cases
where the products have export potential Government has modified policy to allow
medium scale units to enter such areas provided they export at least 50% of
production
• Industries reserved for public sector has declined and in many critical areas have been
opened up to private sector participation including private participation. Example:
Electric power generation; hydrocarbon sector; air transport; telecommunication

Foreign Investment Policy Change


• Earlier the percentage of equity allowed to foreign investors was generally restricted
to a maximum of 40%, except in certain high technology areas, and foreign
investment was generally discouraged in the consumer goods sector unless
accompanied by strong export commitments
• The new policy is much more actively supportive of foreign investment
• Permission is automatically granted for foreign equity investment upto 51% in a large
list of 34 industries. For proposals involving foreign equity beyond 51%, or for
investments in industries outside the list, applications are processed by a high level
Foreign Investment Promotion Board
• Various restrictions earlier applied on the operation of companies with foreign equity
of 40% or more have been eliminated by amendment of the Foreign Exchange
Regulation Act and all companies incorporated in India are now treated alike,
irrespective of the level of foreign equity.

Trade and Exchange Rate Policy

Import Policy
• Import control on raw materials, other inputs into production and capital goods has
been virtually dismantled
• Imports for consumer goods remain restricted
• Lowering of customs duty, especially for capital goods. The customs duty has been
lowered from 90-100% in 1991 to a range between 20% to 40% in 1994. The peak
rate of customs duty applicable to several items was over 200% in 1991. It has been
lowered to 65% in 1994.

Causes of BOP Crisis


• Even as exports continued to grow through the second half of the 1980s but by 1990-
91 the export growth slowed down due to slow growth in important trading partners.
Export markets in Kuwait and Iraq were also lost
• Interest payments and imports rose faster so that India ran consistent current account
deficits.
• There was also an exogenous shock to the economy. The Gulf War led to much
higher imports bill due to the rise in oil prices.
• Also remittances declined and additional burden on repatriation and rehabilitation.

Exchange Rate Policy


• BOP crisis in 1991. The foreign exchange reserves of India in June 1991 amounted to
little more than $1 billion, enough to finance about three weeks’ imports (the prudent
level is generally accepted to be three months’ imports).
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• Devaluation of about 24% in July 1991

India Borrowing from IMF


• Low reserves – India’s recourse to commercial borrowing dried up as the credit rating
agencies down graded India
• Outflow of non-resident Indian deposits
• India approached IMF for an accommodation under the Compensatory and
Contingency Financing Facility (CCFF) and first credit tranche.
• Again higher amount of loan was taken with the promise of continued follow up,
policy reforms in the direction and to the degree required for upper credit tranche
arrangements

Compensatory and Contingency Financing Facility


• The export compensatory element of the CCFF provides timely financing to members
experiencing a temporary shortfall in export earnings or an excess in cereal import
costs, attributable to factors largely beyond the member’s control. This element of the
facility has been used particularly by commodity exporters. The contingency element
helps members with IMF arrangements keep their adjustment programs on track
when faced with unexpected adverse external shocks.

Credit Tranches
IMF credit is subject to different conditionality and phasing, depending on whether it is made
available in the first credit “tranche” (or segment) of 25 percent of a member’s quota or in
the upper credit tranches (any segment above 25 percent of quota). For drawings in the first
credit tranche, members must demonstrate reasonable efforts to overcome their balance of
payments difficulties. Upper credit tranche drawings are made in installments, or phased, and
are released when performance targets are met.

Policy Reform Due to IMF Loan


Macroeconomic Stabilisation
Structural Reforms

Structural Adjustment Programme (SAP)


• Devaluation of rupee by 23%.
• New Industrial Policy allowing more foreign investments.
• Opening up more areas for private domestic and foreign investment.
• Part disinvestment of government equity in profitable public sector enterprises.
• Sick public sector units to be closed down.
• Reforms of the financial sector by allowing in private banks.
• Liberal import and export policy.
• Cuts in social sector spending to reduce fiscal deficit.
• Amendments to the existing laws and regulations to support reforms.
• Market-friendly approach and less government intervention.
• Liberalization of the banking system.
• Tax reforms leading to greater share of indirect taxes
Other Policy Changes
• Devaluation was accompanied by an abolition of export subsidies

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• Increase in export incentives in the form of special incentive licenses (Eximscrips)
given to exporters which could be used to import items which were otherwise
restricted

Exchange Rate Policies in 92 and 93


• In March 1992 the government decided to establish a dual exchange rate regime and
abolish the EXIM scrip system. Under this 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 then unified the exchange rate and allowed, for the
first time, the rupee to float. From 1993 onward, India has followed a managed
floating exchange rate system

Tax Reform
Changes in Tax Policy
• Maximum marginal rate of personal income tax was reduced from 56% in 1991 to
40% in 1993
• Incentive structure for savings in the form of financial assets has been strengthened.
The Wealth Tax, which was earlier applicable to all personal assets, has been
modified to exempt all productive assets including financial assets such as bank
deposits, shares and other securities .
• The rates of corporate income tax, which were 51.75% for a publicly listed company
and 57.5% for a closely held company have been unified and reduced to 46%.
• Customs duties were significantly reduced

Indirect Tax on Domestic Manufactured Goods


• Duties were specific rather than ad valorem
• Large Number of exemption
• A system of tax credit for taxes paid on inputs called Modified Value Added Tax or
MODVAT was in force but excluded important sectors such as textiles and
petroleum. Duty credit was also not available on excise duty paid on capital goods at
the time of investment
• In Budget 1994 the bulk of the taxes shifted to an ad valorem basis
• The number of exemptions greatly reduced
• The coverage of the tax credit for taxes paid on inputs has been extended to include
petroleum and capital goods.
• The number of excise duty rates has been reduced from 21 to 10
• A start has also been made in extending indirect taxation to a few services by
imposing a 5% tax on telephone bills, premium payments for general insurance and
stock brokers' commissions.

Public Sector Policy

 Disinvestment of Government equity in public sector companies, with Government


retaining 51% of the equity and also management control

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 Non-inflationary resources for the Government Budget
 The emergence of private shareholders in public sector units and trading of public
sector shares in the stock markets are both expected to make public sector
managements more sensitive to commercial profitability. This is more as Government
has decided not to use budgetary resources to finance public sector investment in
industry

Policy for Loss Making Public sector Units

• The Government has announced that budgetary support to finance losses will be
phased out over three years
• Active restructuring of these units wherever it is possible to make them economically
viable, and with closure combined with adequate compensation for labour where it is
not
• Objective process for determining whether a unit should be closed or not has been
initiated by bringing sick public sector companies under the purview of the Board for
Industrial and Financial Reconstruction (BIFR)

Financial Sector Reforms

Banking System Reform


• Reduction of statutory liquidity ratio (SLR) and the cash reserve ratio (CRR)
• Interest rates on Government securities are increasing market determined
• Earlier the Reserve Bank of India prescribed a number of different interest rates on
deposits of different maturities and also a large number of prescribed lending rates for
different sectors and classes of borrowers. Deposit rates for different maturities have
now been freed subject only to a single ceiling. On the lending side the number of
prescribed interest rates for different types of borrowers has been reduced
• The Government has announced a programme of contributing fresh capital to the
nationalised banks
• To mitigate the impact on the Budget it is envisaged that the relatively stronger
nationalised banks with good balance sheets will mobilise additional capital from the
market by issuing new equity to the public. This will improve the commercial
viability of the banks
• The banking system is also being opened up to competition from new private banks
• Debt Recovery Tribunal to help facilitate recovery by banks from defaulting
borrowers

Reform in Capital market


• The requirement of Government permission for companies issuing capital, as well as
the system of Government control over the pricing of new issues of equity by private
companies, has been abolished with the repeal of the Capital Issues Control Act in
May 1992.
• The Securities and Exchange Board of India (SEBI) has been established as an
independent statutory authority for regulating the stock exchanges and supervising the
major players in the capital markets (brokers, underwriters, merchant bankers, mutual
funds, etc).

Portfolio Investment

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• Capital market opened for portfolio investment
• Favorable tax treatment has been granted to Foreign Institutional Investors (FIIs) to
encourage capital inflows through these routes.
• Indian companies have been allowed to access international capital markets by
issuing equity abroad through the mechanism of Global Depository Receipts

Labour Market Reforms


• Indian labour laws provide a high degree of protection to labour with retrenchment of
labour and closure of an unviable unit requiring prior permission of the State
Government for units employing more than 100 workers. So Indian firms lack
flexibility. However larger flexibility in labour law may increase unemployment
• National Renewal Fund (NRF) would finance compensation payments to labour
rendered redundant in the course of public sector restructuring and closure of
unviable units. NRF would also finance retraining programmes to help redeploy of
labour. Finance for NRF would come from Central Government and other aid donors

Implication of Reforms on Agriculture


• All Central Government restrictions on domestic trade have been removed though
some State Governments restrictions remain
• Restrictions on agricultural exports have also been reduced significantly though not
as yet fully eliminated
• Reduction of subsidy in electric power and irrigation and increase in investment in
agricultural sector

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Study Material 9

Some data on Indian economy


Data and diagram Source: Economic Survey, 2007-08 (website:http://indiabudget.nic.in)

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