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Course Manual
ECONOMIC ENVIRONMENT AND POLICY
ES-303
PGP 2010-12
I. Course Facilitators
Facilitator Email-id
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.
V. Pre-requisites
Main Textbook
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.
Important Websites:
• www.indiabudget.nic.in
• www.rbi.org.in
• www.ciionline.org
• www.finmin.nic.in
• www.ficci.com
• www.planningcommission.nic.in
3
VII. Assessment (Total 100 Marks)
4
Module 4: Hicksian-Hansen extension of Keynesian Model (IS-LM)
5
Module 7: Inflation and Unemployment
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:
1
0
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:
1
1
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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2
Study Material 1
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
1
3
• 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.
1
4
Study Material 2
National Income: It is defined as the monetary value of all the final goods and services
produced in an economy in a financial year.
It can be measured using three different methods corresponding to the three different phases
in the cycle of economic activity.
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.
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.
AD = C + I + G + X - M
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).
1
7
GNPMP
- Dep - NIT
- NFYROW
- NIT
- Dep - NIT - Dep
- NFYROW - NFYROW
- NFYROW
- NIT - Dep
NDPFC
Legend
NFYROW Net Factor Income from
Abroad
NIT Net Indirect Taxes
Dep Depreciation
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
1
9
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.
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
2
0
Study Material 3
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.
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)
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)
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.
2
1
Consumption
Income
Fig. 2 Consumption Function
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 )
2
2
Graphically,
Savings
Income
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
2
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.
2
4
AD AD = Y
Income
Y*
Y* Figure 4
Income Determination in Keynesian System
Stability Analysis
2
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.
2
6
AD = Y
AD
Income
Y*
Y*
Figure 6
Change in autonomous investment
2
7
Study material 4
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
Monetary Fiscal
Interest policy
policy
Rate
AD = C + I + G + X - M
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
2
8
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
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.
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
3
0
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
3
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 )
3
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,
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
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)
3
4
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’
3
5
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.
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.
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.
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
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–
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.
5. Price stability: Fiscal tools like taxation and price control can be employed to contain
inflationary and deflationary tendencies in the economy.
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.
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.
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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 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:
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.
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
• 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
Pace of Reforms
• 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
• 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
• 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
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.
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.
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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
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
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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
• 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)
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
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Study Material 9
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