MACROECONOMICS & BUSINESS ENVIRONMENT

(SLEC502 – Semester II)

Lecture Notes (Session 1 to 10)

Chapter 1-Introduction to economic Analysis (Session 1)

Microeconomics:-
1. It is the study of individual economic units of an economy.
2. It deals with Individual Income, Individual prices, Individual output, etc.
3. Its central problem is price determination and allocation of resources.
4. Its main tools are demand and supply of a particular commodity/factor.
5. It helps to solve the central problem of ‘what, how and for whom’ to produce. In the
economy
6. It discusses how equilibrium of a consumer, a producer or an Industry Is attained.
7. Price is the main determinant of micro- economic problems.
8. Examples are: Individual Income, Individual savings, price determination of a commodity,
individual firm’s output, consumer’s equilibrium.
Macroeconomics:
1. It is the study of economy as a whole and its aggregates.
2. It deals with aggregates like national Income, general price level, national output, etc.
3. Its central problem is determination of level of Income and employment.
4. Its main tools are aggregate demand and aggregate supply of the economy as a whole.
5. It helps to solve the central problem of full employment of resources in the economy.
6. It is concerned with the determination of equilibrium level of Income and employment of
the economy.
7. Income is the major determinant of macroeconomic problems.
8. Examples are: National Income, national savings, general price level, aggregate demand,
aggregate supply, poverty, unemployment, etc.
Macroeconomic Policy Objectives:
The macroeconomic policy objectives are the following:
(i) Full employment,
(ii) Price stability,
(iii) Economic growth,
(iv) Balance of payments equilibrium and exchange rate stability, and
(v) Social objectives.
(i) Full employment:
Performance of any government is judged in terms of goals of achieving full employment and
price stability. These two may be called the key indicators of health of an economy. In other
words, modern governments aim at reducing both unemployment and inflation rates.
Unemployment refers to involuntary idle-ness of mainly labour force and other produc-tive
resources. Unemployment (of labour) is closely related to the economy’s aggregate output.
Higher the unemployment rate, greater the divergence between actual aggre-gate output (or
GNP/CDP) and potential out-put. So, one of the objectives of macroeco-nomic policy is to
ensure full employment.
(ii) Price stability:
No longer the attainment of full employment is considered as a macroeconomic goal. The
emphasis has shifted to price stability. By price stability we must not mean an unchanging
price level over time. Not necessarily, price increase is unwelcome, particularly if it is
restricted within a reasonable limit. In other words, price fluc-tuations of a larger degree are
always unwelcome.
However, it is difficult again to define the permissible or reasonable rate of inflation. But
sustained increase in price level as well as a falling price level produce destabilizing effects
on the economy. Therefore, one of the objectives of macroeconomic policy is to ensure
(relative) price level stability. This goal prevents not only economic fluctuations but also
helps in the attainment of a steady growth of an economy.

(iii) Economic growth:

Economic growth in a market economy is never steady. These economies experience ups and
downs in their performance. One of the important benchmarks to measure the performance of
an economy is the rate of increase in output over a period of time. There are three major’
sources of economic growth, viz. (i) the growth of the labour force, (ii) capital formation, and
(iii) technological progress. A country seeks to achieve higher economic growth over a long
period so that the standards of living or the quality of life of people, on an average, improve.
It may be noted here that while talking about higher economic growth, it takes into account
general, social and environmental factors so that the needs of people of both present
generations and future generations can be met.
(iv) Balance of payments equilibrium and exchange rate stability:
From a macro- economic point of view, one can show that an international transaction differs
from domestic transaction in terms of (foreign) currency exchange. Over a period of time, all
countries aim at balanced flow of goods, services and assets into and out of the country.
Whenever this happens, total international monetary reserves are viewed as stable.
It is, however, because of growing inter- connectedness and interdependence between
different nations in the globalised world, the task of fulfilling this macroeconomic policy
objective has become more problematic.

(v) Social objectives:

Macroeconomic policy is also used to attain some social ends or social welfare. This means
that income distribution needs to be more fair and equitable. In a capitalist market-based
society some people get more than others. In order to ensure social justice, policymakers use
macroeconomic policy instruments.

Macroeconomic Policy Instruments:

As our macroeconomic goals are not typically confined to “full employment”, “price
stability”, “rapid growth”, “BOP equilibrium and stability in foreign exchange rate”, so our
macroeconomic policy instruments include monetary policy, fiscal policy, income policy in a
narrow sense. But, in a broder sense, these instruments should include policies relating to
labour, tariff, agriculture, anti-monopoly and other relevant ones that influence the
macroeconomic goals of a country. Confining our attention in a restricted way we intend to
consider two types of policy instruments the two “giants of the industry” monetary (credit)
policy and fiscal (budgetary) policy. These two policies are employed toward altering
aggregate demand so as to bring about a change in aggregate output (GNP/GDP) and prices,
wages and interest rates, etc., throughout the economy.

Circular Flow of Income

1. The Circular Flow of Income in a Two-Sector Model:
In this model, the economy is assumed to be a closed economy and consists of only two
sectors, i.e., the household and the firms. A closed economy is an economy that does not
participate in international trade. In this model, the household sector is the only buyer of
the goods and services produced by the firms and it is also the only supplier of the factors
of production. The household sector spends the entire income on the purchase of goods
and services produced by the firms implying that there is no saving or investment in the
economy. The firms are the only producer of the good and services. The firms generate
income by selling the goods and services to the household sector and the latter earns
income by selling the factors of production to the former. Thus, the income of the
producers is equal to the income of the households is equal to the consumption
expenditure of the household. The demand of the economy is equal to the supply. In this
model, Y = C where, Y is Income and C is Consumption. The circular flow of income in
a two sector model is explained with the help of the following diagram, called Model 1.

The Circular Flow of Income in a Two-Sector Model with Saving and Investment:
In the above model, we assumed that the household sector spends its entire income and
that there is no saving in the economy however, in practice, the household sector does not
spend all its income; it saves a part of it. The saving by the household sector would imply
monetary withdrawal (equal to saving) from the circular flow of income. This would
affect thesale of the firms since the entire income of the household would not reach the
firm implying that the production of goods and services would be more than the sale.
Consequently, the firms would decrease their production which would lead to a fall in the
income of the household and so on. There is one way of equating the sales of the firms
with the income generated; if the saving of the household is credited to the firms for
investment then the income gap could be filled. If the total investment (I) of the firms is
equal to the total saving (S) of the household sector then the equilibrium level of the
economy would be maintained at the original level. This is explained with the help of the
following diagram, called Model 1a. The equilibrium condition for a two-sector model
with saving and investment is as follows:Y = C + S or Y = C + I or C + S = C + IOr, S
= I Where, Y = Income, C = Consumption, S = Saving and I = Investment.
2. The Circular Flow of Income in a Three –Sector Model:
The three sector model of circular flow of income highlights the role played by the
government sector. This is a more realistic model which includes the economic activities
of the government however; we continue to assume the economy to be a closed one.
There are no transactions with the rest of the world. The government levies taxes on the
households and the firms and it also gives subsidies to the firms and transfer payments to
the household sector. Thus, there is income flow from the household and firmsto the
government via taxes in one direction and there is income outflow from the government
to the household and firms in the other direction. If the government revenue falls short of
its expenditure, it is also known to borrow through financial markets. This sector adds
three key elements to the circular flow model, i.e., taxes, government purchases and
government borrowings. This is explained with the help of the following diagram called,
Model 2.

In this model, the equilibrium condition is as follows:Y = C + I + GWhere, Y = Income; C =

Consumption; I = Investment and G = Government ExpenditureIn a closed economy,
aggregate demand is measured by adding consumption, investment and government
expenditure. Thus, aggregate demand is defined as the total demand for final goods and
services in an economy at a given time and price level and aggregate supply is defined as the
total supply of goods and services that the firms are willing to sell in an economy at a given
price level.
3. The Circular Flow Of Income in a Four Sector Model:
This is the complete model of the circular flow of income that incorporates all the four
macroeconomic sectors. Along with the above three sectors it considers the effect of foreign
trade on the circular flow. With the inclusion of this sector the economy now becomes an
‘open economy’. Foreign trade includes two transactions, i.e., exports and imports. Goods
and services are exported from one country to the other countries and imports come to a
country from different countries in the goods market. There is inflow of income to the firms
and government in the form of payments for the exports and there is outflow of income when
the firms and governments make payments abroad for the imports. The import payments and
export receipts transactions are done in the financial market. This is explained with the help
of a following diagram, called Model 3.

In this model, the equilibrium condition is as follows:Y = C + I + G + NX

NX = Net Exports = Exports (X) –Imports (M), Where, Y = Income; C = Consumption; I =
Investment; G = Government Expenditure; X = Exports and M = Imports.

Leakages and Injections in the Circular Flow of Income:

The flow of income in the circular flow model does not always remain constant. The volume
ofincome flow decrease due to the leakages of income in the circular flow and similarly, it
increases with the injections of income into the circular flow. Leakages: A leakage is referred
to as an outflow of income from the circular flow model. Leakages are that part of the income
which the household withdraw from the circular flow and is not used to purchase goods and
services. This part of the income does not go to the goods market. There are three main

to purchase of goods and services or pay taxes. It is kept with the financial institutions like
banks that can be lend further by the banks to the firms for investment or capital expansion

g
payments are made to the foreign sector for the good and services bought from them. This is
an outflow of income from the economy. Thus, we see that leakages reduce the volume of
income from the circular flow of income. Leakages = S + T + M , Where, S = Saving; T =
Taxes; and M = ImportsInjections: An injection is an inflow of income to the circular flow.
The volume of income increases due to an injection of income in the circular flow. There are
three main injections and these are: Investment: It is the total expenditure by the firms on
capital expansion. It flows to the goods market. Government Expenditure: It is the total
expenditure of the government on goods and services, subsidies to the firms and transfer
payments to the household sector. Transfer payments are government payments like social
security schemes, pensions, retirement benefits, and temporary aid to needy families etc.
Exports: Export receipts are the payment made by the foreign sector for the purchase of
domestic goods. It is an inflow of income from the foreign sector to the financial market.
Injections = I + G + XWhere, I = Investment; G = Government Expenditure; and X = Exports
Balance of leakages and Injections in an open economy is; S + T + M = I + G + X Or, (S –I)
= (G –T) + (X –M)The leakages and injections can be shown with the help of the following
diagram called, Model 4.
Model 4: The Leakages and Injections in the Circular Flow of Income

Chapter 2- Measuring National output/Income (Session number-2, 3, 4)

Concepts of National Income

The important concepts of national income are:
1. Gross Domestic Product (GDP)
2. Gross National Product (GNP)
3. Net National Product (NNP) at Market Prices
4. Net National Product (NNP) at Factor Cost or National Income
5. Personal Income
6. Disposable Income
1. Gross Domestic Product (GDP): Gross Domestic Product (GDP) is the total market value
of all final goods and services currently produced within the domestic territory of a country in
a year.
Four things must be noted regarding this definition.
First, it measures the market value of annual output of goods and services currently produced.
This implies that GDP is a monetary measure.
Secondly, for calculating GDP accurately, all goods and services produced in any given year
must be counted only once so as to avoid double counting. So, GDP should include the value
of only final goods and services and ignores the transactions involving intermediate goods.
Thirdly, GDP includes only currently produced goods and services in a year. Market
transactions involving goods produced in the previous periods such as old houses, old cars,
factories built earlier are not included in GDP of the current year.
Lastly, GDP refers to the value of goods and services produced within the domestic territory
of a country by nationals or non-nationals.
2. Gross National Product (GNP): Gross National Product is the total market value of all
final goods and services produced in a year. GNP includes net factor income from abroad
whereas GDP does not. Therefore,
GNP = GDP + Net factor income from abroad.
Net factor income from abroad = factor income received by Indian nationals from abroad –
factor income paid to foreign nationals working in India.
3. Net National Product (NNP) at Market Price: NNP is the market value of all final goods
and services after providing for depreciation. That is, when charges for depreciation are
deducted from the GNP we get NNP at market price. Therefore’
NNP = GNP – Depreciation
Depreciation is the consumption of fixed capital or fall in the value of fixed capital due to
wear and tear.
4.Net National Product (NNP) at Factor Cost (National Income): NNP at factor cost or
National Income is the sum of wages, rent, interest and profits paid to factors for their
contribution to the production of goods and services in a year. It may be noted that:
NNP at Factor Cost = NNP at Market Price – Indirect Taxes + Subsidies.
5. Personal Income: Personal income is the sum of all incomes actually received by all
individuals or households during a given year. In National Income there are some income,
which is earned but not actually received by households such as Social Security
contributions, corporate income taxes and undistributed profits. On the other hand there are
income (transfer payment), which is received but not currently earned such as old age
pensions, unemployment doles, relief payments, etc. Thus, in moving from national income
to personal income we must subtract the incomes earned but not received and add incomes
received but not currently earned. Therefore,
Personal Income = National Income – Social Security contributions – corporate income taxes
– undistributed corporate profits + transfer payments.
Disposable Income: From personal income if we deduct personal taxes like income taxes,
personal property taxes etc. what remains is called disposable income. Thus,
Disposable Income = Personal income – personal taxes.
Disposable Income can either be consumed or saved. Therefore,
Disposable Income = consumption + saving.

Measurement of national income

Production generate incomes which are again spent on goods and services produced.
Therefore, national income can be measured by three methods:
1. Output or Production method
2. Income method, and
3. Expenditure method.
1. Output or Production Method: This method is also called the value-added method. This
method approaches national income from the output side. Under this method, the economy is
divided into different sectors such as agriculture, fishing, mining, construction,
manufacturing, trade and commerce, transport, communication and other services. Then, the
gross product is found out by adding up the net values of all the production that has taken
place in these sectors during a given year.
In order to arrive at the net value of production of a given industry, intermediate goods
purchase by the producers of this industry are deducted from the gross value of production of
that industry. The aggregate or net values of production of all the industry and sectors of the
economy plus the net factor income from abroad will give the GNP. If we deduct
depreciation from the GNP we get NNP at market price. NNP at market price – indirect taxes
+ subsidies will give us NNP at factor cost or National Income.
The output method can be used where there exists a census of production for the year. The
advantage of this method is that it reveals the contributions and relative importance and of the
different sectors of the economy.
2. Income Method: This method approaches national income from the distribution side.
According to this method, national income is obtained by summing up of the incomes of all
individuals in the country. Thus, national income is calculated by adding up the rent of land,
wages and salaries of employees, interest on capital, profits of entrepreneurs and income of
self-employed people.
This method of estimating national income has the great advantage of indicating the
distribution of national income among different income groups such as landlords, capitalists,
workers, etc.
3. Expenditure Method: This method arrives at national income by adding up all the
expenditure made on goods and services during a year. Thus, the national income is found by
adding up the following types of expenditure by households, private business enterprises and
the government: -
(a) Expenditure on consumer goods and services by individuals and households denoted by
C. This is called personal consumption expenditure denoted by C.
(b) Expenditure by private business enterprises on capital goods and on making additions to
inventories or stocks in a year. This is called gross domestic private investment denoted by I .
(c) Government’s expenditure on goods and services i.e. government purchases denoted by
G.
(d) Expenditure made by foreigners on goods and services of the national economy over and
above what this economy spends on the output of the foreign countries i.e. exports – imports
denoted by
(X – M). Thus,
GDP = C + I + G + (X – M).
Difficulties in the measurement of national income
There are many difficulties in measuring national income of a country accurately. The
difficulties involved are both conceptual and statistical in nature. Some of these difficulties or
problems are discuss below:
1. The first problem relates to the treatment of non-monetary transactions such as the services
of housewives and farm output consumed at home. On this point, the general agreement
seems to be to exclude the services of housewives while including the value of farm output
consumed at home in the estimates of national income.
2. The second difficulty arises with regard to the treatment of the government in national
income accounts. On this point the general viewpoint is that as regards the administrative
functions of the government like justice, administrative and defense are concerned they
should be treated as giving rise to final consumption of such services by the community as a
whole so that contribution of general government activities will be equal to the amount of
wages and salaries paid by the government. Capital formation by the government is treated as
the same as capital formation by any other enterprise.
3. The third major problem arises with regard to the treatment of income arising out of the
foreign firm in a country. On this point, the IMF viewpoint is that production and income
arising from an enterprise should be ascribed to the territory in which production takes place.
However, profits earned by foreign companies are credited to the parent company.

Special Difficulties of Measuring National Income in Under-developed Countries

1. The first difficulty arises because of the prevalence of non-monetised transactions in such
countries so that a considerable part of the output does not come into the market at all.
Agriculture still being in the nature of subsistence farming in these countries, a major part of
output is consumed at the farm itself.
2. Because of illiteracy, most producers have no idea of the quantity and value of their output
and do not keep regular accounts. This makes the task of getting reliable information very
difficult.
3. Because of under-development, occupational specialization is still incomplete, so that there
is lack of differentiation in economic functioning. An individual may receive income partly
from farm ownership, partly from manual work in industry in the slack season, etc. This
makes the task of estimating national income very difficult.
4. Another difficulty in measuring national income in under-developed countries arises
because production, both agriculture and industrial, is unorganized and scattered in these
countries. Agriculture, household craft, and indigenous banking are the unorganized and
scattered sectors. An assessment of output produced by self-employed agriculturist, small
producers and owners of household enterprises in the unorganized sectors requires an element
of guesswork, which makes the figure of national income unreliable.
5. In under-developed countries there is a general lack of adequate statistical data.
Inadequacy, non-availability and unreliability of statistics is a great handicap in measuring
national income in these countries.
Real and Nominal GDP
Real GDP: Real GDP is an inflation-adjusted calculation that analyzes the rate of all
commodities and services manufactured in a country for a fixed year. It is expressed in
foundation year prices and is referred to as a fixed cost price. Inflation rectified GDP or fixed
dollar GDP. Real GDP is regarded as a reliable indicator of a nation’s economic growth as it
solely only considers production and free from currency fluctuations. Real GDP is regarded
as a reliable indicator of a nation’s economic growth as it solely only considers production
and free from currency fluctuations.
Nominal GDP: Nominal Gross Domestic Product is GDP evaluated at present market prices.
GDP is the financial equivalent of all the complete products and services generated within a
nation’s in a definite time. Nominal varies from real GDP, and it incorporates changes in cost
prices due to an increase in the complete cost price. Generally, economists utilize a gross
domestic factor to change nominal GDP to real GDP also known as current dollar GDP or
chained dollar GDP.

Price Indices and its applicability:

Changes in the levels of prices are mea-sured using a scale called a price index. This is the
most useful device for measuring change in the price level.
In most countries price indexes are used to measure inflation, each focusing on the prices of a
collection of goods and services important to a particular seg-ment of the economy.
Types of Price Indices:
Inflation is measured by constructing inflation indices. Inflation indices which help in
calculating inflation rates indicate how much prices have changed over a period of time. The
indices themselves are a representation of the level of prices at a particular time. Not all
prices are included in the index, only a specified basket of good and services. The basket in
the index is representative of the items which are relevant to a market or group. Thus there
are different price indices for the prices faced by different groups. They are:
1.The Wholesale Price Index(WPI):It includes prices of the goods sold in the wholesale
market, i.e. the market where bulk transactions are made for further sale afterwards.
2. The Consumer Price Index(CPI):It includes prices of goods and services sold in the retail
market, i.e. the final prices which the end consumers have to pay. It is hence also called the
cost of living index. It is also used for indexing dearness allowance to employees for increase
in prices.
3. The Producer Price Index(PPI):It includes producer or output prices which are the prices of
the first commercial transactions of goods and services or the transactions at the point of first
sale. Most of the countries have replaced their WPI with the PPI in the 1970s and the 1980s,
except India. The PPI usually covers the industrial (manufacturing) sector as well as public
utilities. Some countries also include agriculture, mining, transportation and business
services. The WPI prices include taxes and transportation charges, whereas the producer
prices do not.
4. The GDP Deflator: The Gross Domestic Product or the GDP is the total value of the goods
and services produced in an economy in a year. Value means the total quantity of the goods
and services (total output) multiplied by their respective prices.
From this we arrive at two concepts of GDP: the nominal GDP and the real GDP. The
nominal GDP, when compared to the GDP of some previous year reflects the change in the
total output produced by the economy as well as change in their prices.
So, to arrive at the true picture of whether the economy has grown in terms of the actual
output produced, we have the real GDP. The real GDP is calculated by taking the output of
the year under consideration, but multiplied by the prices of the base year.
Hence GDP deflator= (Nominal GDP/ Real GDP) × 100
GDP Deflator shows the change in prices of all goods and services over a particular period
of time. It does not cover just some selected items which form the basket of other price
indices.
5. Private Final Consumption Expenditure Deflator:Movement of the consumption pattern of
the country can be analyzed through this deflator. The private final consumption expenditure
is the expenditure incurred by households, and its deflator measures the change in it at by
dividing its value at current prices by its value in the base year (at constant prices).
Importance of Indexes:
The consumer price index and other measures of inflation are not studied by academics,
business people, and government officials out of idle curiosity. Rather, the indexes have an
important impact on policymakers’ decisions and on the operation of the economy. They
directly affect wages of union workers who receive cost-of-living adjustments based on the
consumer price index, and they influence the size of many non-union income payments as
well.
Employers and employees often look to these indexes in determining “fair” salary increases.
Some government programmes, such as social security, base changes in monthly checks on a
variation of one of these indexes. Private business contracts may provide for price
adjustments based on the producer price index and, in some instances, other payments such as
child support and rent have been tied to one of these indexes.
Index numbers can be used for a variety of purposes. By comparing the index numbers of
several years in succession we can find out whether the price level is rising or falling and the
degree of change. Appropriate measures can then be taken by the government to coun-teract
the bad effects of price changes in either direction.
Cost of living index numbers can be used to judge the conditions of the working class. In
some countries, wages are varied in proportion to the changes in the cost of learning index
number so that the workers may not suffer distress when prices rise.
Index numbers are useful for comparing the price situation of one year with that of another.
For example, the index numbers of the years 1939 to 1945 show how the price level and the
value of money changed during these years. But long range comparisons should not be made.
It is useless to compare the index number of 1939 with that of 1999.
The reason is that in 1999 many new commodities have come into existence and most of the
commodities of 1939, which are still in use in 1999, have considerably changed in quality.
When the time interval is much too long, there is no common base for comparison. This is
also true for index numbers of different countries.

Chapter 3: Aggregate Demand and Aggregate Supply: AD and AS curves ( Session 5 -6)

Introduction
Aggregate demand refers to the total demand for final goods and services in the economy.
Since aggregate demand is measured by total expenditure of the community on goods and
services, therefore, aggregate demand is also defined as ‘total amount of money which all
sectors (households, firms, government) of the economy are ready to spend on purchase of
goods and services.
Aggregate demand is synonymous with aggregate expenditure in the economy. If the total
intended expenditure on buying all the output is larger than before, this shows a higher
aggregate demand.
On the contrary, if the community decides to spend less on the available output, it shows a
fall in the aggregate demand. In simple words, aggregate demand is the total expenditure on
consumption and investment. It should be noted that determination of output and employment
in Keynesian framework depends mainly on the level of aggregate demand in short period.
Aggregate Demand:
In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total
demand for final goods and services in an economy at a given time. It specifies the amounts
of goods and services that will be purchased at all possible price levels. This is the demand
for the gross domestic product of a country.
Aggregate demand includes all four :
Consumption
Investment
Government spending
Net exports—exports minus imports
Aggregate demand=C+I+G+X−M
The term aggregate demand (AD) is used to show the inverse relation between the quantity of
output demanded and the general price level. The AD curve shows the quantity of goods and
services desired by the people of a country at the existing price level. In the Fig. below, the
AD curve is drawn for a given value of the money supply M.

Aggregate Demand Curve

The AD curve is downward sloping for two reasons:
(i) The fall in the quantity of goods and services purchased:
Since the velocity of money is assumed to remain constant, the existing stock of money
determines the rupee value of all transactions in the economy. If the price level rises, more
money is required to carry out each transaction. This means that the number of transactions
and thus the quantity of goods and services has to fall.
(ii) Real balance effect:
A rise in the price level implies a fall in the level of real balances. This, in its turn implies a
smaller quantity of goods and services. In other words, if Y increases, people engage in more
transactions and need higher real balances. For a fixed supply of M, higher real balances
imply a lower price level. The converse is also true.

Aggregate Supply
The total supply of goods and services available to a particular market from producers. “The
aim of the tax changes is to stimulate the supply side of the economy and therefore boost
aggregate supply". Aggregate supply is the total quantity of output firms will produce and
sell—in other words, the real GDP.
The upward-sloping aggregate supply curve—also known as the short run aggregate supply
curve—shows the positive relationship between price level and real GDP in the short run.
The aggregate supply curve slopes up because when the price level for outputs increases
while the price level of inputs remains fixed, the opportunity for additional profits encourages
more production.

Potential GDP, or full-employment GDP, is the maximum quantity that an economy can
produce given full employment of its existing levels of labor, physical capital, technology,
and institutions. Aggregate demand is the amount of total spending on domestic goods and
services in an economy. The downward-sloping aggregate demand curve shows the
relationship between the price level for outputs and the quantity of total spending in the
economy.
The economic intuition here is that if prices for outputs were high enough, producers would
make fanatical efforts to produce: all workers would be on double-overtime, all machines
would run 24 hours a day, seven days a week. Such hyper-intense production would go
beyond using potential labor and physical capital resources fully to using them in a way that
is not sustainable in the long term. Thus, it is indeed possible for production to sprint above
potential GDP, but only in the short run.

Chapter 4: Aggregate Demand and multiplier: (Session 7-8)

Determination of Equilibrium Income: Components of aggregate Demand, Consumption
function, Marginal propensity to Consume, Determinants of Consumption, Saving function,
Investment function, Determinants of Investment, Government spending, Net exports
Components of AD
The main components of aggregate demand (aggregate expenditure) in a four sector economy
are:
1. Household (or private) consumption demand. (C)
2. Private investment demand. (I)
3. Government demand for goods and services. (G)
4. Net export demand. (X-M)
Thus,
AD = C + I + G+(X-M)
Consumption function:
In economics, the consumption function describes a relationship between consumption and
disposable income. The concept is believed to have been introduced into macroeconomics by
John Maynard Keynes in 1936, who used it to develop the notion of a government spending
multiplier
C= Ca + bY
AD =C+I, i.e Y=C + I
C= a + bY (0<b<1)
APC = C/Y

Marginal propensity to Consume: The marginal propensity to consume (MPC) measures

the proportion of extra income that is spent on consumption.
MPC= dC/dY
The marginal propensity to consume measures the change in consumption/change in
disposable income. The marginal propensity to consume can also be shown by the slope of
the consumption function:
Factors that determine the marginal propensity to consume

 Income levels. At low-income levels, an increase in income is likely to see a high

marginal propensity to consume; this is because people on low incomes have many
goods/services they need to buy. However, at higher income levels, people tend to
have a greater preference to save because they have most goods they need already.
 Temporary/permanent. If people receive a bonus, then they may be more inclined to
save this temporary rise in income. However, if they gain a permanent increase in
income, they may have greater confidence to spend it.
 Interest rates. A higher interest rate may encourage saving rather than consumption;
however, the effect is fairly limited because higher interest rates also increase income
from saving, reducing the need to save.
 Consumer confidence. If confidence is high, this will encourage people to spend. If
people are pessimistic (e.g. expect unemployment/recession) then they will tend to
delay spending decisions and there will be a low MPC.

Saving function (S= -a + sY)

Saving is that part of income which is not spent on current consumption. The relationship
between saving and income is called saving function.
Simply put, saving function (or propensity to save) relates the level of saving to the level of
income. It is the desire or tendency of the households to save at a given level of income.
Thus, saving (S) is a function (f) of income (Y).

Assumptions:
Saving fn. S=S(Y)
AS =C+I, i.e Y=C + S
S= Y – C
S= Y – (a+bY)
S= -a + (1-b) Y ( Fig.)
S= -a + sY

Investment Function:
The investment function is a summary of the variables that influence the levels of aggregate
investments. It can be formalized as follows:
I=f(r, ΔY, q)
Where, r is the real interest rate, Y the GDP and q is Tobin's q. The signs under the variables
simply tell us if the variable influences investment in a positive or negative way (for instance,
if real interest rates were to rise, investments would correspondingly fall).
The reason for investment being inversely related to the Interest rate is simply because the
interest rate is a measure of the opportunity cost of those resources. If the resources instead of
financing the investment could be invested in financial assets, there is an opportunity cost of
(1+r), where r is the interest rate. This implies higher investment spending with a lower
interest rate. When GDP increases, the output and the capacity utilization increases. This
results in an increase of capital investment.

Determinants of Investment
 The quantity of investment demanded in any period is negatively related to the
interest rate. This relationship is illustrated by the investment demand curve.
 A change in the interest rate causes a movement along the investment demand curve.
A change in any other determinant of investment causes a shift of the curve.
 The other determinants of investment include expectations, the level of economic
activity, the stock of capital, the capacity utilization rate, the cost of capital goods, other
factor costs, technological change, and public policy.

Assumptions:
The investment demand curve would be affected by each of the following:

1. A sharp increase in taxes on profits earned by firms

2. An increase in the minimum wage
3. The expectation that there will be a sharp upsurge in the level of economic activity
4. An increase in the cost of new capital goods
5. An increase in interest rates
6. An increase in the level of economic activity
7. A natural disaster that destroys a significant fraction of the capital stock

Government spending
It refers to money spent by the public sector on the acquisition of goods and provision of
services such as education, healthcare, social protection. The first Social, and defense.
Government spending or expenditure includes all government consumption, investment, and
transfer payments. In national income accounting, the acquisition by governments of goods
and services for current use, to directly satisfy the individual or collective needs of the
community, is classed as government final consumption expenditure. Government acquisition
of goods and services intended to create future benefits, such as infrastructure investment or
research spending, is classed as government investment (government gross capital
formation). These two types of government spending, on final consumption and on gross
capital formation, together constitute one of the major components of gross domestic product.
Government spending can be financed by government borrowing, or taxes. Changes in
government spending is a major component of fiscal policy used to stabilize the
macroeconomic business cycle.

Net exports (X-M) :

Net exports are a measure of a nation's total trade. The formula for net exports is a simple
one: The value of a nation's total export goods and services minus the value of all the goods
and services it imports equal its net exports.

A nation that has positive net exports enjoys a trade surplus, while negative net exports mean
the nation has a trade deficit. A nation's net exports may also be called its balance of trade.
Chapter 5: Product Market (Session 9-10)
Shifts in the AD Curve:
The AD curve shows alternative feasible combinations of P and Y for a given value of M. If
the central bank changes M, then the possible combinations of P and Y change too and the
AD curve shifts. The AD curve also shifts at a fixed value of M if V changes.
If the central bank reduces M, there will be a proportionate fall in PY (the nominal value of
output). If P remains fixed, Y will fall and, for any given amount of Y, P is lower. In this case
the AD curve showing inverse relation between P and Y shifts to the left from AD1 to AD2.
The Fig. below also shows that the AD curve shifts to the right in case of an increase in M by
the central bank.

Any event that changes C, I, G, or NX – except a change in P – will shift the AD curve.
Example:
A stock market boom makes households feel wealthier, C rises, the AD curve shifts right.
Changes in C
 Stock market boom/crash
 Preferences: consumption/saving tradeoff
 Tax hikes/cuts
Changes in I
 Firms buy new computers, equipment, factories
 Expectations, optimism/pessimism
 Interest rates, monetary policy
 Investment Tax Credit or other tax incentives
Changes in G
 Central Govt. spending, e.g., defense
 State & local spending, e.g., roads, schools
 Changes in NX
Booms/recessions in countries that buy our exports.
Appreciation/depreciation resulting from international speculation in foreign exchange
market.
Concept of Multiplier
A multiplier broadly refers to an economic factor that, when increased or changed, causes
increases or changes in many other related economic variables, like investment, government
expenditure, tax, etc.
The Investment Multiplier
Change in aggregate spending will shift the equilibrium and the shift will reflect change in
level of national income.
Increase in aggregate spending will shift AD upward, so will the equilibrium point along AS
causing increase in national income
This is simple and straightforward.
However, this tells us only the direction of change in NI, it does not tell us the magnitude of
change in NI due to a given change in aggregate spending.
Two Specific Questions
Is there any specific relationship between the change in AD and change in NI?
What determines the relationship and magnitude of change in NI
Theory of multiplier.
Shift in AD may be caused by business investment, government expenditure, taxes, export
and imports.
Investment Multiplier
The essence of multiplier is that total increase in income, output or employment is manifold
the original increase in investment. For example, if investment worth Rs. 100 crores is made,
then the income will not rise by Rs. 100 crores only but a multiple of it.
If as a result of the investment of Rs. 100 crores, the national income increases by Rs. 300
crores, multiplier is equal to 3. If as a result of investment of Rs. 100 crores, total national
income increases by Rs. 400 crores, multiplier is 4. The multiplier is, therefore, the ratio of
increment in income to the increment in investment. If ∆I stands for increment in investment
and ∆Y stands for the resultant increase in income, then multiplier is equal to the ratio of
increment in income (∆K) to the increment in investment (∆I).
Therefore k = ∆Y/∆I where k stands for multiplier.

Now, the question is why the increase in income is many times more than the initial increase
in investment. It is easy to explain this. Suppose Government undertakes investment
expenditure equal to Rs. 100 crores on some public works, say, the construction of rural
roads. For this Government will pay wages to the labourers engaged, prices for the materials
to the suppliers and remunerations to other factors who make contribution to the work of
road-building.
The total cost will amount to Rs. 100 crores. This will increase incomes of the people equal
to Rs. 100 crores. But this is not all. The people who receive Rs. 100 crores will spend a good
part of them on consumer goods. Suppose marginal propensity to consume of the people is
0.8.
Then out of Rs. 100 crores they will spend Rs. 80 crores on consumer goods, which would
increase incomes of those people who supply consumer goods equal to Rs. 80 crores. But
those who receive these Rs. 80 crores will also in turn spend these incomes, depending upon
their marginal propensity to consume. If their marginal propensity to consume is also 0.8,
then they will spend Rs. 64 crores on consumer goods. Thus, this will further increase
incomes of some other people equal to Rs. 64 crores.
In this way, the chain of consumption expenditure would continue and the income of the
people will go on increasing. But every additional increase in income will be progressively
less since a part of the income received will be saved. Thus, we see that the income will not
increase by only Rs. 100 crores, which was initially invested in the construction of roads, but
by many times more.
Government Expenditure Multiplier
The government expenditure multiplier is the ratio of change in income (∆Y) to a change in
government spending (∆G).
The impact of a change in income following a change in government spending is called
government expenditure multiplier, symbolised by kG.
The government expenditure multiplier is, thus, the ratio of change in income (∆Y) to a
change in government spending (∆G). Thus,
KG = ∆Y/∆G and ∆Y = KG. ∆G
In other words, an autonomous increase in government spending generates a multiple
expansion of income. How much income would expand depends on the value of MPC or its
reciprocal, MPS. The formula for KG is the same as the simple investment multiplier,
represented by KI.
Its formula (i.e., KG) is:

The impact of a change in government spending is illustrated graphically in the diagram

below, where C + 1 + G1 is the initial aggregate demand schedule. E1 is the initial
equilibrium point and the corresponding level of income is, thus, OY1If the government
plans to spend more, aggregate demand schedule would then shift to C + I + g2. As this line
cuts the 45° line at E2, the new equilibrium level of income, thus, rises to OY2— an amount
larger than the initial one. It is clear from Fig. 3.19 that the increase in income (∆Y) is larger
than the increase in government spending (∆G).

The reason behind this expansionary effect of government spending on income is that the
increase in public expenditure constitutes an increase in income, thereby triggering
successive increases in consumption, which also constitutes increase in income.
Tax Multiplier
When the government changes the tax rates, the relation between disposable income and
national income changes. When the government increases a tax rate (T) or levies a new tax,
the marginal propensity to consume (c) of the people declines because their disposal income
is reduced. This brings a fall in national income due to the multiplier effect. On the other
hand, reduction in taxes has the multiplier effect of raising the national income. The tax
multiplier (KT) is

Government usually levies two types of taxes, lumpsum tax and proportional tax.
Before the levy of a lumpsum tax, C is the consumption function and the income level is OY.
Now AG amount of tax is levied. As a result, the disposable income is reduced and the
consumption function shifts downward from C to C1. With the decline in the consumption
function, the total expenditure curve (C+I+G) also shifts downward to C+ I + G-T curve. This
intersects the 45° line at E1 and the national income is reduced from OY to OY1.

Second, if the government levies a proportional income tax, this also brings a fall in the
consumption function due to a decline in disposable income of the people. Consequently, the
national income declines due to the tax multiplier.
This is shown the diagram below, where C is the consumption function before the tax is
levied and OY is the income level. When AT tax is levied, the C curve revolves downward to
C1. With the fall in the consumption function, the total expenditure curve (C+I+G) also
revolves downward to C+I+G-T and intersects the 45° line at E1. This brings reduction in
national income from OY to OY1.

Balanced Budget Multiplier

The balanced budget multiplier is used to show an expansionist fiscal policy. In this the
increase in taxes (∆T) and in government expenditure (∆G) are of an equal amount (∆T=∆G).
Still there is increase in income. The basis for the expansionary effect of this kind of balanced
budget is that a tax merely tends to reduce the level of disposable income.
Therefore, when only a portion of an economy’s disposable income is used for consumption
purposes, the economy’s consumption expenditure will not fall by the full amount of the tax.
On the other hand, government expenditure increases by the full amount of the tax. Thus the
government expenditure rises more than the fall in consumption expenditure due to the tax
and there is net increase in national income.
The balanced budget multiplier is based on the combined operation of the tax multiplier and
the government expenditure multiplier. In the balanced budget multiplier, the tax multiplier is
smaller than the government expenditure multiplier. The government expenditure multiplier
is:

And the tax multiplier is

A simultaneous change in public expenditure and taxes may be expressed as a combination of

equations (1) and (2) which is balanced budget multiplier,

Since ∆G = ∆T, income will change (∆Y) by an amount equal to the change in government
expenditure (∆G) and taxes (∆T).
Foreign Trade Multiplier
The foreign trade multiplier, also known as the export multiplier, operates like the investment
multiplier of Keynes. It may be defined as the amount by which the national income of a
country will be raised by a unit increase in domestic investment on exports.
As exports increase, there is an increase in the income of all persons associated with export
industries. These, in turn, create demand for goods. But this is dependent upon their marginal
propensity to save (MPS) and the marginal propensity to import (MPM). The smaller these
two marginal propensities are, the larger will be the value of the multiplier, and vice versa.
The foreign trade multiplier can be derived algebraically as follows:
The national income identity in an open economy is
Y=C+I+X–M
Where Y is national income, C is national consumption, I is total investment, X is exports
and M is imports.
The above relationship can be solved as:
Y–C=1+X–M
or
S = I + X – M (S = Y – C)
S+M=I+X
Thus, at equilibrium levels of income the sum of savings and imports (S + M) must equal the
sum of investment and export (1 + X).
In an open economy the investment component (I) is divided into domestic investment (Id)
and foreign investment (If)
I=S
Id + If = S … (1)
Foreign investment (If) is the difference between exports and imports of goods and services.
If =X – M …. (2)
Substituting (2) into (1), we have
Ld + X – M – S
or
Id + X = S + M
Which is the equilibrium condition of national income in an open economy. The foreign trade
multiplier coefficient (Kf) is equal to –
Kf = ∆Y/∆X
And ∆X = ∆S + ∆M
 AGGREGATE DEMAND & AGGREGATE SUPPLY (GENERAL
EQUILIBRIUM FRAMEWORK)
The money market and the goods market are closely linked. Events that happen in the money
market affect the goods market and vice versa. For instance, when the central bank increases
money supply and reduces interest rates, consumption and investment demand increases and
the goods market equilibrium is affected. Similarly, when there is an increased spending by
households, the money market equilibrium changes. Therefore, we need to analyse the two
markets together to obtain the values of aggregate income/output (Y) and the interest rate (r),
such that both markets are in equilibrium.
Key Concepts
Product Market - The market in which goods and services are exchanged and where the
equilibrium level of aggregate output (Y) is determined.
Money Market - The market where financial instruments are exchanged and where the
equilibrium level of interest rates (r) is determined.
Aggregate Demand – The sum total of demand for goods and services in an economy.
Aggregate demand or aggregate expenditure is the sum of consumption expenditure by
households, planned investment of business firms and government spending or purchases,
Aggregate Demand (AD) Curve – A curve that shows the relationship between aggregate
income/output and price level. Each point on the AD curve corresponds to a point at which
the goods and the money market are in equilibrium. AD curve is negatively sloped.
Aggregate Supply – The total supply of all goods and services in an economy.
Aggregate Supply (AS) Curve – A curve that shows the relationship between the total
quantity of output that firms are willing to supply for each given price level. AS curve has a
positive slope.
Equilibrium Price level- The equilibrium price level is obtained at the point where the AD
curve intersects the AS curve.
Output Gap- The difference between actual real GDP and maximum potential real GDP is
the output gap.
Analysing Interdependence of Money market and Goods Market
Planned aggregate expenditure (AE) is the sum of consumption expenditure (C), planned
investment (I), and government spending (G).
AE = C + I + G
To understand the interdependence of the money market and the goods market, let us look at
the impact of a change in interest rates on aggregate expenditure (which in turn determines
aggregate income or output). It may be summarised as follows
- Planned investment depends on interest rates
- There exists an inverse relationship between interest rate and planned investment
- A rise in interest rate reduces planned investment
- Investment, being a component of aggregate expenditure, aggregate expenditure falls
when interest rate rises
- A fall in aggregate expenditure lowers equilibrium income by a multiple of the
decrease in initial investment due to the working of the investment multiplier
The effect of a change in income on interest rates is summarized as follows:
- An increase in income increases the transaction and precautionary demand for money
- The demand curve for money MD shifts to the right
- Assuming that the supply of money is fixed, interest rate rises
Aggregate Demand (AD) Curve
Aggregate demand shows different levels of aggregate output associated with different levels
of price in an economy. We assume here that the fiscal policy variables – government
expenditure (G) and net taxes (T) and the monetary policy variable, money supply (MS) are
unchanged.
To derive aggregate demand curve, we have to examine the effect of a change in price level
(P) on aggregate output (Y), taking into consideration the effects on both goods and money
market.
An increase in the general price level increases the demand for money - hence the money
demand (MD) curve shifts to the right. The supply of money (MS) is unchanged and is
therefore drawn as a vertical line. Interest rate rises as is shown in Fig 1a. A rise in interest
rate raises borrowing costs, so planned investment falls from I1 to I2 (Fig 1b). Planned
investment is a component of aggregate expenditure (AE). So, the AE curve moves
downwards (Fig 1c). The firms cut back on output so Y falls from Y1 to Y2. Thus, an increase
in the price level leads to a fall in the level of aggregate income (Fig 1d).
The situation is reversed when the price level falls. We will see that aggregate expenditure
rises due to an increase in planned investment. Hence aggregate income or output also rises.
The aggregate demand curve is negatively sloped as is seen in fig 1d.
 Figure (1a) Figure (1b) Figure (1c)

Figure (1d)

Shifts in the Aggregate Demand Curve

In the above analysis, we assume that government expenditure (G), net taxes (T) and money
supply (MS)are unchanged. When these variables change, the AD curve shifts.
Expansionary Monetary Policy
At a given price level, when the money supply rises, interest rates fall. Planned investment
spending (I) rises. This causes an increase in income (output) levels. This at a given price
level, output level rises, causing the aggregate demand curve to shift from AD1 to AD2.
Similarly, when money supply contracts, AD curve shifts inwards.
Expansionary Fiscal Policy
An increase in government expenditure directly increases aggregate expenditure. A decrease
in net taxes increases disposable income, hence consumption rises. AE rises, which leads to
an increase in output at each possible price level. Hence the AD curve shifts outwards.

Aggregate Supply Curve

Aggregate supply curve shows the relationship between aggregate quantity of output supplied
by all firms in an economy and the overall price level. Though differences of opinion exist, it
is generally agreed that in the short run, the AS curve is positively sloped. At very low levels
of aggregate output (as in a recession), the AS curve is relatively flat, while at higher levels
of output, AS curve is relatively steep or nearly vertical.
The reason for the positive slope is summarised as follows:
- A major determinant of aggregate supply is input costs. Wages are generally a large
component of total input costs. In the short run, wages (and other fixed costs like rent)
are inflexible (sticky) and tend to lag behind prices.
- Thus, when aggregate demand rises, there will be some period of time when
producers can sell the increased output at higher prices without much of a rise in
marginal costs. Profits increase.
 - Aggregate supply increases in response to an increase in price and profits giving rise
to an upward sloping AS curve.
The shape of the short -run aggregate supply curve (flatter initially, thereafter relatively steep
and finally near vertical) is explained as follows:
- At low levels of output, as in a recession, firms are likely to have excess capital and
labour (excess capacity)
- Hence the firms can produce additional output in response to an increased aggregate
demand without much rise in additional costs.
- Firms are willing to increase output without increasing in price levels significantly,
i.e. the increase in output is greater than the increase in prices. So, the AS curve is
relatively flat at lower levels of output
- As demand expands further and firms move closer to capacity utilization, the increase
in price is greater than the increase in output.
- In the short run, firms face input scarcity at high levels of output, hence the price rises
steeply, causing the AS curve to become almost vertical.

Long-run Aggregate Supply Curve

In the long run, wages adjust to higher prices if workers can successfully negotiate with
firms as price level increases. Other input costs like rent also adjusts to rising price levels
in the long run. If input costs fully adjusts to prices in the long run, the AS curve will be
vertical.
Determinants of Aggregate Supply
The two main determinants of aggregate supply are
i. Potential output which depends on
- Supplies of inputs such as labour, capital, land, etc. Growth of input increases
potential output and aggregate supply shifts outwards.
- Innovation, technological improvements and increased efficiency
ii. Production costs such as wages, rent, interest costs, import price, etc. An increase in
production costs reduces AS and causes the AS curve to shift inwards, while a fall
in costs results in an outward shift of the AS curve.
Source: Paul A. Samuelson, William B. Nordhaus Published by Tata McGraw-Hill
Publishing Company Ltd.
Equilibrium Price level
The equilibrium price level is obtained at the point where the AD curve intersects the AS
curve. In the diagram, the equilibrium price level is P and the equilibrium level of aggregate
output is Y. We know that each point on the AD curve corresponds to equilibrium in the
goods and the money market. Each point on the AS curve shows price and output response of
all firms in the economy. The equilibrium thus established is the general equilibrium in the
economy where the goods market, money market and the factor markets are in equilibrium.
Output Gap
During economic downturns an economy’s output of goods and services declines. When
times are good, by contrast, that output—usually measured as GDP—increases.
One thing that concerns economists and policymakers about these ups and downs
(commonly called the business cycle) is how close current output is to an economy’s long-
term potential output. That is, they are interested not only in whether GDP is going up or
down, but also in whether it is above or below its potential.
The output gap is an economic measure of the difference between the actual output of an
economy and its potential output. Potential output is the maximum amount of goods and
services an economy can turn out when it is most efficient—that is, at full capacity. Often,
potential output is referred to as the production capacity of the economy.

Potential Output Is Not the Maximum Output: We must emphasize a subtle

point about potential output. Potential output is the highest sustainable level of
national output. It is the level of output that would be produced if we remove business-
cycle influences. However, it is not the absolute maximum output that an
economy can produce.

The economy can operate with output levels above potential output for a short
time. Factories and workers can work overtime for a while, but production
above potential is not indefinitely sustainable. If the economy produces more
than its potential output for long, price inflation tends to rise as
unemployment falls, factories are worked intensively, and workers and
businesses try to extract higher wages and profits.
Figure: 2a
Just as GDP can rise or fall, the output gap can go in two directions: positive and negative.
Neither is ideal.
A positive output gap occurs when actual output is more than full-capacity output. This
happens when demand is very high and, to meet that demand, factories and workers
operate far above their most efficient capacity. A negative output gap occurs when actual
output is less than what an economy could produce at full capacity. A negative gap means
that there is excess capacity, or slack, in the economy due to weak demand.
An output gap suggests that an economy is running at an inefficient rate—either
overworking or underworking its resources.

In Figure: 2a YFE is the potential output. If the aggregate demand curve is AD2 the equilibrium
between AD and AS occurs at output level Y2. it creates a positive output gap which suggests
that an economy is outperforming expectations because its actual output is higher than the
economy's recognized maximum capacity output (YFE). In this case, the economy is operating
at over-capacity and inflationary pressures are likely to be increasing.
Conversely, if the aggregate demand curve is AD1, the equilibrium between AD and AS is at
output level Y1. This creates a negative output gap which suggests that the economy is
underperforming because its actual output is lower than the economy's recognized maximum
capacity output (YFE). This signifies that the economy is operating with spare capacity and
unemployment is likely to be relatively high.

How to close the output gap?

To close a positive output gap a country would follow a contractionary policy as they would
want to reduce rampant inflation by reducing AD:
FISCAL - Taxation (income, corporation etc) would Exceed Government Spending
MONETARY - Increase in Interest Rates
SUPPLY SIDE - Long Term investment projects would potentially be put in place in order to
shift the LRAS curve rightwards which would help reduce the positive output gap and lower
inflation. However, this will most likely not be used as a main strategy as it will take too long
to implement and the effects of inflation as such need to be dealt with in the short run.

To close a negative output-gap it would be the opposite, an expansionary

policy. For example:
FISCAL - Less tax more spending to boost AD (AD=C+I+G+(X-M) )
MONETARY - Low interest rates to make saving less attractive, quantitative
easing/funding for lending schemes etc.
SUPPLY SIDE - Similar long term investment projects/ subsidies etc.
Anything to shift out the Aggregate Demand Curve from AD1 to AD2 as shown in figure 2b,
below.

Figure: 2b
 Effica
cy of demand-side measures vs supply-side measures to close
the output gap.

All expansionary measures to close a negative output gap will be inflationary

in nature (price level increases from P1 to P2 in Figure: 2b) as they will
increase the purchasing power and hence the Aggregate Demand. However,
demand side measures work better as they show results in the short run as
against the supply side measure which empirically fails to close the gap in the
short-run.

Source: ‘Economics’ by Paul Samuelson and William Nordhaus. nineteen editions, 2009.

**********************************
 Business Cycle

According to J.M. Keynes “A trade cycle is composed of periods of good trade characterized
by rising prices and low unemployment percentages alternating with periods of bad trade
characterized by falling prices and high unemployment percentages.”
In simple words, business cycle is a wavelike fluctuation observed in different macro economic
indicators such as GDP, unemployment, inflation, interest rate, etc. over a period of time.
The important features of business cycle are as follows:
 Business cycles are recurring in nature.
 A minor cycle may last for 3-4 years and a major one may last for 7-8 years.
 In a business cycle, there are changes in variables such as GDP, employment, inflation, etc.
During the expansionary stage, these variables will rise and during contractionary stage,
these variables will fall.
 In a business cycle, co-movement of variables can be predicted. For e.g. the impact of
downfall in GDP and its impact on unemployment can be predicted.
 Business cycles are international in character. For e.g. the Great Depression of 1930s,
financial crisis of 2007, etc.

Phases / Stages of Business Cycle

The important stages of trade cycle are:

Real GDP

D
G
S
Growth Trend Line

C
S
A
F
B
O Time
32
SS = Sustainable Growth Trend, BD = Expansion, DF = Contraction, Points ‘D’ & ‘G’ = Peak,
Points ‘B’ & ‘F’ = Trough, DE = Slowdown, AB & EF = Recession (Can result in depression),
CD = Prosperity, BC = Recovery
The different phases of business cycle are as follows:
 Prosperity:
During this period, there is rise in profits, GDP, employment, demand for raw material as
well as finished goods, wage rate, inflation, investment, stock prices, bank deposits and bank
credits, etc. The point at which growth rate achieves its maximum level is known as peak.
Prosperity itself is the beginning of recession. If price level rises tremendously due to
shortage of raw materials, it may lead to fall in profits, investment, growing inventories, etc.
 Slowdown:
Slowdown is a term used by many economies now. It is a stage where GDP of a country
falls but is positive. For e.g. if GDP was 8% in last quarter and its 6% in this quarter, it
indicates slowdown. GDP has decreased but it is positive.
 Recession:
During this stage, there is downfall of income, consumption, demand, investment, stock
prices, bank deposits and bank credit, etc. It is said that if GDP is negative for two
consecutive quarters, it is known as recession. The point at which growth reaches the lowest
point is known as trough.
Under recession, people would find it difficult to maintain he same consumption pattern
when the income is decreasing. They will reduce the demand which in turn will reduce the
production of consumer goods. This will bring down the level of investment in an economy.
The stock prices will go down as industries may not perform well. Banks will follow cautious
approach and the volume of credit will decrease. This can result in unemployment.
It is said that if GDP becomes negative and is more than 10%, it indicates depression.
During this stage, the consumption falls even if the price level is decreasing.
 Recovery:
It starts when downward movement of prices is restricted. Producers see no risk in
undertaking production. They will utilize the idle resources which create employment,
increases the income of the people, increases the demand for goods and services, etc. The

33
 profit levels will start rising leading to increase in demand for investments. This will increase
bank credit. Increase in income of the people will also increase the bank deposits.
As such we do not have any exact definition for recession, recovery, prosperity and
depression.

Samuelson’s Model of Business Cycle: Multiplier Accelerator Interaction

Samuelson states that interaction between multiplier and accelerator results in trade cycles.
An increase in investment will increase the national income on the basis of multiplier. This
increase in income will increase the demand for goods and services. To fulfill the increased
demand for goods and services, investment is needed. It is explained by accelerator.
The assumptions of this model are as follows:
 There is time lag in consumption. Increase in consumption in the current period is based on
change in income in preceding period.
 There is time lag in investment. Increase in investment in the current period is based on
change in income in preceding period.
 Government’s investment is autonomous and assumed to be constant.
 This model is applicable in closed economy.
 The production capacity is limited.
The working of this model can be shown as:

 1 
ΔY  ΔIa  
 1 - MPC  ΔI d  v. Y

∆Ia = Increase in autonomus investment, ∆Y = Increase in income

MPC = Marginal propensity to consume, ∆Id = Increase in induced investment
V = Size of accelerator which depends on capital output ratio
This model can be mathematically represented as:
Yt = Ct + It …..(1)
t refers to current period, a refers to autonomous and t-1 refers to previous period.
Ct = Ca + c (Yt-1) …..(2)

34
 It = Ia + v (Yt-1 –Yt-2) …..(3)
Substituting (2) and (3) in (1) we get,
Yt = Ca + c (Yt-1) + Ia + v (Yt-1 –Yt-2)

Multiplier & Acceleration Interaction Effect on Income:

Let us assume that MPC = 0.5 and Acceleration Co-efficient = 2
Induced Induced Total
Multiplier Autonomus
Consumption Investment Income
Period Investment (Rs.)
(Rs.) (Rs.) (Rs.)
I=
C = c (Yt-1) a (Ct - Ct-1)
1 2 3 4 2+3+4
T 100.00 0.00 0.00 100.00
T+1 100.00 50.00 100.00 250.00
T+2 100.00 125.00 150.00 375.00
T+3 100.00 187.50 125.00 412.50
T+4 100.00 206.25 37.50 343.75
T+5 100.00 171.88 -68.75 203.13
T+6 100.00 101.56 -140.63 60.94
T+7 100.00 30.47 -142.19 -11.72
T+8 100.00 -5.86 -72.66 21.48
T+9 100.00 10.74 33.20 143.95
T+10 100.00 71.97 122.46 294.43

Source: Multiplier & Acceleration Interaction Effect on Income

35
 The value of multiplier and accelerator will determine the movements in income. In this
theory, one period time lag is assumed i.e. increase in income in period t will increase the
consumption in period t+1.
Since MPC < 1, the cumulative process of increase in income tends to end. The main reason
for this is when income rises to a very high level, people prefer to save more and consume less.
As consumption falls, induced investment will also fall which is affect national income. When
induced investment becomes negative, there is shortage of goods in the market. So producers
make try to increase the level of output due to which income and consumption may increase.
This process continues.

Business Cycle Indicators

The important business cycle indicators are as follows:

A) On the Basis of Time:
 Leading Indicators:
These indicators give an idea about what will happen in the economy in future. It guides
the government about how to intervene in future. The important leading indicators are
interest rates, exchange rates, price of gold, price of oil, stock market, inventory rates, retail
sales, building permits, unemployment rate, business license applications, etc.
 Co-incident Indicators:
These indicators show the current stage of the economy. They change as the business
cycle moves ahead. The important co-incident indicators are industrial production, number of
employees by sector, personal income, gross national product, etc.
 Lagging Indicators:
These indicators give an idea about what has happened in the economy. They confirm the
trend of leading indicators. The important lagging indicators are profits, spending, balance of
trade, duration of unemployment, inflation, wages, layoffs, financial statements, etc.

B) On the Basis of Direction:

 Pro-cyclical Indicators:

36
 A pro-cyclical indicator moves in the same direction of an economy. If an economy is
making progress, this indicator will move up and vice versa. For e.g. GDP, HDI, etc.
 Counter Cyclical Indicators:
A counter cyclical indicator moves in the opposite direction of an economy. If an
economy is facing downfall, this indicator will move up and vice versa. For e.g.
unemployment rate, population living below poverty line, etc.
 Acyclical Indicators:
An acyclical indicator is neither pro-cyclical nor counter cyclical. For e.g. sports result
will not have any impact on the growth of an economy.

37
Classical Aggregate Supply Model

To arrive at the Classical Aggregate Supply Model, we need to look at the production
function and thereby the demand and supply functions for labor.

Production Function
As studied in Managerial Economics, the Production function gives us the relationship
between the factor inputs and the output. What holds true about a firm holds true for the
economy as well, the Real Output produced is a function of the land, labor, capital and
enterprise. Other things remaining constant in the short run, the production is a function of
the capital stock of the economy and the labor force.

Y = f(K, N)
Y = Real GDP
K = Capital Stock
N = Labor Employed

In the short run, the capital stock and technology is assumed to be constant and hence the
output produced would be a function of the labor employed.

Y = f(N)

The output increases as represented on the Y axis with an increase in the employment of
labor on the X axis but a diminishing rate as shown in the diagram below:

Source: Google Images

38
Demand for Labor

Assuming that there is pure competition the demand for labor would reflect its marginal
productivity and firms would keep on hiring till the value of the marginal product is greater
than the money wage rate

W = P * MPL
W = Money wage rate
P = Price Level
MPL = Marginal Productivity of Labor

Diving both the sides of the equation by the price level, we get

W/P = MPL

Which implies that the real wage in the economy would be a reflection of the marginal
product of labor which is diminishing as more and more labor is employed.

Source: ICFAI Center for Management Research

39
As seen in the above diagram, at a higher real wage rate the firms are only willing to employ
labor to a point where the marginal product is high and thereby employ lesser workers at a
high real wage and vice-versa.

Supply Function of Labor

The supply of labor is directly proportionate to the real wages and hence its an upward
sloping curve.

Ns = f(W/P)

Ns = Supply of Labor
W/P = Real Wage Rate

Source: ICFAI Center for Management Research

Deriving the Aggregate Supply Curve

As per the Say’s Law, the supply create its own demand and the Output Y is determined by
the labor market. In the first portion of the diagram below, the demand and supply curve lead
to an employment of N at a real wage rate of (W/P), when we go down to the second portion
of the diagram, we see that with this labor employed of N in the Production Function which

40
reflects the diminishing returns and we arrive at an equilibrium output of Y and this would
adjust to a rise in the real wage rate giving us a perfectly inelastic aggregate supply curve in
the third portion of the diagram.

Source: ICFAI Center for Management Research

41
Keynesian View of the Aggregate Supply Model

The Classical approach to Aggregate Supply was based on the fact that the labor market is
completely flexible and the money wages would easily move up or down and the
unemployment existing in the economy is voluntary in nature. However, this didn’t happen
during the Great Depression where we had large scale unemployment and an involuntary one
and thereby John Maynard Keynes came with his view of the Aggregate Supply Model where
he said that the money wages are sticky and the labor market is not that flexible to respond to
the unemployment.

Hence as per Keynes the Aggregate Supply Curve is a J shaped with three distinct segments,
the first flat segment shows the inflexibility of labor market and output can be expanded
without an increase in the price level, the second segment or the curvy segment shows the
flexibility in the labor market where output could be expanded at a higher price level and the
last segment is the vertical segment which indicates that the output has reached the full
employment level and cannot be expanded and any attempt to expand output would just
result in higher price levels.

This J shaped Aggregate Supply curve is illustrated in the upcoming chapters.

42
Inflation:
Inflation is defined as a continuous increase in the aggregate price level of the economy. The
aggregate price level is measured as a weighted average of prices in the economy. There are two
primary indices to measure the aggregate price level. The index that tracks the change in retail
prices of essential goods and services consumed by households is the Consumer Price Index or
CPI. The Whole sale price index or WPI is a weighted average of the price of a representative
basket of wholesale goods purchased by the producers and businessmen. So WPI does not
include services, whereas the retail price index does.

While CPI is the most relevant index for the consumer as it shows the increase in their
spending, it is not a fully accurate cost of living indicator since it does not included all goods
and focuses on certain goods and services more than others. The weightage of food in the CPI
is close to 50%, but most households don’t spend nearly that much of their overall
expenditure on food. For many consumers, major part of expenditure is on services such as
education, health care and transportation, where inflation levels are much higher. In India, the
CPI is used as an indicator of inflation.

The rate of inflation is expressed as a percentage. The formula is

Rate of inflation = {Price level (year t) – Price level (year t-1)} *100
Price level (year t-1)

According to the National Statistical Office retail inflation accelerated to 6.93% in July 2020
from 6.23% in the preceding month, with food inflation rising to 9.62% in July 2020 from the
June level of 8.72%.
Inflation can be classified as:
According to Degree:
a. Creeping or crawling Inflation (< 2%)
b. walking inflation (<5%)
c. Running Inflation (<10%)
d. Galloping Inflation (<25%)
e. Hyperinflation (>25%)

43
While creeping inflation is a very low rate of inflation, with a slight pressure on prices,
Galloping inflation and hyper- inflation is a situation where the prices of goods and services rise
uncontrollably over a time period as was seen in Zimbabwe
Disinflation is a situation where the rate of inflation falls – it is a slowdown in the rate of
increase of the general price level of goods and services
Deflation is a situation of falling prices.
According to causes:
Demand Pull Inflation takes place when aggregate demand increases faster than the economy’s
ability to produce those goods and services.
The causes of demand pull inflation can be

a) Increase in Consumption and Investment will cause aggregate demand to increase

b) Exchange rate: A depreciation of exchange rates can increase exports and thus lead to
increase in aggregate demand

c) Higher fiscal spending due to a stimulus

d) Expectations: Sometimes simply the expectation of inflation can itself lead to higher actual
prices as all wage, rent contracts are revised upwards to take care of the higher expected
inflation.

An increase in aggregate demand is shown by the rightward shift of the Aggregate Demand
Curve. In the following diagram, the AD curve has shifted right from AD0 to AD1 leading to an
increase in aggregate prices from P0 to P1. It can be observed that this price increase has been
accompanied by an increase in national output as well. Any Demand Management policy –
Fiscal, Monetary or Trade shifts the AD curve rightwards and causes inflation to take place. In
fact a big dilemma of policy making is that there is a tradeoff between growth and inflation.

Fig 1: Demand Pull Inflation

44
Source : www.economicshelp.org

Cost Push Inflation: takes place when the Aggregate Supply curve shifts upwards primarily due
to an increase in the cost of production.

The main causes of supply side inflation are as follows

a) Supply shock: It can be a result of a sudden rise in the prices of essential commodities. An
increase in price of crude oil declared by OPEC can be an example as oil is a necessary raw
material across sectors.

b) Higher wages: When wages are increased maybe due to active trade unions, companies pass
on the higher cost to higher retail prices.

c) Imported inflation: Increase in prices of imported raw materials can also increase the retail
prices of finished products.

d) Higher taxes: Hike in indirect taxes like GST, sales tax and excise duties can also lead to
cost push inflation as the AS curve will inflation by forcing prices up.

In the following diagram, the AS curve has shifted upwards, leading to an increase in prices. A
difference here is that this increase in prices is not accompanied by an increase in output. The

45
leftward shift of AS curve from AS0 to AS1 leads to an increase in prices from P0 to P1. The
output shrinks from Y0 to Y1.
Fig 2: Cost Push Inflation

Source : www.economicshelp.org
Cost Push inflation is also called supply side inflation.
Wage Price Spiral: Combination of both demand pull and cost push can be a result of
indexation of wages when the workers demand higher wages due to increasing retail prices. In
this case a demand full inflation results in higher prices leading to higher wages and a higher
inflation.

Costs of Inflation:
a) Redistribution of income and wealth- borrowers’ gain and creditors lose. All those who earn
fixed income such as those who rely on pensions and interest lose whenever inflation takes place
Balance of payments effect- exports become expensive. Hence exchange rate depreciates.
b) Uncertainty about the value of money may lead to a flight of capital to other economies as
people would want to protect the real value of their money.
c) Exports become more expensive due to inflationary price rise. Consumers are also tempted to
import goods from abroad. On both counts, the current account deficit worsens.
d) There is a “menu cost “of changing all price tags without any real gin to the economy

46
e) Inflation is an indicator of health of an economy and high levels of inflation reduces the
credibility of the country and may impact foreign and domestic investment leading to a
slowdown in growth.

Inflation Targeting:
When the Central Bank of the economy sets a target level of inflation, it is called inflation
Targeting”. In India, RBI has a target of keeping inflation at 4% with a tolerance limit of 2%.
This meant that inflation should be between 2% and 6% and any deviation from this range is
outside the comfort level of RBI and monetary policies are initiated to get the inflation rate
within that range.
It is desirable that the economy faces a slight pressure on price to keep the producers motivated
and hence a creeping to walking inflation is a healthy sign for the economy.

Stagflation:
Stagflation is a situation of a simultaneous increase in inflation and stagnation of economic
growth. This situation was first recognized during the 1970's, where it was seen that in high
unemployment coexisted with high inflation. One reason cited for this was oil price shocks.
Stagflation cannot be explained by the earlier discussion of demand pull inflation as it was seen
in the diagram that the higher rates of inflation were always accompanied by higher growth and
lower unemployment. This led to the famous model of the Philips curve which using empirical
data described this trade- off between inflation and unemployment

Origin of Phillips Curve

An article titled “The Relationship between Unemployment and the Rate of Change of Money
Wages in the United Kingdom, 1861-1957” by A. W. Phillips was published in 1958. The article
out forth a negative correlation between the rate of unemployment and the rate of inflation. The
data showed that the years when unemployment rate was high, inflation was low and the years
with low unemployment experienced high inflation.

Here, A. W. Phillips put forth that the Phillips curve is an inverse relation between rate of
unemployment and rate of increase in money wages. The higher the unemployment, the lower the

47
rate of wage inflation. In other words, the trade-off is between wage inflation and
unemployment:

gw = -a (u – u*)
where
gw is the growth rate in wages
u is the actual unemployment
u* is the natural rate of unemployment
a is the responsiveness of wages to unemployment
The equation shows that wages are falling when u > u*.

Similar relation was also found by Paul Samuelson and Robert Solow in the U.S. economy,
reporting a negative correlation between inflation and unemployment in the United States also.
This relation was found in other economies as well and came to be known as the Phillips Curve.

The Phillips Curve

The Phillips Curve is the graphical depiction of the short-term relationship between
unemployment and inflation in an economy. The curve is a downward sloping curve representing
the negative, or inverse, relationship between the unemployment rate and the inflation rate in an
economy.

The relation can be explained using Keynesian economics that propounds the use of monetary
and fiscal policy to bring growth by increase in aggregate demand. This stimulus is expected to
increase employment and output accompanied by increasing price level. In order to ensure price
stability, policymakers need to reduce output and employment in the short run.

48
Figure 3:

Source: Lumen Learning

Samuelson and Solow stated that the Phillips Curve could be used by policymakers by selecting
the unemployment – inflation combination as preferred by the economy. To illustrate, point A in
Fig 3, depicts a situation of high unemployment and low inflation. Policymakers would
endeavour to increase output by possibly increasing government spending and/ or cutting taxes
to push demand in the economy (Fig.3). Given the implementation of expansionary fiscal policy,
employment and output are expected to rise.

However, as there is a limit to how much the output can be increased given inelastic aggregate
supply curve, once reached, any further increase in demand leads to inflation. This position is
explained by point B. Also, at point B, the economy experiences low unemployment but high
inflation. Although, policymakers would prefer both unemployment and low inflation to be are
low simultaneously, it appears to be nearly impossible based on historical data studied by
Phillips, Samuelson, and Solow.

49
Figure 4 Phillips Curve

Source: Lumen Learning

Long-run Phillips Curve

American economist and chief proponent of monetarism, Milton Freidman, put forth that the
monetary policy is unable to reduce unemployment by raising inflation, in paper titled “The Role
of Monetary Policy.” in 1968. His belief was primarily based by the classical macroeconomic
theory that money being a nominal variable, cannot have an impact on a real variable such as
unemployment or output. Further, in 1970, another Nobel Prize-winning economist, Edmund
Phelps, stated that there is no long-term trade-off between inflation and unemployment.

Both the economists together gave us the ‘Friedman-Phelps Phillips Curve’ that depicts the long-
term relationship between the inflation rate and the unemployment rate in an economy. It is
vertical (Fig.5), representing the inelastic nature of unemployment to price levels in an economy.
The ‘Friedman-Phelps Phillips Curve’ settles at the natural rate of unemployment.

50
Figure 5

Source: Lumen Learning

(gw - πe) = -a (u – u*)

Where πe is the level of expected inflation.

The above equation shows that as long as there is excess wage inflation over expected inflation,
actual unemployment will be lower than natural rate of unemployment (Point B). This also
means that policy efforts to reduce unemployment will result in temporary adjustments along the
short-run Phillips curve. However, unemployment will revert to the natural rate of
unemployment and will result in higher inflation.

Let’s assume the economy is at point A (Fig. 5) at an initial level of unemployment and inflation
rate. In case the government implements an expansionary policy to reduce unemployment
further, then inflation will increase as aggregate demand shifts to the right. This causes
movement along the short-run Phillips curve, to point B, where unemployment has fallen and
inflation has increased. However, this is an unstable equilibrium. The increased aggregate
demand, on account of expansionary fiscal policy, makes producers employ more workers to
meet demand, thereby reducing unemployment. However, the higher inflation fuels workers’
expectations of future inflation changes. This expectation causes a shift in the short-run Phillips
curve to the right, thereby moving from an unstable equilibrium point B to the stable equilibrium

51
point C. But at point C, the unemployment rate has reverted to its natural rate, but inflation
remains higher than its initial level.

Hence policy makers can try to reduce the Natural Rate of Unemployment, the unemployment
rate towards which the economy moves in the long term.

It is evident from the above equation that the tradeoff between growth and inflation can be
explained by the short run Philips curve and it is only the expectations augmented Philips curve
which can justify the possibility of stagflation in the economy.

---------------------------------------------------------------------------------------------------------------------

52
 Demand for Money and Determination of Interest Rate
Definition of Money
Money is a unit of exchange and has evolved to solve the problem of the barter
system. Money can buy all goods and services, and this is more convenient than
goods buying goods. “Money buys goods and goods buy money, but goods do not
buy goods” (Robert W).
Functions of Money :
Money performs four functions: A medium, a unit, standard, and a store
1. Medium of Exchange:
Money is a fungible mode of exchange for goods and services, it is a marked
improvement from the barter system and an efficient way of transacting in a
complex economy. Its birth has improved exchange for all parties.
2. Unit of Account:
For money to serve as medium of exchange, it must have a common denominator
for measuring goods and service. Everything that we purchase with money is
measured in different units (gm, litres, yarns, inches). There is a need for a
common yardstick to measuring value of different goods and service. Money
provides that singular unit of account and helps to measure all goods and services
in a common denomination - rupees, pounds, dollars. All goods and service thus
have a single measure of value. The prices of all goods and services can be fixed
in terms of money. Money gives a monetary unit of measure to all goods and
services, and hence a relative comparison of different values of different goods
and services is facilitated. Knowing the value or price of a good in terms of
money, enables both the supplier and the purchaser of the good to make decisions
about how much of the good to supply and how much of the good to purchase.
3. Store of Value:
For money to retain its purchasing power or to ensure it can be used in future, it
needs to have a store of value. Money should be stored easily to serve as a
medium of exchange and command a purchasing power at a future date too.
Hence money holds its value in future time. Of course, inflation, and deflation
render a compromise in purchasing power of money, Yet it remains valuable as a
medium of exchange in future times, as it is not perishable and is readily accepted
everywhere.

53
4. Standard of deferred Payment:
In an economy everything is not instantaneously cash settled. Buyers can buy
goods and services in the present and can pay for them in future. In other words,
the payments are deferred, and can be made in future. Money has made this
function easier as loans can also be taken and settled in future. Money can be
used as a standard benchmark for specifying future payments for current
purchases, that is, buying now and paying later.

The Demand for Money : Classical Versus Keynesian Theories

The demand for money is the demand for real balances. A stable demand for
money is a cornerstone of monetary policy, and hence it needs to be subjected to
extensive examination and scrutiny. With passage of time, theories of Money
demand have evolved. The theories explore demand for money and their
determinants. This section touches on two fundamental approaches to money
supply - The Classical, and the Keynesian approach.
Classical Approach to demand for Money :
The classical demand for money hinges on assumption of neutrality of money.
Money serves as a medium of exchange and changes in money supply affect
absolute prices and not relative prices. There are two version to the Classical
School:
a) Cash Transaction Approach / Fisher Quantity theory of Money, and
b) Cash Balance Approach / Cambridge School
Cash Transaction Approach:
Popularly known as the Quantity theory of Money, this was postulated by Irwing
Fisher in his famous book: “Purchasing Power of Money”. It analyses the relation
between quantity of money and Price level.

The famous Fishers equation is given by:

Where M = Money Supply, V = Velocity of Circulation, P = Price Level, and T =

Transactions in an economy (quantity of goods and services offered in an
economy). Holding T and V constant, we can see that increases in the money
supply will cause price levels to increase. In other words, this equation means that
in an economy, the total value of all goods sold during any period (PT) is equal to

54
the total quantity of money spent during that period (MV). In other words, the
price levels are directly proportional to the quantity of money in circulation in the
economy. So, if the supply of money is doubled, then the price of money would
double too. Fisher stresses that money is fundamentally a medium of exchange
and people demand money to fulfil their need for transactions. However, money
also fulfils future needs and needs to be stored.
Another group of economists belonging to the Cambridge School - economists
Marshal, Pigou, Robertson etc. opined that “The amount of money which is kept
by the individual, commercial institutions and government to meet their day to
day needs is called demand of money”. The value of money is determined by
cash balances that people demand, and they evolved a separate set of equations
called the cash balance equations.
Cambridge Version

where
M = Money demand, P = Price Level, Y = Real Income, K = the portion of real
income which people want to keep with them in the form of cash. This version
stressed that people like to hold money in form of cash. It is K that determines
demand for money and makes demand for money a positive function of real
national income. If national income increases people demand for money will also
increase, by the coefficient K. If K= 0.1, and National income is Rs. 100 crores,
the economy demand for cash balances is Rs. 10 crores. Both Fisher and
Cambridge opined that money demand is a positive function of National income
or GDP. However, Fisher concentrated on the medium of exchange function,
whereas Cambridge stressed on the Store value function. Both the versions had a
fatal flaw, in that they could not explain role of interest rate as a determinant to
demand for money.

Keynes Demand for Money :

Keynes brought a paradigm change in the theory of demand for money by
specifying the role of interest, which was ignored by his predecessors. He divided

the demand for money into three motives - Transactionary Motive ( b), a

Precautionary Motive ( c), and a Speculative Motive .

55
Transactionary Motive: People demand cash to meet their transactions, and to
meet their payments. This part of demand is a positive function of Income and is
inextricably linked with medium of exchange in a money-exchange economy.

Precautionary Motive: Money is demanded by people to meet their contingency

requirements. Both demand for transaction and precautionary motive are
determined by income and are vaguely analogous to what the classicals opined.

The Speculative Demand for Money: The cornerstone of Keynesian analyses is

speculative demand for money or demand for idle cash balances, and this brings
in a paradigm change. Keynes opined that money merely is not just a medium of
exchange but is an asset which competes with other assets like bonds in the
Portfolio of every investor. The wealth of an individual has idle cash and Bonds.
Individuals after meeting their precautionary and transaction demands, use money
as an asset. He made a simplistic assumption that there are Bonds and idle Cash
only in every investor’s portfolio. Bonds earn an interest rate, whereas idle Cash
does not. But Bond prices fluctuate, and income can be more than wiped out if
bond prices fall in future. Keynes believed that interest rate expectations of all
investors or portfolio holders vary, but at very high rate of interest all asset
holders would want to convert their idle cash into bonds. Hence, the demand for
idle cash balances, known as speculative demand, will be very low. Similarly, if
rate of interest is very low, people would not want to invest in bonds and keep
more idle cash. At low rates of interest, the bond prices are high (Bond prices and
rate of interest are inversely related)i. So, speculative demand for money is very
high. Hence at high rate of interest people have low demand for Idle cash
balances and at low interest rates people demand for idle cash balances increase.

Interest

Speculative demand for Money

Fig: 1

56
 The Speculative demand for money has an inverse relation to interest rates and is
downward sloping. Thus, Keynes, by adding demand for idle cash balances made
money demand a negative function of interest rates. The transaction and
precautionary motive are a positive function of national Income whereas idle cash
balances are a negative function of interest rates.

Liquidity Trap:

What happens to investors when the rate of interest because Zero bound?

During a depression, when rate of interest becomes zero bound or are very low,
people hoard money with an expectation that interest will rise, and the demand
for idle cash balances become very high. Even if the central bank pumps more
money supply, excess money supply is already hoarded in the form of idle cash
balances. The demand for speculative motive becomes infinitely elastic and
monetary policy becomes ineffective. The economy is said to be under what
Keynes calls as a liquidity trap, as seen in the diagram below:

Fig 2
Interest
Rates
Speculative demand for
money is infinitely
elastic

Speculative Demand for Money

The next section explores money supply and the interplay of demand and supply forces
to explain determination of interest rate.

Interest Rate Determination

We now try to explore the link between money demand, money supply and interest rate and
also determine the equilibrium rate of interest. Rate of interest as we know is the opportunity

57
cost of holding our wealth in the form of liquid money instead of non-monetary asset like
interest bearing bonds.
Supply of Money
The supply of money is the amount of money available in an economy. In modern economies
the money supply is determined by the central bank of the country.
We assume here that the only form of money is currency held by public, demand deposit and
other checkable deposit, M1.
The supply curve of money depicts the relationship between the quantity of money supplied
in an economy and the interest rate, all other determinants of supply remaining unchanged.
And because of our assumption that the money supply is determined by the central bank
depending upon its monetary policy, we consider the money supply to be invariant to the rate
of interest. Hence the supply curve of money is represented as a vertical line at the given
period of time.

Interest Rate Fig 3

M Quantity of Money per period

We assume that the quantity of money supplied in the economy is determined as a fixed multiple of the
quantity of bank reserves, which is determined by the Central Bank. The supply curve of money is a
vertical line at that quantity.

58
Equilibrium in the Money Market
Money market is the term associated with interaction among institutions through which
money is demand and supplied to individuals and firms. We have examined earlier the
relationship between demand for money and interest rate and we also have mentioned that
money supply has been assumed to be given at a period of time. Therefore the equilibrium in
the money market brings out the unique combination of interest rate and quantity of money at

Ms

7%

5%

3%

Md

The market for money is in equilibrium if the quantity of money demanded is equal to the
quantity of money supplied. Here, equilibrium occurs at interest rate 5%. At 7% there is excess
supply of money while at 3% there is excess demand for money.

which money demand is equal to money supply.

Effects of Changes in the Money Market
Changes in the demand and supply of money results in changes in the equilibrium interest
rate.
Changes in Money Demand
As seen earlier, there can be two factors that cause demand for money to change:
 An Increase in Income/Wealth
o With more income, people would like to consume more. To increase
consumption, demand for holding liquid cash increases leading to a rightward
shift to the money demand curve, ceteris paribus.
o Money supply being constant this leads to an increase in the price of holding
liquid money meaning equilibrium interest rate rises
 An Increase in Prices
o With higher prices, the same quantity of money held buys fewer goods and
services. To maintain consumption, people need to hold more money, which
leads to an upward shift of the money demand curve.
o Other things remaining constant this leads to an increase in the equilibrium
interest rate
 We can also consider several other factors that can increase money demand:

59
 o An increase in the risk of non-monetary assets (i.e. bonds)

Ms
Fig 5

7%

5%

Md0 Md1

The initial equilibrium interest rate is 5% while the demand for money is Md0. As money demand
increases the curve shifts up to Md1. There arises excess demand in the money market, as the
supply is constant. The market mechanism pushes the interest rate up to 7% at which the money
demand and supply equates again.

o A decrease in the liquidity of non-monetary assets

As demand for holding liquid cash increases the demand for other non-monetary asset like
bond. This results in increase in the equilibrium interest rate leading to a lower quantity of
investment. Also, higher interest rates will lead to a higher exchange rate reducing net
exports. Thus, the aggregate demand reduces. All other things unchanged, real GDP and the
price level will fall.
The impact of a reduction in money demand is the opposite of the above explanation.

60
Changes in Money Supply
If the central bank wants to increase the money supply in the economy by conducting open
market operation (buying of bonds), the demand for bond increases raising the bond prices.
As a result the money supply increases in the market. This causes a shift of the vertical
money supply curve to the right. People then do not wish to hold liquid money at the original
equilibrium interest rate, they would prefer other non-monetary assets. To re-establish the
equilibrium in the money market, the interest rate falls and reaches at a level where money
demand becomes
Ms1 Ms0 Fig 6
equal to the new
Interes
money t Rate supply.
5%
3%

Md Quantity of Money
The initial equilibrium interest rate is 5% while the supply for money is Ms0.
As money supply increases the curve shifts right to Ms1. There arises excess
supply in the money market at 5% interest rate, as the demand is constant.
The market mechanism pull the interest rate down to 3% at which the money
demand and supply equates again.
Lower interest rates will stimulate investment and net exports, via changes in the foreign
exchange market, and cause the aggregate demand to rise. For a given aggregate supply, the
economy moves to a higher real GDP and a higher price level.
The impact of a reduction in money supply is the opposite of the above explanation.
Nominal versus Real Interest Rate
Interest rates reflect how the rupee value of an interest-bearing asset increases over time.
However, we also need to determine the value of the asset in terms of its real or purchasing
power.
Example: Let us consider that a savings of Rs.300 having an yearly interest rate of 4%. The
return on this savings at the end of the year is, therefore, Rs. 312. If we assume that there is
no inflation during the period, then the depositor can by 4% more goods and services in real
terms than the initial Rs. 300 at the beginning of the year. However, if the inflation rate is
4%, what cost Rs. 300 one year earlier will cost Rs. 312 at the end of the year. This means
that, in terms of purchasing power, the worth of the savings account at the end of the year is
same as that of the beginning.
In order to distinguish the changes in the real value of money from the nominal value, we use
the concept of real interest rate.

61
Real Interest Rate  The rate at which the real value or the purchasing power of money
increase over time. This is the inflation adjusted interest rate.
Nominal Interest Rate  The rate at which the nominal value of money increase over time.
Real interest rate, nominal interest rate and rate of inflation are related as follows:
r = i – π, where r = real interest, i = nominal interest and π = rate of inflation.

62
 Macroeconomics and Business Environment
Notes

Hicks- Hansen Model: IS-LM Analysis

The Hicks-Hansen Model, also called the IS-LM model was developed by two economists
John Hicks and Alvin Hansen. The model is a tool in macroeconomics which shows the
simultaneous equilibrium in the goods market (through the equality of savings and
investment) and the money market (through the equality of demand for and supply of
money). The intersection of the IS and LM curves gives us the equilibrium interest rate and
equilibrium income prevailing in the economy. We explain the IS-LM analysis in a two-step
model by first deriving the IS curve and explaining its relationship with interest rate and then
the LM curve.

The IS Curve
We have seen the theory of output determination and the theory interest rate determination in
the goods market and the money market. To recapitulate in the goods market equilibrium
output is determined at the level where investment is equal to saving (I=S). Equilibrium
interest rate is determined in the money market where demand for money is equal to supply
of money. At every level of interest rate there is a certain level of output or real income that is
determined. This is captured by what is called the IS curve. It is downward sloping to show
that as interest rate in the economy comes down, real output increases because investment
demand which is inversely related to interest rate increases with a fall in interest rate. And
since higher investment means more spending it leads to higher levels of GDP. This is shown
in the following graph:

63
Source: www.economicoutlook.net
As you can see in the diagram when interest rate is i0 the output generated in the economy is
Y0 and when interest rate comes down to i1 income increases to Y1 because of increase in
aggregate expenditure shown by an upward shift in the AE curve.

The LM Curve
While interest rates are determined by the forces of demand and supply of money with
equilibrium interest rate being determined at the point where demand for money is equal to
supply of money. In the short run the money supply is fixed. Therefore, interest rate changes
are only because of changes in demand for money. The money market equilibrium occurs at
several combinations of interest rates and output levels which are captured by the LM where
L stands for demand for money (Liquidity) and M stands for supply of money. At higher
levels of income, more money is required for financing the transactions thus making the LM
curve upward sloping.

64
https://sites.google.com/site/mukondafred/teaching/intermediate-macroeconomics/the-is-lm-
model-part-b
In the diagram we can see that interest rates are determined at the intersection of demand and
supply of money. When output is Y1, the interest rate is r1. If output increases to Y2, more
money is required for transaction and other purposes, increasing the demand for money. But
in the short run as the supply of money is fixed increase in the demand for money only
increases the interest rate to r2 and the new equilibrium in the money market goes from A to
C at higher rates of interest rate and output levels.

The money and goods market equilibrium

For simultaneous determination of goods and money market we bring together the IS and LM
curves and we find combinations of interest rates and output levels at which both the goods
and money market are in equilibrium.

65
Source: www.businesstopia.com

As we can see in the diagram at the intersection of the IS and LM curves the equilibrium
interest rate and income levels get simultaneously determined at Or and OY. Any shifts in IS
or LM curve will cause the equilibrium to change and the new income and interest rates will
be either at higher or lower levels.

The IS-LM Curves and the Aggregate Demand Curve

From the IS-LM curves we can derive the aggregate demand curve given the various price
levels. There is an inverse relationship between price level and aggregate demand.

66
Source: www.economicsdiscussion.com

From the diagram we can see that at a given level of output and interest rate pair of Y1 and i1
the prevailing price level is P1. If price level increases to P2 it causes the output to reduce to
Y2. This happens because an increase in the price level reduces the purchasing power of
money. This increases the demand for money as more money is required to finance the same
level of transactions. This causes the LM curve to shift to the left causing the interest rate to
rise to i2. This is the relationship between IS-LM curves and Aggregate Demand curve.

67
 Unemployment
It is defined as a state of affair when in a country there are large number of able -bodied
persons of working age who are willing to work but cannot find work at the current wage
levels.
Labour force – refers to the population 15 years old and over who contribute to the
production of goods and services in the country. It refers to the total number of workers, both
employed and unemployed. It does not include full time students, homemaker and retiree.
Labour force participation rate – is calculated as the labour force divided by the total
working age population. The working age population refers to people aged 15 to 64 years.
Unemployment rate – is the percentage of the labour force that is unemployed.
Unemployment rate = x 100
Full employment – refers to a situation where all those who are willing and able to work at
the prevailing wage rates are infact employed for the work in which they are trained.
However, even at full employment there will always be some amount of unemployment in
the economy.
Types of Unemployment
There are three main types of unemployment:
1. Frictional unemployment
2. Structural unemployment
3. Cyclical unemployment
Frictional Unemployment
There is always some minimum amount of unemployment that prevails in the economy
among workers who have voluntarily quit their previous jobs and are searching for new better
jobs or looking for employment for the first time. They are said to be between jobs. They are
not able to get jobs immediately because of frictions such as lack of market information about
availability of jobs and lack of perfect mobility on the part of workers.
Structural Unemployment
This is another type of unemployment which always exists to some extent in a growing
economy. It refers to the mismatch between the unemployed persons and the demand for
specific type of workers for employment that occurs because while demand for one kind of
labour is expanding, the demand for other kind of labour is declining either due to the
changes in the structure (ie. composition) of demand for industrial products or due to the
change in technology that takes place in an economy. The unemployed workers lack the skills
required by the expanding industries.
Cyclical Unemployment
This type of unemployment occurs due to deficiency of effective demand. It greatly increases
during periods of recession or depression. It happens due to the fact that the total effective
demand of the community is not sufficient to absorb the entire production of goods that can
be produced with the available stock of capital.

Natural rate of unemployment

It is the unemployment rate that would exist in a healthy and growing economy. It indicates
the normal rate of unemployment around which the unemployment rate fluctuates. Frictional
and structural unemployment together constitute natural rate of unemployment. It doesn’t
include cyclical unemployment. It is the rate of unemployment at exists at full employment.
When full employment exists real GDP is said to be equal to potential GDP. When the
economy is below full employment, the actual unemployment is greater than the natural
unemployment rate and real GDP is less than the potential. When the economy is above full
 employment, then unemployment rate is less than the natural rate of unemployment and real
GDP is greater than the potential GDP.
If the actual rate of unemployment is closer to the natural rate of unemployment, it reduces
the scope of fiscal and monetary policy to influence the level of unemployment.
Labour market Equilibrium
Voluntary and Involuntary Unemployment
An involuntary unemployment means a situation in which all able persons who are willing to
work at the prevailing wage rate do not get work. Such people are physically and mentally fit
to work and are also willing to work at the going rate but are out of job. This type of
unemployment is due to deficiency of aggregate demand sufficient to ensure full
employment. If involuntary unemployment exists, the economy cannot be said to be at the
level of full employment equilibrium. It will indicate under-employment equilibrium in the
economy.

Voluntary unemployment refers to a situation when persons who are able to work but are not
willing to work though suitable work is available for them

W/P E

Nf Employment of
or labour
(https://www.economicsdiscussion.net/theory-of-income/classical-theory-of-income-and-
employment-economics/25971)
Consider the labour market equilibrium in the given figure. DL is the downward sloping
demand graph for labour which shows that at lower wage-rate more labour is demanded and
employed and vice versa.SL is the upward sloping supply curve which shows that at higher
wages more labour is supplied and vice-versa. These demand and supply curves of labour
intersect at point Eat which real wage rate W/P and labour employment of Nf are determined.
At the wage rate W/P, all those who are willing to work and supply their labour services are
employed. Thus, at this labour market equilibrium, there is full employment of labour and
involuntary unemployment does not prevail.
Now suppose aggregate demand for goods and services declines, as in times of recession.
Demand for labour is derived demand. Decline in aggregate demand for output causes
demand curve of labour to shift to the left to D’D’. now at the given real wage rate W/P,
quantity of labour demanded is ON1 while the supply remains ON0 (which is full employment
as indicated by Nf).. RE number of workers represent cyclical unemployment ie. workers
who are willing to work but their services are not demanded by the economy.
 Effect of higher minimum wages

(W/P)
’
(W/P
)

(https://www.economicsdiscussion.net/unemployment/keynes-money-wage-rigidity-model-
of-involuntary-unemployment/10397)
If the government increases the minimum wage rate from (W/P) to (W/P)’, then RT indicates
the involuntary unemployment created in the economy due to this measure.

Okun’s Law
The law states that for every 2 percent that GDP falls relative to potential GDP, the
unemployment rate rises about 1 percentage point.
This simply implies that a 1 percent increase in cyclical unemployment rate is associated with
a 2 percentage point of negative growth in real GDP. The relationship varies with the country
and he time period under consideration. Mathematically, it can be expressed as:

= c (u- )
is potential GDP
Y is actual output
u is the actual unemployment rate
is the natural rate of unemployment
c is the factor relating changes in unemployment to changes in output
The Okun’s Law can be used to relate changes in the unemployment rate to the growth in
output. There is an inverse relationship between output and unemployment. As a consequence
of the law, the actual GDP must grow as rapidly as potential GDP to prevent the
unemployment rate from rising. If the unemployment rate has to be reduced, then actual GDP
must grow faster than potential GDP. Thus, it provides a vital link between the output market
and the labour market.
 MACRO ECONOMICS AND BUSINESS
ENVIRONMENT
Semester - II
NOTES FOR SESSION NUMBER 21 TO 33

Session 21, 22, 23: Monetary

Policy
1.Objectives
2 Introduction
2.1 Meaning of Monetary policy
2.1.1 The goals of Monetary Policy
2.1.2 Monetary policy Framework
2.1.3 Monetary Policy Process
2.1.4 Instruments of Monetary Policy

Outcome
After studying this chapter, you will be able to:
Understand the Monetary policy Framework
Appreciate the role of Monetary Policy in achieving macro-economic
goals Discuss the application of monetary policy
2.Introduction
Central banks play a crucial role in ensuring economic and financial stability. They conduct monetary policy
to achieve low and stable inflation. In the wake of the global financial crisis, central banks have expanded
their toolkits to deal with risks to financial stability and to manage volatile exchange rates. Central banks
need clear policy frameworks to achieve their objectives. Operational processes tailored to each country’s
circumstances enhance the effectiveness of the central banks’ policies. In the given section we will discuss
about the Monetary policy and its role in achieving macro- economic goals.

2.1 Meaning of Monetary policy

Monetary policy refers to the policy of the central bank with regard to the use of monetary instruments
under its control to regulate magnitudes such as interest rates, money supply and availability of credit with
a view to achieving the ultimate objective of economic policy. The Reserve Bank of India (RBI) is vested with
the responsibility of conducting monetary policy. This responsibility is explicitly mandated under the
Reserve Bank of India Act, 1934.

2.2 Definition of Monetary policy: According to A. J. Shapiro, “Monetary Policy is the exercise of the
central bank’s control over the money supply as an instrument for achieving the objectives of economic
policy.” In the words of D.C. Rowan, “The monetary policy is defined as discretionary action undertaken
by the authorities designed to influence (a) the supply of money, (b) cost of money or rate of interest and
(c) the availability of money.”

Points to remember
1.The primary goal of the monetary policy is to maintain the price stability.
 2. The central bank frames monetary policy to control the credit in the market.
3. Monetary policy helps in achieving the economic goal.
2.2 Goals of Monetary Policy

1. Price Stability: The primary objective of monetary policy is to maintain price stability while keeping
in mind the objective of growth. In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended
to provide a statutory basis for the implementation of the flexible inflation targeting framework. The
amended RBI Act also provides for the inflation target to be set by the Government of India, in
consultation with the Reserve Bank, once in every five years. Accordingly, the Central Government has
notified in the Official Gazette 4 per cent Consumer Price Index (CPI) inflation as the target for the
period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower
tolerance limit of 2 per cent.

2. To control Unemployment: Monetary policies help in controlling unemployment in the economy by

fuelling growth.

3. Exchange rate stability: Monetary policy plays a role in maintaining exchange rate stability.
2.3 Types of Monetary Policy

1. Expansionary monetary policy: Expansionary monetary policy is where the central bank uses economic
stimulation instruments, to raise money supply, decrease interest rates, and increase demand. It promotes
economic development, lowers currency value, and weakens the exchange rate.

2. Contractionary monetary policy: Contractionary monetary policy reduces the rate of monetary
expansion to tackle inflation. Inflation increase is considered the primary predictor of an overheated
economy, which may result from sustained periods of economic growth. The policy decreases economic
money supply to discourage unregulated inflation and unnecessary capital spending.

2.4 Monetary Policy Process

Section 45ZB of the amended RBI Act, 1934 also provides for an empowered six-member
monetary policy committee (MPC) to be constituted by the Central Government by
notification in the Official Gazette. Accordingly, the Central Government in September
2016 constituted the MPC as under:
1. Governor of the Reserve Bank of India – Chairperson, ex officio;
2. Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy – Member, ex officio;
3. One officer of the Reserve Bank of India to be nominated by the Central Board – Member, ex officio;
4. Three experts in the field.

The MPC determines the policy interest rate required to achieve the inflation target. The first
meeting of the MPC was held on October 3 and 4, 2016 in the run up to the Fourth Bi-
monthly Monetary Policy Statement, 2016-17.
The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the
monetary policy. Views of key stakeholders in the economy, and analytical work of the
Reserve Bank contribute to the process for arriving at the decision on the policy repo
rate.
The Financial Markets Operations Department (FMOD) operationalises the monetary policy,
mainly through day-to-day liquidity management operations. The Financial Markets
Committee (FMC) meets daily to review the liquidity conditions so as to ensure that
the operating target of the weighted average call money rate (WACR).
 Before the constitution of the MPC, a Technical Advisory Committee (TAC) on monetary policy
with experts from monetary economics, central banking, financial markets and public
finance advised the Reserve Bank on the stance of monetary policy. However, its role
was only advisory in nature. With the formation of MPC, the TAC on Monetary Policy
ceased to exist.

Instruments of Monetary Policy

Several direct and indirect tools are used to implement monetary policy.

Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to
banks against the collateral of government and other approved securities under the
liquidity adjustment facility (LAF).

Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an
overnight basis, from banks against the collateral of eligible government securities under
the LAF.

Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo
auctions. Progressively, the Reserve Bank has increased the proportion of liquidity
injected under fine-tuning variable rate repo auctions of range of tenors. The aim of
term repo is to help develop the inter-bank term money market, which in turn can set
market-based benchmarks for pricing of loans and deposits, and hence improve
transmission of monetary policy. The Reserve Bank also conducts variable interest rate
reverse repo auctions, as necessitated under the market conditions.

Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can
borrow additional amount of overnight money from the Reserve Bank by dipping into
their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest.
This provides a safety valve against unanticipated liquidity shocks to the banking
system.

Corridor: The MSF rate and reverse repo rate determine the corridor for the daily movement in the
weighted average call money rate.

Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of
exchange or other commercial papers. The Bank Rate is published under Section 49 of
the Reserve Bank of India Act, 1934. This rate has been aligned to the MSF rate and,
therefore, changes automatically as and when the MSF rate changes alongside policy
repo rate changes.
Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with
the Reserve Bank as a share of such per cent of its Net demand and time liabilities
(NDTL) that the Reserve Bank may notify from time to time in the Gazette of India.

Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to maintain in safe
and liquid assets, such as, unencumbered government securities, cash and gold.
Changes in SLR often influence the availability of resources in the banking system for
lending to the private sector.

Open Market Operations (OMOs): These include both, outright purchase and sale of government
securities, for injection and absorption of durable liquidity, respectively.

Market Stabilisation Scheme (MSS): This instrument for monetary management was introduced
in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is
absorbed through sale of
 short-dated government securities and treasury bills. The cash so mobilised is held in a separate
government account with the Reserve Bank.

Activity:
Discuss the role of monetary policy committee (MPC) in recent times
References: See https://www.rbi.org.in/scripts/FS_Overview.aspx?fn=2752

Session 24, 24,26 (Fiscal Policy and Instruments)

What is Fiscal Policy?
Fiscal policy is the use of government revenue and expenditure to influence the level of
economic activity. Changes in the level and composition of taxation and government
spending can impact the following variables in the economy:

a. Aggregate demand and the level of economic activity;

b. The pattern of resource allocation; and
c. The distribution of income.

The three main stances of fiscal policy are:

Neutral fiscal policy, usually undertaken when an economy is in equilibrium. Government
spending is fully funded by tax revenue and overall the budget outcome has a neutral
effect on the level of economic activity.
Expansionary fiscal policy, which involves government spending exceeding tax revenue, and is
usually undertaken during recessions.
Contractionary fiscal policy, which occurs when government spending is lower than tax
revenue, and is usually undertaken to pay down government debt.

Objectives of fiscal Policy

1. Optimum allocation of economic resources: The aim is that fiscal policy should be so framed as to
increase the efficiency of productive resources. To ensure this, the government should spend on those
public works which give the maximum employment.

2. Equitable distribution of wealth and income: It means that fiscal policy should be so designed as to
bring about reasonable equality of incomes among different groups by transferring wealth from the rich
to the poor.

3. Maintain price stability: Deflation leads to a sharp decline in business activity. On the other extreme,
inflation may hit the fixed income classes hard while benefiting speculators and traders. Fiscal policy
has to be such as will maintain a reasonably stable price level thereby benefiting all sections of society.
4. Achievement and maintenance of full employment: Fiscal policy aimed at full employment envisages
 the direction of tax structure, not with a view to raising revenue but with a view to noticing the
effects with specific kinds of taxes have on consumption, saving and investment.

The Government
Budget Sources of
Revenue

Fiscal policy puts the government’s budget into action to stimulate or contract AD as needed.
The budget is simply the combination of revenues earned from taxes and expenditures
made by all goods and services by nation’s government in a year.

Tax revenues: A government’s primary source of revenues is through the collection of taxes.

Direct taxes: Taxes on incomes earned by households and firms. These are usually progressive
in nature, meaning that the percentage paid increases as income increases, or
proportional, meaning that all individuals (or firms) pay the same percentage no
matter what their income.

Indirect taxes: Taxes on consumption are indirect, meaning they are actually paid by the sellers
goods, but they are born by both producers and consumers.

Other sources of revenue: To a lesser extent, a government may earn

revenue from: The sale of goods and services,
The sale of government property,
The privatization of state-owned enterprises to private sector investors.

Types of Expenditures
While a government’s revenues come from the taxes it collects. its expenditure depend on the
goods and
services the government provides the nation. Government expenditures include:

Current Expenditures: This is the day to day cost of running the government. The wages and
salaries of public employees, including in local, state and national government, such as
police, teachers, legislatures, military servicemen, judges, etc…

Capital Expenditures: These are investments made by the government in capital equipment and
infrastructure, such as money spent on roads, bridges, schools, hospitals, military
equipment, courthouses, etc...

Transfer payments: This type of government spending does not contribute to GDP (unlike
those above), because income is only transferred from one group of people to another in
the nation. Includes welfare and unemployment benefits, subsidies to producers and
 consumers, etc… Money transferred by the government from one group to another,
without going towards the provision of an actual good or service.

Surpluses and Deficits

In a particular year, a government’s budget can either be balanced, in surplus or in deficit. The net
effect on aggregate demand depends on the government’s budget balance.

A balanced budget: A government’s budget is in balance if its expenditures in a year equals its
tax revenues for that year. A balanced budget will have no net effect on aggregate
demand since the leakages (taxes collected) equal the injection (expenditures made).
A budget surplus: If, in a year, the government collects MORE in taxes than it spends, the budget is in
surplus. A surplus may sound like a good thing, but in fact the net effect of a budget surplus on AD is
negative, since
leakages exceed injections. A budget surplus will reduce the national debt.

A budget deficit: If a government’s expenditure in a year a greater than the tax revenue it collects,
the
government’s budget is in deficit. A deficit has a positive net effect on AD, since injections exceed
leakages from the government sector. A budget deficit will add to the national debt.

Following are three types (measures) of deficit:

1. Revenue deficit = Total revenue expenditure – Total revenue receipts.
2. Fiscal deficit = Total expenditure – Total receipts excluding borrowings.
3. Primary deficit = Fiscal deficit-Interest payments.

The national debt: A nation’s debt is the sum of all its past deficit minus its past surpluses. If
this number is negative, then it means the government has borrowed money over the
years to finance its deficits that it has not paid back through accumulated surpluses

Instruments of fiscal Policy

1. Public Revenue- Public revenues are the funds of the government to finance its expenditure. The main
sources of revenue are taxes, fees, fines penalties etc. For example, the income tax paid by the residents
of the country, the house tax, the entertainment tax on our leisure activities are all examples of public
revenue.

2. Public Expenditure- It is expense that the government incurs on the maintenance of the country or for
the welfare of the society. For example, expenditure on parks, water works, education and health,
defense, law and order, construction work etc are all examples of public expenditure.

3. Public Debt- Debt means borrowings, therefore, public debt is made by the government when it is
unable to meet its expenditure with current revenue. The government can borrow from the public by
issuing bonds or take a loan from any international finance institute. This usually happens when public
expenditure exceeds public revenue. Debt can be required to pay interest payments on previous loans or
to finance new construction projects or to make public welfare schemes etc.

The Laffer Curve

The Laffer Curve states that if tax rates are increased above a certain level, then tax revenues can
actually fall because higher tax rates discourage people from working.
Equally, the Laffer Curve states that cutting taxes could, in theory, lead to higher tax
revenues. It starts from the premise that if tax rates are 0% – then the
government gets zero revenue.
Equally, if tax rates are 100% – then the government would also get zero revenue – because
there is no point in working.
If tax rates are very high, and then they are cut, it can create an incentive for business to expand
and people to work longer. This boost to economic growth will lead to higher tax
revenues – higher income tax, corporation tax and VAT.
The importance of the theory is that it provides an economic justification for the politically
popular policy of cutting tax rates.
However, economists disagree on the level at which higher tax rates actually cause disincentives
to work.

Source: https://images.app.goo.gl/BwLAiARP9WJm7X1X6

Use of Fiscal Policy to Stabilize the Economy

If an economy has experienced a fall in aggregate demand, it might be in a demand-deficient
recession. To combat such a slump in economic activity, a government can use
expansionary fiscal policies.
Assume an economy is experiencing a recessionary gap as seen here
(below fig.): Private spending in the economy has fallen (C, I or
Xn)
To make up the gap, the government can attempt to use expansionary fiscal policies. These
include: A reduction in taxes, and / or
An increase in government spending
The size of the tax cut or increase in government spending needed depends on two
factors: The size of the recessionary gap
The size of spending multiplier

PL SRA
LR
A

P
P AD

AD
Y Y real GDP
 Recessionary Gap

Once an expansionary fiscal policy has been undertaken, it impact on the economy can be
understood as follows:
After an increase in government expenditures: Government may spend more on current
expenditures or capital expenditures.
 The effect is that households see more employment opportunities as the government demands
more goods and services.
There is an immediate increase in AD by the amount of increased government spending, but then
household consumption and investment by firms increase as well, since there is greater
income and more demand in the economy
The ultimate increase in AD is thereby multiplied by a factor determined by the proportion of the
initial change in incomes that led to further consumption (the MPC)
After a tax cut: Governments may reduce the level of taxes, or offer tax refunds, to households and
businesses.
The private sector sees its disposable income increase, leading to more consumption and
investment, but… Some of the tax cut will be ‘leaked’ as increases savings and
investment.
The increase in AD will be multiplied by a factor determined by the MPC. But the tax
multiplier will always be less than the spending multiplier due to the leakage that results
from a tax cut.

Automatic Stabilizers

Not all changes to fiscal policy require explicit action by the government. In most economies,
changes to the level of taxation and the level of government spending happen
automatically. Study the graph below.

When output falls:

Tax revenues fall automatically decreases:
Incomes and revenues decrease when AD decreases
At lower incomes levels, households pay lower tax
rates Government spending increases
automatically:
 More households receive government welfare
payments. More workers receive government
unemployment benefits

When output increases:

Tax revenues increase because households incomes and firms revenues increase. Some households move
up to higher tax brackets and pay higher rates.
Government
Fiscal spending
policy and decreases
the Crowding Outbecause
Effect: fewer households depend on government support.
The use of fiscal policy in times of recession is highly controversial. Opponents argue that an increase in
the size of the government during recessions will crowd-out private spending in the economy, reducing
an
 economy’s ability to self-correct from the recession, and potentially reducing the economy’s long-
run economic growth rate.

Expansionary fiscal policy’s effect on the interest rate: Fiscal stimulus requires that a
government increases its deficit. This means the government must borrow money in order
to stimulate AD. Government borrowing is done using government bonds.

Government bonds: These are certificates of debt that a government sells in order to borrow money
to finance an expansionary fiscal policy.

The cost of borrowing: When a government has a history of balanced budgets, investors will be
willing to lend it money at very low interest rates, therefore the government does not
need to offer a high rate of interest on its bonds. Fiscally responsible nations can
borrow money cheaply. But if a government has a history of large deficits, investors
will demand a higher rate of interest in order to lend it money.

Crowding-out: The increase in interest rates that often accompany a deficit-financed fiscal
stimulus may cause private investment and consumption in the economy to decrease.
Therefore, any increase in AD from new government spending may be off-set by a
decrease in private spending, which is crowded-out by higher borrowing costs.

Illustrating the Crowding Out Effect

Interest rates paid by private borrowers in a nation are a primary determinant of the levels of
savings, investment, and consumption. The market in which private interest rates is
illustrated is called the loanable funds market.

The Loanable Funds Market: A nation's loanable funds market represents the money in
commercial banks that is available to be loaned out to firms and households to finance
private investment and consumption.

The price of loanable funds is the real interest rate

The market shows relationships between real returns on savings and real price of borrowing and the
private sector's willingness to save and invest.

The supply curve represents household

savings At higher interest rates,
households save more At lower rates,
households save less
The demand curve represents
investment At higher interest
rates, firms invest less At lower
interest rates, firms invest more
 When a government borrows in order to finance a budget
deficit, it must increase the interest rates on its bonds in order to attract more lenders.
Higher rates on government debt will lead households to take their savings out of private banks and lend
it to government instead
This causes the supply of loanable funds to decrease, leading to higher borrowing costs in the private
sector.

Before the expansionary fiscal policy, the level investment was Qpr.
Higher interest rates on government bonds cause the supply of loanable funds to decrease to S1.
Less money in banks leads to higher interest rates. The quantity funds demanded for private investment
falls to Qp.
Overall spending increases to Qg, but there is a decrease in private investment of Qp-Qpr
Private sector spending is ‘crowded-out’ by the government’s deficit spending. This means AD will not
increase by as much as the spending multiplier would predict.

Session 27, 28, 29: Open Economic Framework

International trade vs domestic trade

International trade is any business transaction that occurs between two or more countries. All businesses
that are transacted across the boundaries of your country fall under international trade. For example, if the
United States imports cocoa from Ghana, then we refer to that as an international trade. International
 trade can either occur between one country and another country or between people located in
different countries. Another name for international trade is foreign trade.
In simple words, it refers to trade between two different countries (such as India and
Bangladesh) or one country and the rest of the world (e.g., India and Great Britain,
Germany, U.S.A., etc.). The former is called bilateral trade and the latter multilateral
trade.
On the other hand, Domestic trade or internal trade is the trade which takes places between the
different regions of the same country (e.g., the trade between Calcutta and Mumbai or
Calcutta and Chennai, etc.). Domestic trade can also be called an internal trade. A
domestic trade is a trade which is within the borders of a given country. For example,
all trading activities that go on within your country are referred to as domestic trade.

Other major differences between domestic trade and international trade

a) Domestic trade always takes place within the borders of a given country, while international trade
always goes beyond the borders of a given country.

b) Domestic trade can never involve more than one country, but international trade always involves two
or more countries.

c) Domestic trade, to a large extent involves the use of mainly local currency in trading, whereas
international trade involves the use of foreign currencies. The U.S. dollar is the standard currency used
in international trade.

d) Domestic trade is free off restriction, so long as it is a legal commodity being traded. Legal and
wholesome commodities dealt with in domestic trade can move around the country without facing any
forms of restrictions such as embargoes and quotas. But this is not the case for international trade. In
international trade, certain goods, though legal, can be subjected to certain restrictions such as
embargoes and quotas.

e) Domestic trade is not subject to being controlled by external bodies, but this isn’t the same for
international trade. International trade is controlled by certain external bodies to which a country is a
member. A very good example of an external body that controls trade all over the world is the World
Trade Organization.

f) International trade generally involves very long distances, but this is normally not the case with
domestic trade. Take for example a trade between South Africa and Sweden or between New Zealand
and Egypt. These trades certainly involve very lengthy distances to be covered. But a trade between any
two points in South Africa or Sweden can never be that lengthy.

Theories of International Trade

The earliest theory as to what are the causes of trade and why a country will benefit from trade
is given by19th Century English economist David Ricardo . This theory is popularly
known as Comparative Advantage Theory of international trade.
Ricardo considered what goods and services countries should produce, and suggested that they
should specialise by allocating their scarce resources to produce goods and services for
which they have a comparative cost advantage. There are two types of cost advantage
–absolute, and comparative.
 Absolute advantage means being more productive or cost-efficient than another country whereas
comparative advantage relates to how much productive or cost efficient one country is
than another.

THEORY OF COMPARATIVE ADVANTAGE AND ABSOLUTE ADVANTAGE

Absolute Advantage
In economics, the principle of absolute advantage refers to the ability of a party (an individual,
a firm, or a country) to produce more of a good or service than competitors while using
the same amount of resources. Adam Smith first described the principle of absolute
advantage in the context of international trade, labor as the only input. Since absolute
advantage is determined by a simple comparison of labor productivities, it is possible
for a party to have no absolute advantage in anything; in that case, according to the
theory of absolute advantage, no trade will occur with the other party. It can be
contrasted with the concept of comparative advantage, which refers to the ability to
produce a particular good at a lower opportunity cost. Smith also used the concept of
absolute advantage to explain gains from free trade in the international market. He
theorized that countries’ absolute advantages in different commodities would help
them gain simultaneously through exports and imports, making the unrestricted
international trade even more important in the global economic framework.

Comparative Advantage
More popular as compared to the above theory, the theory of comparative advantage assumes
only two countries and only two commodities although the principles are by no means
limited to such cases. Again for clarity, the cost of production is usually measured only
in terms of labour time involved in a unit of cloth, for example, might be given as two
hours of work. The two countries will be called A and B; and the two commodities
produced, wine and cloth. The labour time required to produce a unit of either
commodity in either country is as follows:

COST OF PRODUCTION (LABOUR TIME)

COUNTRY A COUNTRY B
Wine (1 Unit) 1 hour 2 hours
Cloth (1 Unit) 2 hours 6 hours

As compared with country A, country B is productively inefficient. Its workers need more time
to turn out a unit of wine or a unit of cloth. This relative inefficiency may result from
differences in climate, in worker training or skill, in the amount of available tools and
equipment, or from numerous other reasons. Ricardo took it for granted that such
differences do exist, and he was not concerned with their origins.
Country A is said to have an absolute advantage in the production of both wine and cloth
because it is more efficient in the production of both goods. Accordingly, A’s absolute
advantage seemingly invites the conclusion that country B could not possibly compete
with country A, and indeed that if trade were to be opened up between them, country
B would be competitively overwhelmed.

Ricardo, who focused chiefly on labour costs, insisted that this conclusion is false. The critical
factor is that country B’s disadvantage is less pronounced in wine production, in which
its workers require only twice as much time for a single unit as do the workers in A,
than it is in cloth production, in which the required time is three times as great. This
means, Ricardo pointed out, that country B will have a comparative advantage in wine
production.
 Both countries will profit, in terms of the real income they enjoy, if country B specializes in wine
production, exporting part of its output to country A, and if country A specializes in
cloth production, exporting part of its output to country B. Paradoxical though it may
seem, it is preferable for country A to leave wine production to country B, despite the
fact that A’s workers can produce wine of equal quality in half the time that B’s
workers can do so.

In this simple example, based on labour costs, the result is complete (and unrealistic)
specialization: country A’s entire labour force will move to cloth production and country
B’s to wine production.. The model can be expanded in other ways—for example, by
involving more than two countries or products, by adding transport costs, or by
accommodating a number of other variables such as labour conditions and product
quality.

The essential conclusions, however, come from the elementary model used above, so that this
model, despite its simplicity, still provides a workable outline of the theory. .The major
purpose of the theory of comparative advantage is to illustrate the gains from
international trade. Each country benefits by specializing in those occupations in which
it is relatively efficient; each should export part of that production and take, in
exchange, those goods in whose production it is, for whatever reason, at a comparative
disadvantage. The theory of comparative advantage thus provides a strong argument
for free trade.

Heckscher-Ohlin theory

Another theory of international trade, According to this theory, countries with plentiful
natural resources will generally have a comparative advantage in products using those
resources. This was put forward by two Swedish economists, Eli Heckscher and Bertil
Ohlin.

The Heckscher-Ohlin theory focuses on the two most important factors of production, labour
and capital. Some countries are relatively well-endowed with capital; the typical
worker has plenty of machinery and equipment to assist with the work. In such
countries, wage rates generally are high; as a result, the costs of producing labour-
intensive goods—such as textiles, sporting goods, and simple consumer electronics—
tend to be more expensive than in countries with plentiful labour and low wage rates.
On the other hand, goods requiring much capital and only a little labour (automobiles
and chemicals, for example) tend to be relatively inexpensive in countries with
plentiful and cheap capital. Thus, countries with abundant capital should generally be
able to produce capital-intensive goods relatively inexpensively, exporting them in
order to pay for imports of labour-intensive goods.
In the Heckscher-Ohlin theory it is not the absolute amount of capital that is important; rather,
it is the amount of capital per worker. A small country like Luxembourg has much less
capital in total than India, but Luxembourg has more capital per worker. Accordingly,
the Heckscher-Ohlin theory predicts that Luxembourg will export capital-intensive
products to India and import labour-intensive products in return. Despite its
plausibility the Heckscher-Ohlin theory is frequently at variance with the actual
patterns of international trade. As an explanation of what countries actually export and
import, it is much less accurate than the more obvious and straightforward natural
resource theory.

One early study of the Heckscher-Ohlin theory was carried out by Wassily Leontief, a Russian-
born U.S. economist. Leontief observed that the United States was relatively well-
endowed with capital. According to the theory, therefore, the United States should
export capital-intensive goods and import labour- intensive ones. He found that the
opposite was in fact the case: U.S. exports are generally more labour
intensive than the type of products that the United States imports. Because his findings were the
opposite of those predicted by the theory, they are known as the Leontief Paradox.

PROTECTIONISM AND WTO

The concept of Protectionism became more pronounced when the world faced Great Depression
from 1873 consequent upon following free market system propounded by Adam
Smith. Thereafter, more and more countries started resorting to protectionism to
protect their economic interests by forming different trade blocks.

Protectionism is the practice of following protectionist trade policies. A protectionist trade policy
allows the government of a country to promote domestic producers, and thereby boost
the domestic production of goods and services by imposing tariffs or otherwise
limiting foreign goods and services in the marketplace. An economy usually adopts
protectionist policies to encourage domestic investment in a specific industry. For
instance, tariffs on the foreign import of shoes would encourage domestic producers to
invest more resources in shoe production. In addition, nascent domestic shoe
producers would not be at risk from established foreign shoe producers. Although
domestic producers are better off, domestic consumers are worse off as a result of
protectionist policies, as they may have to pay higher prices for somewhat inferior
goods or services. Protectionist policies, therefore, tend to be very popular with
businesses and very unpopular with consumers.

The economic case for an open trading system based on multilaterally agreed rules is simple
enough and rests largely on commercial common sense. But it is also supported by
evidence: the experience of world trade and economic growth since the Second World
War.

Tariffs on industrial products have fallen steeply and now average less than 5% in industrial
countries. During the first 25 years after the war, world economic growth averaged
about 5% per year, a high rate that was partly the result of lower trade barriers. World
trade grew even faster, averaging about 8% during the period.

From the early days of the Silk Road to the creation of the General Agreement on Tariffs and
Trade (GATT) and the birth of the WTO, trade has played an important role in
supporting economic development and promoting peaceful relations among nations.
This page traces the history of trade, from its earliest roots
to the present day.
World Trade Organization (WTO)

It is an intergovernmental organization which regulates international trade. The WTO officially

commenced on 1 January 1995 under the Marrakesh Agreement, signed by 123 nations on 15 April
1994, replacing the General Agreement on Tariffs and Trade (GATT), which commenced in 1948. The
WTO deals with regulation of trade between participating countries by providing a framework for
negotiating trade agreements and a dispute resolution process aimed at enforcing participants&#39;
adherence to WTO agreements, which is signed by representatives of member governments and ratified
by their parliaments. Most of the issues that the WTO focuses on derive from previous trade
negotiations, especially from the Uruguay Round (1986–1994).
 Well before GATT&#39;s 40th anniversary, its members concluded that the GATT system was
straining to adapt to a new globalizing world economy. In response to the problems
identified in the 1982 Ministerial Declaration (structural deficiencies, spill-over
impacts of certain countries&#39; policies on world trade GATT could not manage
etc.), the eighth GATT round known as the Uruguay Round – was launched in
September 1986, in Uruguay

It was the biggest negotiating mandate on trade ever agreed: the talks were going to extend the
trading system into several new areas, notably trade in services and intellectual
property, and to reform trade in the sensitive sectors of agriculture and textiles; all the
original GATT articles were up for review. The Final Act concluding the Uruguay
Round and officially establishing the WTO regime was signed 15 April 1994, during
the ministerial meeting at Marrakesh, Morocco, and hence is known as the Marrakesh
Agreement. The GATT still exists as the WTO&#39;s umbrella treaty for trade in
goods.

GATT was established after World War II in the wake of other new multilateral institutions
dedicated to international economic cooperation – notably the Bretton Woods institutions
known as the World Bank and the International Monetary Fund. A comparable
international institution for trade, named the International Trade Organization was
successfully negotiated. The ITO was to be a United Nations specialized agency and
would address not only trade barriers but other issues indirectly related to trade,
including employment, investment, restrictive business practices, and commodity
agreements. But the ITO treaty was not approved by the U.S. and a few other signatories
and never went into effect.

DETERMINATION OF EXCHANGE RATES

Definition: An exchange rate is the price of a country’s currency in terms of another currency.
In other words, it represents how many units of a foreign currency a consumer can buy
with one unit of their home currency.
Exchange rates are ratios that are used across all international markets, including finance,
trading, and investment. Businesses and investors use these rates to compare their
currency’s purchasing power with another country. They also use this to determine
the comparative strength of their domestic currency against foreign currencies.
Additionally, these rates can either be floating or fixed. A floating rate occurs when the
market determines the rate. A fixed rate is where a country pins their domestic
currency to some widespread currency.

Types of exchange rate management

A. Fixed Exchange Rate
B. Flexible Exchange Rate
A. The Fixed Exchange Rate

When the exchange rate between the domestic and foreign currencies is fixed by the monetary
authority of a country and is not allowed to fluctuate beyond a limit, it is called fixed
exchange rate. Under the IMF system, the monetary authority of a member nation
fixes the official value of its currency in terms of a reserve currency (usually the US
dollar) or a basket of &#39;key currencies.&#39; The exchange rate so determined is
known as currency&#39;s par value. It is also called &#39;pegged&#39; exchange rate.
However, flexibility is allowed within the upper and lower limits prescribed by the
IMF, usually 1% up and down, under the normal conditions.

The basic purpose of adopting fixed exchange rate system is to ensure stability in foreign trade
and capital movements. Under fixed exchange rate system, the government assumes the
responsibility of ensuring
 stability of exchange rate. To this end, the government undertakes to buy and sell the foreign
currency-buy when it becomes weaker and sell when it gets stronger. Private sale and
purchase of foreign currency is suspended. Any change in the official exchange rate is
made by the monetary authority of the country in- consultation with the IMF. In
practice, however, most countries adopt a dual system: a fixed exchange rate for all
official transactions and a market rate for private transactions.

Arguments in Favour of Fixed Exchange Rate:

First, it provides stability in the markets, certainty about the future course of actions in the
Foreign Exchange Market, and it eliminates the risk caused by the uncertainty. Second,
it creates a system for a smooth flow of foreign capital between the nations, as it gives
assurance of fixed return on investment.
Third, It removes the possibility of speculative transactions in foreign exchange markets.
Lastly, it reduces the possibility of competitive exchange depreciation or devaluation of
currencies.

Flexible Exchange Rate

When the exchange rate is decided by the market force (demand and supply of currency), it is
called the flexible exchange rate. The advocates of flexible exchange rate have put
forward equally convincing arguments in its favour. They have challenged all the
arguments against the flexible exchange rate. It is often argued that flexible exchange
rate causes destabilization, uncertainty, risk and speculation. The proponents of the
flexible exchange rate have not only rebutted these charges but also have put forward
strong arguments in favour of flexible exchange rate.

Arguments in favour of Flexible Exchange Rate:

First, flexible exchange rate provides a good deal of autonomy in respect of domestic policies as it
does not require any obligatory constraints. This advantage is of great significance in
the formulation of domestic economic policies.

Second, flexible exchange rate is self-adjusting and therefore it does not devolve on the
government to maintain an adequate foreign exchange reserves to stabilize the exchange
rate.

Third, since flexible exchange rate is based on a theory, it has a great advantage of predictability
and has the merit of automatic adjustment.

Fourth, flexible exchange rate serves as a barometer of actual purchasing power of a currency in the
foreign exchange market.
 Finally, some economists argue that the most serious charge against the flexible exchange rate,
that is, uncertainty, is not tenable because speculative tendency under this system itself
creates conditions for certainty and stability. They argue that the degree of uncertainty
under flexible exchange rate system, if any, is not greater than one under the fixed
exchange rate

Floating Rates

Unlike the fixed rate, a floating exchange rate is determined by the private market through
supply and demand. A floating rate is often termed & quot; self-correcting,& quot; as
any differences in supply and demand will automatically be corrected in the market.
Look at this simplified model: if demand for a currency is low, its value will decrease,
thus making imported goods more expensive and stimulating
 demand for local goods and services. This, in turn, will generate more jobs, causing an auto-
correction in the market. A floating exchange rate is constantly changing.

In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also
influence changes in the exchange rate. Sometimes, when a local currency reflects its
true value against its pegged currency, a & quot; black market & quot; (which is more
reflective of actual supply and demand) may develop. A central bank will often then
be forced to revalue or devalue the official rate so that the rate is in line with the
unofficial one, thereby halting the activity of the black market. In a floating regime, the
central bank may also intervene when it is necessary to ensure stability and to avoid
inflation. However, it is less often that the central bank of a floating regime will
interfere.

THE CASE OF INDIA

Historical Background
Since Independence, the exchange rate system in India has transited from a fixed exchange rate
regime where the Indian rupee was pegged to the pound sterling on account of historic
links with Britain to a basket-peg during the 1970s and 1980s and eventually to the
present form of market-determined exchange rate regime since March 1993.

Liberalised Exchange Rate Management System(LERMS)

The Finance Minister announced the liberalised exchange rate management system (LERMS) in
the Budget for 1992- 93. This system introduced partial convertibility of rupee. Under
this system, a dual exchange rate was fixed under which 40 per cent of foreign
exchange earnings were to be surrendered at the official exchange rate while the
remaining 60 per cent were to be converted at a market-determined rate. But from the
next year, rupee was made fully convertible on the current account with the sole aim
of promoting exports. Now we have Foreign Exchange Management Act, 1999, which
replaced the Foreign

Exchange Regulation Act, 1973. FEMA 1999

Foreign Exchange Regulation Act, 1973 (FERA) was replaced by the Foreign Management
Act, 1999 (FEMA). FEMA was enacted by Parliament of India and it came into force on
1st June, 2000. There are a total of 49 Sections divided into 7 chapters. The reason for
the replacement emerged because it was not suitable for the prevailing environment
and was harsh as it contained a provision for imprisonment. On the other hand, FEMA
was introduced with the changes because of the new, liberal and changing
environment. Also, earlier FERA was passed due to the insufficient foreign exchange in
the country and FEMA was passed with the objective to relax the controls on foreign
 exchange in India. The head office of FEMA is situated in New Delhi known as
Enforcement Directorate and is headed by a Director.

Kinds of foreign Exchange Market in India:

A. Spot market: It refers to a market in which the sale and purchase of foreign currency are settled within
two days of the deal. The spot sale and purchase of foreign exchange make the spot market. The rate at
which the foreign currency is bought and sold is called spot exchange rate. For all practical purposes,
spot rate is treated as the current exchange rate.

B. Forward Market: It refers to that market, which deals in the sale and purchase of foreign currency at
some future date at a pre-settled exchange rate. When buyers and sellers enter an agreement to buy and
sell a
foreign currency after 90 days of the deal, it is called forward transaction. The exchange rate settled
buyer and seller for forward sale and purchase of currency is called forward exchange rate.
between

Balance of Payment (BOP)

Balance of Payment (BOP) of ac country can be defined as a systematic statement of all

economic transactions of a country with the rest of the world during a specific period
usually one year. The systematic accounting is done on the basis of double entry book
keeping (both sides of transactions credit and debit are included). Economic
transaction includes all such transactions that involve the transfer of title or ownership
of goods and services, money and assets.
The systematic accounting is done on the basis of double entry book keeping (both sides of
transactions credit and debit are included). Economic transaction includes all such
transactions that involve the transfer of title or ownership of goods and services,
money and assets.
The Balance of Payments (BOP) is the method countries use to monitor all international
monetary transactions at a specific period of time. Usually, the BOP is calculated every
quarter and every calendar year. All trades conducted by both the private and public
sectors are accounted for in the BOP in order to determine how much money is going
in and out of a country.
If a country has received money, this is known as a credit, and, if a country has paid or given
money, the transaction is counted as a debit. Theoretically, the BOP should be zero,
meaning that assets (credits) and liabilities (debits) should balance. But in practice this
is scarily the case and, thus, the BOP can tell the observer if a country has a deficit or a
surplus and from which part of the economy the discrepancies are stemming.

Balance of Trade V/s Balance of Payment

The Balance of Payment takes into account all the transaction with the rest of the
worlds The Balance of Trade takes into account all the trade transaction
with the rest of the worlds For preparing a BOP accounts, economic
transactions between a country and rest of the world are grouped under
two broad categories:

A. Current Account
B. Capital Account

Current Account:
It includes export and import of gods and services i.e. visible and invisible trade. This type of
transaction changes (increase or decreases) the current level of consumption of the
country.
Within the current account are credits and debits on the trade of merchandise, which includes
goods such as raw materials and manufactured goods that are bought, sold or given
away (possibly in the form of aid). Services refer to receipts from tourism,
transportation (like the levy that must be paid in Egypt when a ship passes through
the Suez Canal), engineering, business service fees (from lawyers or management
consulting, for example), and royalties from patents and copyrights. When combined,
goods and services together make up a country&#39;s balance of trade (BOT).
The BOT is typically the biggest bulk of a country&#39;s balance of payments as it makes up
total imports and exports. If a country has a balance of trade deficit, it imports more
than it exports, and if it has a balance of trade surplus, it exports more than it imports.
Receipts from income-generating assets such as stocks (in the form of dividends) are also
recorded in the current account. The last component of the current account is unilateral
transfers. These are credits that
 are mostly worker&#39;s remittances, which are salaries sent back into the home country of a national
working abroad, as well as foreign aids that are directly received.

Capital Account:

Inflow and outflow of capital including foreign investment, gold and foreign exchange reserves. This is
of stock nature. The capital account is where all international capital transfers are recorded. This refers
to the acquisition or disposal of non-financial assets (for example, a physical asset such as land) and
non- produced assets, which are needed for production but have not been produced, like a mine used for
the extraction of diamonds.
The capital account is broken down into the monetary flows branching from debt forgiveness, the
transfer of goods, and financial assets by migrants leaving or entering a country, the transfer of
ownership on fixed assets (assets such as equipment used in the production process to generate income),
the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death
levies, and, finally, uninsured damage to fixed assets.

Balance of Payment in India

The Reserve Bank of India (RBI) is responsible for compilation and dissemination of BoP data. The data on
India’s Balance of Payments (BoP) are published by the Reserve Bank on a quarterly basis with a lag of one
quarter BoP is broadly consistent with the guidelines contained in the BoP Manual of the International
Monetary Fund.

Current Accounts

Balance of Trade / Visible

Also known as balance on merchandising goods
Records all transactions of foreign currencies on account of export &amp; import of goods only
BOT is always deficit in India means import &gt;&gt; export
Means insufficiencies of foreign currency through export to pay for critical imports
Capital Account

Foreign investment in India ( FDI, FII, ADR, Direct purchase of land or assets)
External commercial borrowing (IMF, WB, ADB etc.), External assistance &amp; Grants
etc. Indian Diaspora maintain deposits in foreign currency in India known as NRI deposits
Overall BOP cannot tell the health of an economy, weather there is CAD or CAS but what
is important is the manner in which inflow &amp; outflow are matched
As CAD can be fulfilled by ECB (external borrowings)/RBI (internal
borrowings) in capital account of BOP
The true picture can be seen from current account of

BOP Globalisation and Global Imbalance

Globalisation
Globalization means the speedup of movements and exchanges (of human beings, goods, and services,
capital, technologies or cultural practices) all over the planet. One of the effects of globalization is that
it promotes and increases interactions between different regions and populations around the globe. In
other
 words, the increasing interdependence of world economies as a result of the growing scale of
cross-border trade of commodities and services, the flow of international capital and the
wide and rapid spread of technologies. It reflects the continuing expansion and mutual
integration of market frontiers and the rapid growing significance of information in all
types of productive activities and marketization are the two major driving forces for
economic globalization.

Some taste of economic history

People have been trading goods for almost as long as they’ve been around. For the first time in
history, luxury products from China started to appear on the other edge of the
Eurasian continent – in Rome. They got there after being hauled for thousands of miles
along the Silk Road. Trade had stopped being a local or regional affair and started to
become global.
That is not to say globalization had started in earnest. Silk was mostly a luxury good, and so were
the spices that were added to the intercontinental trade between Asia and Europe. As a
percentage of the total economy, the value of these exports was tiny, and many
middlemen were involved to get the goods to their destination. But global trade links
were established, and for those involved, it was a goldmine. From purchase price to
final sales price, the multiple went in the dozens. The Silk Road could prosper in part
because two great empires dominated much of the route.
The end of the World War II marked a new beginning for the global economy. Under the
leadership of a new hegemon, the United States of America, and aided by the technologies
of the Second Industrial Revolution, like the car and the plane, global trade started to
rise once again. At first, this happened in two separate tracks, as the Iron Curtain
divided the world into two spheres of influence. But as of 1989, when the Iron Curtain
fell, globalization became a truly global phenomenon.
In the early decades after World War II, institutions like the European Union, and other free
trade vehicles championed by the US were responsible for much of the increase in
international trade. In the Soviet Union, there was a similar increase in trade, albeit
through centralized planning rather than the free market. The effect was profound.
Worldwide, trade once again rose to 1914 levels: in 1989, export once again counted for
14% of global GDP. It was paired with a steep rise in middle-class incomes in the West.
When the wall dividing East and West fell in Germany, and the Soviet Union collapsed,
globalization became an all-conquering force. The newly created World Trade
Organization (WTO) encouraged nations all over the world to enter into free-trade
agreements, and most of them did, including many newly independent ones. In 2001,
even China, which for the better part of the 20th century had been a secluded, agrarian
economy, became a member of the WTO, and started to manufacture for the world

Global imbalances
Refers to the situation where some countries have more assets than the other countries. In
theory, when the current account is in balance, it has a zero value: inflows and outflows
of capital will be cancelled by each other. Hence, if the current account is persistently
showing deficits for certain period it is said to show an inequilibrium.

During recent years, global imbalances have become a concern in the rest of the world. The
United States has run long term deficits, as well as many other advanced economies,
while in Asia and emerging economies the opposite has occurred. Due to the severe
recession the world is feared to face, exports and imports have come down, Shifting of
industries is taking place from China and closure thereof in other countries in a big
way. The linkage effect, accordingly, is worsening the situation. With the large chunk
of workforce falling below poverty line, upsurge in unemployment, rise in World
Poverty Index and fall in world trade apart from the trade war, international economic
order has certainly been badly impacted. The crisis of COVID-19 has caused a sharp
reduction in trade and significant movements in exchange rates but
 limited reduction in global current account deficits and surpluses. The outlook remains highly uncertain
as the risks of new waves of contagion, capital flow reversals, and a further decline in global trade still
loom large on the horizon. External deficits and surpluses are not necessarily a cause for concern. There
are good reasons for countries to run them at certain points in time. But economies that borrow too
much and too quickly from abroad, by running external deficits, may become vulnerable to sudden stops
in capital flows.

Countries also face risks from investing too much of their savings abroad given investment needs at
home It is estimated that about 40 percent of global current account deficits and surpluses were excessive
in 2019 and, as in recent years, concentrated in advanced economies. China’s assessed external position
remained, as in 2018, broadly in line with fundamentals and desirable policies, due to offsetting policy
gaps.

Another bout of global financial stress could trigger more capital flow reversals, currency pressures,
and further raise the risk of an external crisis for economies with pre-existing vulnerabilities, such as
large current account deficits, a high share of foreign currency debt, and limited international reserves,
as highlighted in this year’s analytical chapter. A worsening of the COVID-19 pandemic could also
dislocate global trade and supply chains, reduce investment, and hinder the global economic recovery.

Session 30: Case Study: US-China Exchange rate

Stand-off
Synopsis

The case is about US allegations of currency manipulation on China and China’s denial to the
allegations claiming that its currency policy was shaped by national interest. The case
also lays down various events of US continuing to exert pressure on China to revalue
its currency. China is a major trading partner of the US, and the country with which
the US ran a huge trade deficit. The US government attributed the large trade deficit
with China to the Chinese government’s manipulation of its currency, which made
Chinese exports “artificially attractive”, thus giving it an unfair trade advantage. So,
on January 31, 2007, the Fair Currency Bill was introduced in the US Congress. The bill
was representative of the US stand that China’s currency was grossly undervalued.
The bill was introduced to allow US industry to seek relief from damage caused by
“imports that benefit from a subsidy in the form of foreign exchange-rate misalignment.
Criticism of China’s currency policy grew after China’s accession into the WTO, which
allowed China’s share of world exports to grow from 4.4% in 2001 to more than 8%
(2006), with a significant portion of these exports reaching US shores. Post-WTO, the
US government had been using several means - including the threat of trade sanctions -
to pressurize China to revalue its currency against the US Dollar.

The Chinese government, on the other hand, maintained that the exchange rate of the Yuan
against the US Dollar was not fixed. However, some Chinese officials agreed that their
government did intervene to maintain the exchange rate within a narrow band. But
they added that a stable Yuan- Dollar exchange rate was necessary as it promoted
economic and financial stability in China. While US government and
 trade representatives were critical of China’s alleged pegging of the currency, economists were
of the view that undervaluation of the Yuan against the Dollar brought some benefits to
the US economy as well. The low prices of imported Chinese goods lowered the costs
for US firms that used these cheap Chinese imports as inputs in their production. Also,
the cheap Chinese imports helped keep inflation down in the US.

Case Analysis:

A note on the Currency in China –

Renminbi was not convertible - In the late 1940s, the communists took control of the
government in China. They established the People’s Bank of China (PBC) in December
1948 and the bank started issuing the Renminbi.

Fixed exchange rate - Initially, the foreign exchange rate of the Renminbi or the Yuan was fixed
taking into account price comparisons of China’s imports and exports. Between 1955
and 1971, the Yuan-Dollar exchange rate was set at 2.46. From 1972, the Yuan was
revalued gradually to reach 1.50 to the US Dollar by 1979. In this period, the value was
set based on the weighted average values of a basket of major currencies. However,
according to most economists, the Yuan was overvalued in this period.
Dual exchange rate - In 1978, a dual track currency system (situation in which a currency
has two official exchange rates, one pegged to another currency and the other floating)
was instituted in China. However, the dual exchange system soon created problems
for China with the IMF and the US, a major trading partner by then, raising objections
to the system. Chinese exporters were able to benefit from the dual system and made
quick profits. Yielding to pressure, China scrapped the internal settlement rate and
fixed the official rate at 2.8 Yuan to the US Dollar in 1985.

Devaluation of Yuan - In 1989, the Yuan was devalued to 4.72 to the US Dollar and further to
5.8 in 1993. In spite of these devaluations, the Yuan was still regarded as overvalued by
most economists. In early 1994, the exchange was reset at 8.7 Yuan to the US Dollar. In
1996, China adopted current account convertibility. The late 1990s and early 2000s saw
the Yuan stabilize at around 8.3 to the US Dollar.

China became a member of the WTO

After China joined the WTO, trade between China and the US increased significantly.
However, the Yuan continued to hover around 8.0, sparking criticism from its trading
partners. Despite the increasing trade between the two countries, the US was not
satisfied with China’s efforts to implement some of its WTO commitments. The major
areas of concern were the subsidies given to Chinese manufacturers, and the
undervalued Yuan. The US emphasized that the exchange rate should be determined
by market forces. US claimed that China’s currency policy was a “risk to its economy,
China’s trading partners, and global economic growth”. Whereas in June 2005, China,
defending its currency policy stated that the fixed exchange rate helped maintain
China’s high levels of employment. A stable Yuan is in the interests of China and the
world. All the same, US continued to exert pressure on China to revalue its currency.

China softens its stand

On July 21, 2005, China announced a new exchange rate system, referred to as the “crawling
peg”. Under
this system, the Yuan was to be referenced, not just to the US Dollar, but to a basket of currencies,
which
was welcomed by analysts. US government officials too felt that China was finally moving
towards a flexible exchange rate system. The IMF too expressed satisfaction with
China’s decision. However, some critics remained skeptical too.

Was Yuan’s revaluation a mirage?

On July 27, 2005, the Chinese central bank announced that no further changes in the value of
the Yuan were to be expected in the near future. Immediately after the July 21
announcement, the Yuan strengthened marginally, moving from 8.28 to 8.11 to the
dollar. This prompted analysts to conclude that Chinese authorities were adopting a
managed float system, where some market flexibility was allowed but with many
government controls still in place. In August 2005, the Chinese central bank announced
that the basket of currencies included, apart from the US Dollar, the Yen, the Euro, the
Korean Won and some other currencies. China’s major trading partners are the United
States, the Euro land, Japan, Korea, etc., and naturally, the US dollar, the Euro, the
Japanese Yen and the Korean Won become major currencies of the basket. Whatever
the compulsions behind China’s move to peg its currency against a basket of
currencies, the change in policy seemed to have little effect on the Yuan-US Dollar
exchange rate in the months following the announcement.
In 2006, the US trade deficit with China hit an all-time high of US$ 232.5 billion44, the largest
ever recorded between any two countries. On the other hand, China’s foreign exchange
reserves crossed US$ 987 billion (in October 2006). Many analysts argued that the fact
that China was able to build up its reserves, and that the US trade deficit with China
was ballooning, which indicated that the Yuan was still undervalued. While analysts
agreed that they were other factors such as Chinese subsidies to its manufacturing
sector, low labor costs, etc., behind Chinese exports being competitive, the distorted
Yuan-US Dollar exchange rate was considered the prime reason.

Arguments in favour of Yuan’s undervaluation or the arguments against Yuan revaluation

1. Yuan-US Dollar exchange rate was favorable to bilateral trade. Having a trade surplus with the US
was not proof that the currency was undervalued.

2. An abrupt increase in the value of the Yuan could lead to a fall in foreign investment and a slowdown
in Chinese exports adversely affecting growth in the domestic economy.

3. Appreciation of the Yuan can lead to a rise in Chinese imports of food articles, which could lead to a
fall in the prices of domestic food products. Hence, A stronger Yuan was expected to lead to a fall in
China’s agricultural exports, which would no longer be competitive in the world market, resulting in
lower incomes for Chinese farmers.

4. Chinese banks were burdened with sizable non-performing assets; they would not be able to deal
effectively with speculative pressures in the currency exchange market arising from the transition to a
floating exchange rate system.
5. The reason behind the growing trade deficit was not an undervalued Yuan but the low US savings
rate, which made the country reliant on foreign investment. US should encourage savings if it wanted to
reduce the trade deficit with China.

Positive consequences of Yuan ‘s undervaluation for the US economy

The Chinese central bank was forced to invest the dollar earnings from exports in US assets,
mainly US Treasury securities, which helped to keep interest rates in the US low. This
stimulated economic activity in the US. After Japan, China was the second largest
foreign holder of US treasury securities. If China were to stop buying US Treasury
securities, it was possible that interest rates in the US could rise.

An undervalued Yuan lowered the price of imports from China, which increased the purchasing
power of the US consumer, which, in turn, increased the consumption level in the US.
Low-priced imports from China also lowered the costs for US producers who used
these imports as inputs in their production. imposing tariffs on Chinese goods would
disrupt the mutually beneficial relationship between the US and China. Others
pointed out that while it was true that US trade deficit with China was growing, the
fact that US trade deficit with the rest of the world was also growing at more or less the
same rate should also be noted.

The blame game - Is it reasonable or fair to blame China for problems in the US economy?

One of the major criticisms against the pegging of the Chinese currency had been that it had a
debilitating effect on the US manufacturing sector as it encouraged imports of Chinese
manufactured products. However, some economists claimed that no clear link
between increase in US imports of manufactured products from China and declining
profitability or job losses in the US manufacturing sector could be established.
According to some economists, more than any factor, the job losses in the US
manufacturing sector had been due to the economic recession in the US.

China's increasing share in the world's trade prompted some US government officials to
express dissatisfaction over the pace at which China was moving toward a floating
exchange rate system. In March 2007, the US Department of Commerce announced the
imposition of penalty tariffs on the imports of coated free sheet paper from China. The
Chinese government opposed this decision trade sanctions would backfire and hurt
US producers, as they would have to look for new sources for cheap raw materials;
and US consumers, as they would have to pay more for their purchases. It was also
said that US companies doing business across East Asia would bear the brunt of the
fallout of sanctions, as their supply chains would be disrupted. It was generally
believed that if China allowed the Yuan to appreciate, it would result in a rise in prices
in the US as well as in several other countries.
 Session 31, 32, 33: Business Environment in Indian
Context
Suggestions for India’s Economic Development for future

India is at a decisive point in its journey towards prosperity, and it is time to make the next step change
in the pace of reform. The economic crisis sparked by COVID-19 could spur actions that return the
economy to a high-growth track and create gainful jobs for 90 million workers by 2030; letting go of this
opportunity could risk a decade of economic stagnation.

1.A reform agenda can be implemented in the next 12 to 18 months to pave the way for economic growth
in the coming decade.
With the right measures now, India can raise productivity and incomes for workers, small,
midsize, and large firms, keeping India in the ranks of the world's outperforming
emerging economies.

2. With 90 million more workers in search of nonfarm jobs by 2030, India needs to act decisively to resume
its high‐growth path.
Post COVID-19, annual GDP growth of 8.0 to 8.5 percent will be required with continued
strong productivity growth and faster employment growth than in the past to create
the 12 million gainful nonfarm jobs annually that are needed, up from just four million
created each year between fiscal year 2013 to 2018. Even before the pandemic, India’s
economy faced structural challenges, and GDP growth fell to 4.2 percent; the crisis
compounds the challenge. Absent urgent steps to spur growth, India risks a decade of
stagnating incomes and quality of life.

3.In the high‐growth path, the manufacturing and construction sectors can accelerate the most.
Manufacturing could contribute one-fifth of incremental GDP to 2030, while construction could add one
in four of the incremental nonfarm jobs required. Labour- and knowledge- intensive services sectors also
need to maintain their past strong growth momentum

4. Across all sectors, three growth booster themes spanning 43 frontier businesses have potential to create
$2.5 trillion of economic value and 30 percent of India’s nonfarm jobs in 2030.
These themes provide productivity momentum throughout their sectors and higher-wage
pathways for workers. They are: global hubs that serve India and the world such as in
manufacturing and agricultural exports and digital services; efficiency engines to
boost competitiveness, including next-generation financial products and high-
efficiency logistics and power; and new ways of living and working, including the
sharing economy and modern retail.

5. To capture frontier opportunities, India needs to triple its number of large firms, with more than
1,000 midsize and 10,000 small companies scaling up.
India has about 600 large firms with more than $500 million in revenue. They are 11
times more productive than average and generate almost 40 percent of all exports.
However, many more are needed: large firms’ revenue contribution to GDP in 2018
was 48 percent, and India’s potential is to achieve 70 percent by 2030, in line with
outperformer economies. Addressing a “missing middle” of midsize firms can enable
the emergence of 1,000 more large firms and 10,000 more midsize firms by 2030.
Improving access to capital and easing other barriers to business would help the best-
performing firms of all sizes climb the ladder of scale and global competitiveness.

6. Reforms in six areas can raise productivity and competitiveness; more than half could be
implemented rapidly via policy or law.
They are: (i) sector-specific policies to improve productivity in manufacturing, real estate,
agriculture, healthcare, and retail; (ii) unlocking supply in land markets to reduce land
costs by 20 to 25 percent; (iii) creating flexible labour markets for industry, with better
benefits and safety nets for workers;
(iv) enabling efficient power distribution to reduce commercial and industrial tariffs by 20 to 25
percent; (v) privatising 30 or so of the largest state-owned enterprises to potentially
double their productivity; and (vi) improving the ease and reducing the cost of doing
business.

7. Financial‐sector reforms and streamlining fiscal resources can deliver $2.4 trillion in investment while
boosting entrepreneurship by lowering the cost of capital for enterprises by about 3.5 percentage
points.
In the high- growth scenario, investment will need to rise to at least 37 percent of GDP
from 33 percent pre-crisis, with a sharp uptick in private-sector investment. To finance
this, some four percentage
points of household savings could move to financial products, through measures to unshackle
insurance, pension funds, and capital markets. Measures like a “bad bank” for
nonperforming loans and reforms in directed bank lending could reduce capital costs.
Some 3.6 percent of GDP may be channelled to productive infrastructure and other
expenditure through measures to streamline government spending and government-
owned assets, along with the tax buoyancy effects of higher growth itself.

8. While the central government’s pro‐growth agenda is critical, roughly 60 percent of the reforms can be
led by the states, and all require active participation by the business sector.
State governments could select frontier businesses and set up “demonstration clusters,”
for example, manufacturing export hubs, while pursuing other key reforms, including
in agriculture, power, and housing. Businesses would need to commit to productivity
growth, develop a long-term value creation mindset, and develop capabilities in
innovation, digital and automation, M&A, partnerships, and corporate governance.
With this, the coming decade for India could be one of high growth, gainful jobs, and
broad- based prosperity.
A clarion call is sounding for India to put growth on a sustainably faster track and avoid a
decade of potential stagnation
Over the decade to 2030, India needs to create at least 90 million new nonfarm jobs to absorb the
60 million new workers who will enter the workforce based on current demographics,
and an additional 30 million workers who could move from farm work to more
productive nonfarm sectors. To absorb this influx, the country will need about 12
million additional gainful nonfarm jobs every year starting in fiscal-year 2023— triple
the four million nonfarm jobs created annually between 2012 and 2018.2 If an
additional 55 million women enter the labour force, at least partially correcting
historical underrepresentation, India’s job creation imperative would be even greater.

For this magnitude of employment growth to be gainful and productive, India’s GDP will need to
grow by
8.0 to 8.5 percent annually over the next decade, based on economic scenarios we have
developed and benchmarks of how economic growth and employment have correlated
in other emerging economies. The economy grew at just 4.2 percent in fiscal year
2020.3 Moreover, at the time of writing, many forecasters expect it to sharply contract
due to the COVID-19 pandemic, with high uncertainty about the range of possible
economic outcomes for fiscal years 2021 and 2022.4 Our analysis looks beyond the
COVID-19 crisis, with scenarios beginning in fiscal year 2023, assuming India takes
steps to transition out of the COVID-19 recession by then. Many of our proposed
actions would start well before 2023, however, and in fact be implemented in the next
12 to 18 months.

Choosing a high-growth path that creates 90 million gainful jobs requires India to
simultaneously increase its rate of employment growth sharply and maintain its
historically strong productivity growth. To achieve
8.0 to 8.5 percent GDP growth, net employment would need to grow by 1.5 percent per year
from 2023 to 2030, similar to the average net employment growth rate of 1.5 percent
that India achieved from 2000 to 2012, but much higher than the flat net employment
experienced from 2013 to 2018. At the same time, India will need to maintain
productivity growth at 6.5 to 7.0 percent per year, the same as it achieved from 2013 to
2018.5 The two objectives are not contradictory; indeed, employment cannot grow
sustainably without high productivity growth, and vice versa

If India fails to put in place measures to address pre-pandemic trends of flat employment and
slowing economic growth, and does not manage the shock of the crisis adequately, its
economy could expand by just 5.5 to 6.0 percent from 2030, with a decadal growth of
just 5 percent. The economy would absorb only about six million new workers into the
workforce as compared to 60 million in the high-growth path, marking a decade of lost
opportunity
Sustained reforms have delivered rapid growth, but India’s economy was stalling even before
COVID-19, and with the crisis, it risks a stagnant decade
Over the past three decades, India has outpaced many other global economies, propelling the
country into the ranks of just 18 outperforming emerging economies that achieved
robust and consistent high growth over that period
Yet India’s economy was already stalling and showing signs of structural weaknesses before the
COVID-19 crisis.

India’s real GDP growth has averaged 6.8 percent annually since 1992, with nominal per capita
GDP rising 18-fold and real per capita GDP by a multiple of 3.6. Growth has been
inclusive, with economic prosperity translating into significant improvement in living
standards. In just the decade between 2005–06 and 2015–16, about 270 million people
were lifted out of extreme poverty. More recently, the push to reduce
multidimensional poverty by addressing basic needs holistically has also made
progress: about 95 percent of households had access to electricity in 2018, up from
72 percent a decade earlier, while almost 100
percent of the population had access to basic sanitation as of July 2019. The share of Indian
adults with at least one bank account has more than doubled since 2011, to 80 percent in
2017, driven by Jan-Dhan Yojana, a mass financial inclusion programme.

India’s track record of inclusive growth was the fruit of pro-growth reforms that lifted
productivity and helped the country weather shocks and cycles (Exhibit E2). These
reforms featured early pro-competition measures, including the 1991 dismantling of
anachronistic licensing rules, sharp cuts in customs tariffs, and the privatisation and
deregulation of telecommunications and electricity. Among other initiatives were
measures to boost capital accumulation, including through liberalisation of foreign
direct investment, issuance of new banking licenses to the private sector, and steep cuts
in personal income tax. More recently, measures including the Aadhaar digital ID
programme and the introduction of the Goods and Services Tax system marked
attempts to formalise the economy.

However, since the 2008 global financial crisis, India’s growth trajectory has slowed and
structural weaknesses have become apparent. Since 2013, the country’s main demand
engines—domestic private investment and global demand—have stalled. On the
investment side, bank credit to industry slowed, and the proportion of nonperforming
assets to total assets tripled to more than 9 percent in the period from fiscal year 2012
to 2019, driven by loans to the corporate sector, predominantly before 2010. Due to
mounting credit risk aversion, the cost of capital remained high despite falling
inflation, and this held back investment. From a demand perspective, the trade
intensity of global GDP declined, and India was unable to take advantage of shifts in
global value chains. Exports declined as a share of India’s GDP from 25 to 19 percent
between 2013 and 2019. Gross domestic savings and household savings growth
slowed down, while labour force participation fell from 58 to 49 percent between 2005
and 2018; much of the decline was in female, rural labour force participation. Core
sectors, including manufacturing and construction, showed signs of stress. For
example, average annual car production grew by about 4 percent from fiscal year 2013
to 2018, compared with 16 percent in 2004–12, while cement production growth
averaged 4 percent,
compared with more than 11 percent in the previous period.
Assessing the impact of the COVID-19 crisis on India’s economy

The COVID-19 pandemic has caused considerable suffering worldwide, in both lives
and livelihoods. According to scenarios developed by Company and
McKinsey &
Oxford Economics, global GDP could contract by 3.5 to 8.1 percent in 2020. In
the pandemic and the lockdowns implemented in an effort to contain it have reduced demand and India,
could
bring about the most severe decline in GDP in about four
decades. At the time of writing, the McKinsey–Oxford Economics scenarios suggest that India’s GDP
could contract. between 3 and 9 percent in the current year, depending on the effectiveness of virus
containment and economic policy responses. Uncertainty remains high on both dimensions, and
therefore on the depth and duration of the health and economic costs for India. The initial 10-week
lockdown saw the economy operate at about half of full capacity, by our estimates, with significant
strain on micro, small, and medium-size (MSMEs) businesses and large corporates. Our estimates
suggest that the financial strain on households, MSMEs, and corporates, if unmitigated, would increase
the level of nonperforming assets by seven to 14 percentage points in fiscal year 2021 (mitigatory steps
taken by the Reserve Bank of India and the government could moderate the effect on nonperforming
assets). Unemployment rose to an all-time high of over 20 percent in the first two months of the first
quarter of fiscal year 2021, although it fell significantly
to about 10 percent in the third month.
The government responded with a package of liquidity and fiscal measures to stabilise the
economy in the short term, to support low-income households, farmers, MSMEs, and
the financial system. These reforms may have a potential fiscal deficit impact of about
1.5 percent in fiscal year 2021. Coupled with contracting GDP and reduction in
government revenue, this could lead to an incremental central fiscal deficit of about
four percentage points over the budgeted 3.5 percent of GDP, with possible medium-
term implications on
government borrowing as well.

The government also announced several long-pending structural reforms that go some way to
addressing issues we raise in this report. These included allowing farmers to sell
produce more freely in the agricultural sector; starting the process of privatising power
distribution companies in states and union territories; and providing more robust and
portable benefits to migrant workers. India’s state governments have been given some
incentive to push these reforms further, by linking additional borrowings to progress
on the reform agenda. If the detailed policies required in each of these areas are
designed and implemented well, these reforms have the potential to help India
recover to pre- COVID-19 levels and provide real growth impetus in 2023 and beyond,
although at the time of writing, most execution details were still awaited.
Six areas of targeted reform are critical to unlock opportunities

To seize the chances offered by the frontier business opportunities—and to help

increase the productivity and competitiveness of India’s firms—we outline
reform options on six key themes to boost productivity and job growth
and in general make doing business easier. These reforms would also
continue the push to formalise the economy and make it more inclusive.
Exhibit E8 lists reforms critical for major sectors and frontier business opportunities. In
a number of cases, the government in its reaction to the COVID-19 pandemic has
already begun to introduce some of the measures. However, much more needs to be
done across all six themes in order to achieve the
$2.5 trillion in economic value and the decade of high GDP and productivity growth we
envision. The measures are not exhaustive, but focus on the main policies that will
move the needle most significantly.

1. Introduce sector‐specific policies to raise productivity in manufacturing, real estate, agriculture

and food
processing, retail, and healthcare
 Specific measures in key sectors can boost India’s competitiveness and raise investment in
product markets. In all, we estimate that these sectors—manufacturing, construction,
labour- intensive services, knowledge- intensive services, utilities and mining, and
agriculture—could contribute $6.3 trillion in GDP in 2030,
compared to $2.7 trillion in 2020.

Manufacturing.

The manufacturing sector has the potential to generate $1.25 trillio

n for
in GDP in 2030, more than double the $500 billion it accounted for in 2020. A key step forward
India to
build out the global manufacturing hubs described earlier
will be a holistic policy framework that takes into account each sector’s needs
and priorities. This can have three components. First, a stable and declining tariff regime, with
removal of inverted duty structures. For example, high-tech firms and others can import certain
items at customs duties of 10
 percent or less, whereas raw materials including seamless alloy steel tubes, pipes, and carbon
steel all carry a 15 percent customs duty.53 Second could be building well-functioning,
port-proximate manufacturing clusters, with free-trade warehousing zones, faster
approval processes, and more flexible labour laws, as China has done in its free-trade
zones. A final element is select sets of incentives, which are targeted, time- bound, and
conditional and reduce the cost disadvantage India faces
in comparison with other outperforming emerging economies. For example, handset production
is between 10 and 20 percent more expensive in India than in Vietnam or China, which
have benefited from cheaper components due to a strong manufacturing ecosystem
and better infrastructure.54 These incentives, potentially including tax concessions as
well as incentives for capital investment and innovation, could be granted on
achievement of certain output and investment-linked targets to help close the gap in
key sectors, including electronics, auto, chemicals, pharmaceuticals, and food
processing. To take one possible example, that of chemicals, incentives might be
provided for capital expenditure, for example, for plant and machinery for integrated
chemical parks, or tax concessions for environmental protection facilities,
and incentives for innovation.

Real estate.

The construction sector has the potential to more than double its GDP to $550 billion, from $250 billion
in 2020. Productive and resilient cities, which we identify as an aspiration for India, will require
significant changes in the real estate sector. The ratio of home price to income is on average 4.3 in the
eight largest cities in India, compared to less than 1.5 in a set of OECD countries.55 The higher price of
land in India is a large contributing factor and land market reforms, which we discuss below, would
have a substantial impact; other sector-specific measures could also help boost the real estate sector.
Home- ownership could be incentivised by rationalising stamp duties and registration fees to reduce
costs to buyers and offering greater tax incentives, potentially including US-style tax deductions for
mortgages up to a certain level. Regulatory amendments in tenancy and rent control policies could
bring additional investment into the construction of rental stock. Large-scale affordable housing
projects could enable modern construction methods that can increase productivity and reduce costs.
Creating a level playing field with respect to goods and services tax for prefabricated and regular
buildings would also help. Finally, time and cost delays can be brought down substantially by
introducing a digitally enabled, single-window clearance for large
affordable housing projects.
Agriculture and food processing.

India’s potential to generate up to $95 billion in high-value agricultural exports will require a number
of domestic reforms. This export growth could be driven predominantly by livestock and fisheries,
pulses like soybean, spices, fruits, and vegetables, horticulture, dairy, and other agricultural produce. It
could raise agricultural productivity and farmers’ incomes. Possible options include changing the
Agricultural Produce Marketing Committee (APMC) Act to ensure barrier-free interstate trade and
amending the Essential Commodities Act (ECA) to deregulate the supply and distribution of agricultural
commodities. Such steps would, in turn, enable private entities to set up their own markets, attract
investment in infrastructure, and offer farmers competitive remuneration. These reforms have been
announced by the government as part of its COVID-19 package, but they will need to be supported by
specific policies and implemented at the state level. Furthermore, reforms to the system of minimum
support prices could also potentially bring down the cost of commodities and help farmers develop a
more accurate sense of market pricing; farmers
 could in return receive direct subsidies or other forms of support. The goods and services tax
structure could also be reformed to encourage more value-added activities. Commodities
currently are not taxed, unlike
processed foods, which incur a tax of up to 18 percent.

Retail trade.

Achieving the potential $125 billion in economic value by 2030

that we have identified will require a fundamental transformation of the retail
landscape, with traditional models that account for more than 85 percent of sales
volume giving way to a much larger share of e-commerce and modern trade.
Improving supply chains, ensuring procurement scale, and enabling omnichannel and
online-to-offline channels could also boost productivity. To achieve this shift, India will
need a level playing field across trade formats, which would imply minimal regulatory
intervention and a competitive environment with improved ease of doing business.
One possible measure would be to adopt a foreign direct investment policy that is
agnostic to both business models and products.
— Healthcare. India’s potential to increase access to quality healthcare and
attract medical tourism will require ramped-up spending and investment from the
public sector; more than half of households in urban areas and about two in five
households in rural areas currently depend on private- sector healthcare.57
India currently spends about
3.5 percent of GDP on healthcare, below the level in China (5.2 percent)
and Brazil (9.5 percent); in OECD countries, the average is just below 9 percent. We
estimate that India could nearly double healthcare spending to 6.4 percent of GDP by
leveraging public- private-partnership models and doubling public investment from
about 28 percent to 56 percent. India could also increase healthcare productivity by
enabling new business models, including telemedicine, that make more effective use
of human resources along the healthcare value chain. To attract medical tourists, India
will need to simplify and rationalise processes, such as visa approvals and access to
medical professionals through a digital portal, innovative services, and medical
packages.

Unlock land supply to reduce the cost of residential and industrial land use, spurring demand
for construction labour and building materials, and making industry more competitive
As noted in the real estate section above, buying a home is financially out of reach for many
Indians, especially those in the bottom two income segments. The high cost of land is a
key reason. For companies, too, high-cost land is a brake on expanding productive
capacity. We estimate that, by enacting several key reforms, India has the potential to
reduce land costs by 20 to 25 percent and increase the supply of land
available for construction.

Steps towards achieving this could include mapping out 20 to 25 percent of public and state-
owned enterprises’ land that is suitable for construction and currently underused.
Large amounts of land are available with defence, railways, port trusts, and airports. A
portion of this land could be leased out at affordable prices to private developers.
Other countries have already tried this; for example, Turkey released 16,000 hectares of
land for affordable housing at marginal prices between 2003 and 2013.60 Floor space
index zoning regulations could also be reformed to reflect variations in accessibility via
public transit or the distance from central business districts. Informal settlements and
unregistered land could be formalised, including by speeding up the digitisation of
land records, cadastral maps, and surveys, deploying modern technologies including
differential GPS and drones. Finally, the process of land acquisition for industrial use
could be significantly eased. Some states have implemented measures like
land pooling, enhancing the state land bank for industrial use, and introducing legislative
amendments to ease the acquisition of land by the private sector, subject to high- level
clearance.61 To ease conversion of land from agricultural to industrial use, Karnataka
has implemented a simplified online, single-window system that requires fewer document
submissions for land use conversion for industrial purposes. Approval is automatic
after 30 days if no response has been received.

Create flexible labour markets with stronger social safety nets and more portable benefits to help
the labour force become more mobile across occupations, sectors, and locations.
More vibrant manufacturing and a more vibrant economy in general will require more flexible
labour markets. India continues to place labour restrictions on manufacturing
companies. The limits encourage small firms to remain small, imposing high
compliance costs as firms cross a low threshold of employment. India has about 250
national and state labour laws. Per-worker costs for firms increase by 35 percent after
the tenth worker due to additional regulations. Given the scale of the employment
challenge over the next decade, the government could consider reviewing the various
laws on the books and examine options to improve labour market flexibility. Barriers
to labour flexibility could be removed by providing more freedom to manufacturing
companies to shape the size, composition, and skills of the workforce, in line with
evolving needs. For example, the requirement that firms obtain government
permission for layoffs, retrenchments, and closures was introduced in 1976

World Health Organization Global Health Expenditure database; “Health expenditure and
financing: Health expenditure indicators”, Organisation for Economic Co-operation and
Development (OECD) Health Statistics database.
Reduce commercial and industrial (C&I) power tariffs by 20 to 25 percent through new
business models in power distribution

To create the high-efficiency power distribution models we identified as being among India’s
frontier opportunities will likely require structural reforms to the power system. Power
tariffs are 20 to 40 percent higher than in peer economies. Measured against 20 other
economies, both emerging and developed, India is the only country with higher tariffs
for industrial consumers than residential on. Moreover, as a result of low collection
efficiency, theft, and poor billing practices, India’s aggregate technical and commercial
losses are high on average at about 19 percent, compared to 10 percent in best-in-class
players.
Various reform measures could help reduce C&I power tariffs by 20 to 25 percent. These
include a shift to franchising models or privatisation of power distribution companies in
the top 100 cities; the introduction of cost-reflective tariffs for C&I customers and
direct benefit transfers for subsidies, which can bring down cross-subsidies; and a
focus on smart meter penetration. While some of these reforms have been announced
 by the government as part of its COVID-19 package, they may need to be supported by
specific policies and implemented at the state level. In addition, India could consider
separating carriage and content operations, which would introduce competition and
improve efficiency.

Monetise government‐owned assets and increase efficiency through privatisation of more than 30
state‐
owned enterprises (SOEs)
A sharp uptick in productivity will be the common denominator of growth-boosting reforms. Achieving that
will require changes to state-owned enterprises, whose productivity for the most part lags behind that of
private-sector firms. Large-scale privatisation could give a needed boost to key sectors, more than doubling
or tripling productivity, and potentially contribute between 0.2 and 0.4 percentage points annually on
average to incremental GDP, as per our estimate. For this to happen, privatisation would need to be
 accompanied by an appropriate institutional framework and effective competition. This has
been found to be critical in bringing about improvements in company performance
because it is associated with lower costs, lower prices, and higher operating efficiency.
Privatisation proceeds would contribute to government coffers. In all, India has
about 1,900 state-owned enterprises. We analysed companies for which data are
available, some 577 of the 1,900 total. These had a total book value of about 20 lakh crore
rupees (about $290 billion) in 2018.69 We estimate that about 400 of
these SOEs could be privatised. That figure excludes SOEs
in strategic sectors, such as nuclear energy, and in sectors in which the assets of state-
owned enterprises are worth more than their equity, such as power transmission
companies, in which the government may want to maintain control through a majority
stake and realise value via an asset monetisation programme. For the 400 or so SOEs
that could be privatised, the government’s share of the book value was $140 billion in
2018, and potential privatisation proceeds could be $540 billion between 2020 and 2030.
Privatisation could be carried out through a combination of public equity issuance or
shares sale on the stock market, divestiture to a strategic investor, or employee
participation in equity, with the purpose of reducing the government stake below 50
percent. Large gains would be possible even if a relatively small number of
privatisations were carried out: we estimate that just 2 percent of all SOEs could yield as
much as 80 percent of all potential proceeds from privatisation. In addition, assets
owned by the government, including roads, railways, ports, airports, power
infrastructure (for example, transmission grids), and telecom towers could be monetised.

Improve the ease and reduce the cost of doing business at the state and city level

India has made significant progress in the World Bank rankings for ease of doing business. The
country rose from 130th overall in 2016 to 63rd in 2020 and earned a citation as one of the
ten economies that had made the most improvement across three or more dimensions.
However, Indian companies large and small still face obstacles in doing business that
crimp their effectiveness and limit their productivity. These range from payments for
public procurement that are sometimes significantly delayed; limited efficiency in
export- import processes and compliances that make exporting twice as long a process
as in some other emerging economies; duplication of compliances from both central
and state authorities across processes; tedious and slow processes to obtain
construction permits; a lack of judicial capacity to enforce contracts; time- consuming
compliance stipulations for tax payments that can require 250 hours or more;
understaffed patent offices that mean the average time for granting patents is 64
months, almost triple the time in China, Europe, and the United States; and a low
recovery rate for insolvencies.
A number of the issues and obstacles that companies face could be resolved if the government
adopted global best practices in relevant areas. For
 example, to accelerate the granting of patents would require more
staff, but also more adept use of technology to improve process
efficiency. To simplify and expedite tax payments, the existing electronic
filing system could be extended, creating a one-stop shop for a range of taxes. China,
for example, has included stamp duties and other taxes in its e-filing system. To enable
prompt, on-time payments, South Korea has created an e-procurement system to
ensure transparency in the contracting and payment processes. Some countries have
set up a single portal for business licences by integrating company registries, tax
administration, and social welfare departments. An “e-governance for business”
mission at the state government level would be required to improve the ease of doing
business at the local level across a large number of cities and towns within each state.
i
The inverse relation between bond prices and interest rate is explained by following example: Suppose a Bond
price is Rs. 100 with 10 percent interest rate for five-years of maturity at September 2025. In 2021 the bond prices
fall to Rs 50. The fixed interest of Rs 10 as a percentage of bond prices is 20 percent! So as bond prices halved, the
interest rate doubled.